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  • Print publication year: 2009
  • Online publication date: December 2009

4 - A basic funding tool – the tranched mortgage-backed security

Summary

This chapter and the two that follow look at the new arrangements for the funding of consumer and corporate credit that supported the recent global credit boom. As Figure 2.2 illustrates, these were rather complicated. But they are not impossible to understand. The right place to start is with the basic building block, the relatively simple financial product known as the tranched mortgage-backed security. This ‘tranching’, derived from the French word tranche, meaning ‘slice’, is used to protect the holders of so-called senior securities at the top of the structure, giving them the first claim on the interest and principal payments of the underlying loans. Most of the more complex and more dubious arrangements that broke down during the crisis were built upon this simple, secured financing instrument.

The mortgage-backed security (MBS) has become a very widely used financial instrument around the globe. Banks in different countries, not just in the United States, have used them to finance their lending. For example, in the United Kingdom, according to the interim report of Sir James Crosby commissioned by the Treasury (Mortgage Finance (HM Treasury, 2008) http://www.hm-treasury.gov.uk/fin_mort_crosby.htm), the issue of mortgage-backed securities provided some two thirds of the funds for new mortgage lending in 2006, the peak of the UK mortgage boom.

Mortgage-backed securities are similar to the bonds issued by larger companies. Like those bonds they offer a fixed regular ‘coupon’ payment and then, eventually, a repayment of the original investment, known as the ‘principal’.