Securitization is the combining of many individual loans into one security. If you had one semester of Latin, you would have been able to guess this. Provided you still remembered any of it. What you would not have been able to guess is how idiots, unethical people, greedy bankers and government bureaucrats asleep at the switch were able to so screw up something that should have been simple.
Specifically, what happens in a securitization of mortgages is that is a broker-like individual divides all of the mortgages under a given system (like Fannie, Freddie or others) and creates 5 buckets into which loans will live. Call them bucket A, B, C, D, and F (just like your report card). Loans in buckets A are almost certain to be paid off. This would be the guy who has a net worth of $10 million, $350,000 loans, a great credit score, great income, and a union job guarantee. The rest of the grades decline from there all the way to F, where an F is someone who is in default (has missed a payment), or has thirty or more “tardies.”
Just as there are buyers of loans (for example, you buying your house), there are sellers of loans. Think of a lender – your neighbor, the bank, or China.
Someone wanting to buy loans of Grade A has to live with the low interest rate of certainty, i.e., an A level package of mortgages might yield only 5% interest. In a package of grade C, there might be 10 or 15% of the portfolio that is doing this. They may hope they “make it they swear,” but the union’s on strike. A grade C might yield 7 or 8%, maybe more. A package of D or F flavor is true junk and the yield could be 10 or 20%, or 0% if the whole thing evaporates.
The system got into trouble because what people should have sold as a B got marketed well as an A. Then it got repackaged again and again until no one knew anymore what loans they were buying (and didn’t want to care that they were D’s in an A portfolio) because the incentives were so high to “churn” and a greater fool theory came alive. Instead of holding these mortgages to maturity, brokers quickly flipped them so that the bad quality loans became someone else’s problem. The cycle repeated itself and people took out debt (leverage) to buy the yield from these portfolios.
As yields came down globally, the financial attractiveness of being highly leveraged went up dramatically. You could buy a “safe” package of 7% yielding mortgage loans but borrow money at a cost of 4%; if you leveraged yourself 10 times, you could “gross” 70% return on the mortgage at a cost of 40% from the borrowings and net a 30% return, which is usually phenomenal.
Leverage works the other way as well. When the loan package went down in value 30% (because people defaulted), the value of the entire package went quickly to zero. When nervous redeemers went to sell out the individual loans, there were no buyers at any price that was above the 4% threshold, so there was panic and a lot of people got hurt. More than just boo-boos on their pinkies.