THE SHERMAN LAW FIRM
Each mortgage backed security (MBS) included different tiers, called “tranches”, which permitted investors to select from a series of different risk-return profiles within the MBS.
The top tier of a MBS, called the senior tranche, was the safest investment in a mortgage-backed-security and carried the lowest yield. By giving up yield, investors in senior tranches of mortgage-backed-securities had the first claims on the cash-flows generated by monthly payments on underlying mortgages. Even though the senior tranche of a MBS often held only subprime mortgages, S&P, Moody’s and Fitch almost always rated the senior tranche as “investment grade.”
Investment banks turned low quality mortgages into investment grade securities by over-collateralizing the senior tranches of MBS's. In other words, Wall Street stuffed senior tranches full of enough extra subprime mortgages to allegedly give investors a sufficient cushion of extra cash-flow to protect investors against the possibility that some subprime borrowers might default. That explanation - along with the high fees Bear Stearns, Merrill Lynch, Lehman and others paid to S&P, Moody’s and Fitch for rating the securities – was nearly always sufficient to secure the all-important investment grade credit rating.
Because investors had almost no way to tell what was in a MBS, or a CDO filled with many mortgage-backed-securities, the word of the ratings agencies was gold. This is how Wall Street used a little double-talk, and a lot of cash, to get their subprime junk an investment grade rating.
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