The securitization of mortgage loans has come in for some heavy criticism since our financial crisis began. Unfortunately, most of this criticism is way too vague to be very useful. And since our regulators are bent on reviving the securitization market, we need a much better understanding of what went wrong.



So here it is: the top tranches of the mortgage bonds were too big.



There’s a compelling logic to the way subprime mortgages were securitized. Bundling thousands of mortgages into a common pool should produce a reliable stream of income because exposure to unlikely events on the downside and upside should be limited. Geographic diversity limits exposure to housing market bubbles. Dividing the bonds into tranches allows investors to choose their level of risk and yield. Mixing mortgages with low prepayment risk and those with low default risk can further ameliorate interest rate risk. These innovations are good but only if they are done right.



The tranched nature of mortgage backed securities confuses a lot of people. How can some tranches have more risk than others? Importantly, the risk of default on the underlying mortgages is the same for entire pool. But that’s not the risk a buyer of a MBS needs to worry about. Instead, a buyer worries about the risk to his income stream, which depends on tranching. The senior tranches only absorbed losses after the lower tranches. In effect, the senior tranches were built on the leverage of the lower tranches, who received higher yields in exchange for greater risk.



What went wrong is rooted in investor demand for safety over yield. The senior tranches were far more popular than the subordinate tranches. There are lots of explanations for this but legislative prohibitions on certain institutional investors owning non-triple A rated investment played a large role. This put pressure on investment banks—who then pressured ratings agencies to go a long with the scheme—to enlarge the size of the senior tranches. And when the senior tranches grew too big, they were actually becoming far riskier than many understood.



To understand how the width of the senior tranche creates risk it helps to start with a very simple mental experiment. Imagine a situation where 90 percent of mortgages in a pool default. Now if there were a super-senior tranche consisting of only 10 percent of the total investment in the pool, that money would be safe. But as the senior tranche grows, its exposure to losses increases.



Historical data about mortgage defaults and prepayment risk from before 2002 seemed to justify wide senior tranches. Unfortunately, mortgage lending after 2002 had deviated from historical norms, which turned out to make historical data misleading. This meant that the senior tranches were too broad, they included a greater percentage of investments in the overall mortgage pool than turned out to be justified by the risk.



In short, it wasn’t the complexity of MBSs or CDOs that led to their meltdown. It was the fact that demand for safety of senior tranches was so strong—and historical data from before 2002 misleading—that the pools were widened beyond warrant.