The previous chapter described the tranched mortgage-backed security or MBS, like its close cousin the asset-backed security or ABS, a simple and effective product. The purpose of tranching these structures is to create a hierarchy of securities, from most senior to most junior tranches, whose repayment is based on the underlying loans. This concentrates risk in the lower junior and mezzanine tranches, thus allowing the senior AAA tranches to be for all intents and purposes free of the possibility of default. Tranched MBS and ABS deals do this job very well, creating as much as $70 or $80 of default-risk-free debt from $100 of underlying loans.

In this respect the AAA tranches of MBSs and ABSs are very similar to covered bonds, the bank-issued bonds such as the Pfandebriefe widely issued and held in Germany, which are secured or ‘covered’ by bank loans, but MBSs and ABSs have been preferred by banks in many other countries because of their simplicity and flexibility.

Simple tranched securities of this kind have been around since the 1980s. They were really rather boring, a basic tool for commercial banks to raise low-cost funds. But as traders and investors became familiar with these products, investment banks saw an opportunity to do something more exciting and more profitable. Their innovation was to use the same tranching techniques to make a short-term transaction profit. These profits depended on selling the tranched securities. They found that they could make more profit by creating much more complex products and by extending the range of credit exposures that could be securitized (the so-called ‘hunt for yield’).