Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Slicing and dicing loans

But surely people would quickly cotton-on that the ‘safe’ package of 100 mortgages wasn’t so safe after all? Well, the financial whizz-kids had one last trick in their book:

Instead of selling the entire package of 100 mortgages, including both ‘good’ loans (those that are repaid) and ‘bad’ loans (those that aren’t), let’s slice them into different levels called tranches; for example, say, five tranches, each one containing 20 mortgages.


If you own the ‘top tranche’, you get paid first – so long as at least 20 people out of the 100 repay their loans, you get paid. After the top tranche owners are paid, the second tranche would be next and so on.

Figure 16-1 shows the 100 mortgages being sliced into five tranches. The tranche owners get paid in order of seniority, making the top tranche the safest, the second tranche less so, the third tranche even less safe and so on. The bottom tranche holders are least likely to get repaid.

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Figure 16-1: Slicing into tranches.

Why would anyone want to hold the lower tranches? Well, they were offered a risk premium to compensate them for the additional risk. In this case, purchasing the loans in the lower tranches costs substantially less than those in the higher tranches. For example, £1 million worth of top tranche loans may cost near enough to £1 million to buy, whereas the same amount of bottom tranche loans may only cost £200,000, the trade-off being that you’re less likely to ever see your money again!

The idea behind the different tranches was that even if, on average, the loans being made were of low quality, it was so unlikely that more than 80 people out of the 100 would fail to repay their mortgages that the top tranche was safe. Like modern-day alchemists, the ‘clever’ people in finance thought that they’d found a way of turning junk (low-quality loans) into pure gold. Before they could start selling this stuff as gold, though, they had to convince everyone else that it was gold.