Floyd Norris of the New York Times offers this handy description of the crap that is clogging up Wall Street balance sheets:
First there were mortgages, taken out by homeowners. Then there were mortgage-backed securities. Those securities were sliced into tranches.
Some tranches got first call on the interest and principal payments from the mortgages. Each month, if money was left over, it went to the next level of tranches, and then to the next, and so on down.
If there were enough mortgage defaults, the lowest tranch would be wiped out. More losses would make the next tranch up worthless, and so on.
The next level of complexity is CDOs, or collateralized debt obligations. The CDOs own tranches of mortgage-backed securities.
They issue their own tranches. So-called super-senior tranches – a term coined to indicate they were all but risk-free – rank near the top of a CDO.
I won’t get into synthetic CDOs, which are supposed to act like they own MBS tranches, but don’t. Nor will I get into CDO-squareds, which are CDOs that own tranches of other CDOs.
It is not clear if Merrill owned any of those.
The super-senior tranches were once rated AAA, and perhaps some of them still are. The theory was that even if the underlying mortgages were very risky, the top tranches were protected by the fact that the lower tranches would absorb the first losses.
Similarly, even CDOs that included some poor tranches of MBS would have safe tranches, since not all the dicey MBS tranches would go bad.
Glad we got that straight. The easy way to think about it is that CDOs that once sold for $1.00 are now worth about $0.05 (OK, $0.22, assuming the loans used to buy them are paid off).