Subprime financing. Nuts and Bolts

By Kristin Goff

The Ottawa Citizen

Oct 13, 2007

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The idea of creating securities backed by pools of mortgage debt has been around for a couple of decades, at least.

But what used to be a fairly straightforward process has a lot more complex bells and whistles that can be incorporated into the process now.

Wall Street wizards have cooked up an alphabet soup of variations on the simple idea of mortgage "securitization," which is basically aimed at turning an asset that can't be easily traded, into one which can be.

Here's a look at some financial products related to mortgages.

ABS: Asset backed securities are bonds or notes backed by pools of financial assets, typically with predictable income flows. When mortgages are used, they are often called mortgage-backed securities (MBS).

ABCP: Asset backed commercial paper takes things a step further. A company or legally created "conduit" acquires long-term mortgage debt as an asset. It then uses that to underwrite its issuance of short-term commercial paper. It can reap a profit on the difference in long and short-term rates, but it's a financial high wire act because the short term commercial paper needs to be refinanced frequently.

CDO: Collateralized debt obligation is a security backed by a pool of mortgages which are sliced into several portions, called tranches which represent different levels of risk. Each is also assigned a pecking order for writing off bad loans in the CDO. The tranche with the highest risk loans also take the hit on writeoffs first. If it survives, it also gets the highest interest rate payments.

Synthetic CDOs: These are derivatives created by some hedge funds which can track mortgage-backed CDOS. Synthetic CDOs were one way hedge funds increased their exposure, and potential gains and losses, to the mortgage-backed investments.