How the sausage got made

The Federal Reserve Bank of New York’s Tobias Adrian and Hyun Song Shin have published a new report – “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-09” – in which there is a very clear explanation of the intermediary steps taken by market actors in creating many of the toxic mortgage securities that so palsied the financial system. The excerpt is below, but I’d encourage you to read the whole report, which is surprisingly accessible for a Fed Staff Report.

“In this illustration, mortgages are originated by financial institutions such as banks who sell individual mortgages into a mortgage pool such as a conduit. The mortgage pool is a passive firm (sometimes called a warehouse) whose only role is to hold mortgage assets. The mortgage is then packaged into another pool of mortgages to form mortgage-backed securities (MBSs), which are liabilities issued against the mortgage assets. The MBSs might then be owned by an asset-backed security (ABS) issuer who pools and tranches them into another layer of claims, such as collateralized debt obligations (CDOs). Then, a securities firm (e.g., a Wall Street investment bank) might hold CDOs on their own books for their yield, but finance such assets by collateralized borrowing through repurchase agreements (repos) with a larger commercial bank. In turn, the commercial bank would fund its lending to the securities firm by issuing short-term liabilities, such as financial commercial paper. Money market mutual funds would be natural buyers of such short-term paper, and, ultimately, the money market fund would complete the circle as household savers would own shares of these funds.”