What Caused the Housing Bust (3)

RMBS securities were organized into risk levels


Wall Street's biggest banks (Goldman Sachs, Lehman Bros., Bear Stearns) would buy, say, $500 million worth of low-quality mortgages, underwritten by a mortgage broker, like NovaStar Financial.

The individual mortgages – thousands of them at a time – were organized by type and geographic location into a new security, called a residential mortgage-backed security (RMBS).

Unlike a regular bond, whose coupon is paid by a single corporation and organized by maturity date, RMBS securities were organized into risk levels, or "tranches."

Thousands of homeowners paid the interest and principal for each tranche.


Rating agencies (like Moody's) and other financial analysts, believed these large bundles of mortgages would be safer to own because

i) the obligation was spread among thousands of separate borrowers and

ii)organized into different risk categories that, in theory, would protect the buyers.

For example, the broker (like NovaStar) that originated the mortgages would be on the hook for any early defaults, which typically only occurred in fraudulently written mortgages.

After that risk padding, the next 3%-5% of the defaults would be taken out of the "equity slice" of the RMBS.



By Porter Stansberry