Securitization's Role in the Financial Crisis: Part 3

Editor's note: This is Part 3 of a special series. Here are Part 1 and Part 2

NEW YORK (TheStreet) -- OK, if you are still with me, thank you. I want to add a little more complexity and talk about the growth of "mezzanine" and "resecuritization."

You may recall our discussion about the basic senior senior/subordinated structure of 85% senior/15% subordinated. Given that we have a ratings agency methodology for determining the risk profile for a desired rating, can we further tranche the 15% piece? The answer is, sure, the methodology is in place.

Maybe if we want a triple-B rating we don't have to be quite as stringent as six times the normal historical loss rate. Maybe we only need to use four times that rate. As long as there is 10% subordination or credit enhancement, we can achieve a triple-B rating. Maybe the requirement for a single-A rating is five times the historical loss rate. So now we have a four-tranche deal: triple-A for the top 85%, single-A for 12.5% to 15%, triple-B for 10%-12.5% and equity for 0-10% of losses.

If you remember the option market analogy, where the senior tranches are being short a put on the portfolio and the equity is being long a call on the portfolio, how should we think of these two mezzanine tranches? That's a very good question.

These pieces are knock-in levered loss pieces. Once the equity gets eaten away, they become the first-loss pieces. Here, a 2.5% loss to the portfolio now becomes a 100% loss to the triple-B piece. All is fine as long as there is some subordination, but once that gets eaten through, these pieces take great pain. Probability of default is determined, but loss given default is huge. These are kind of like a straddle or strangle with respect to loss rates. As long as losses are between "X" and "Y," you are OK. But if they go outside those boundaries, you would have been better off in the seniors or in the true equity. From an options standpoint, these are much tougher to price given their sensitivity.

I can make an analogy here to corporate bonds and stocks as well. At the bottom of the capital structure of a corporation you have common stock, then you have preferred stock, then subordinated debt, then senior debt and lastly senior secured debt. So the tranching process we have been discussing has legitimate parallels.

But the difference with mortgage pools is that if we tweak an assumption, there is a dramatic effect. With a company, the outcome is pretty binary: it either survives or it defaults, so one doesn't tend to think of the leverage embedded in each of these securities. With a mortgage pool, there are many outcomes that can occur, all of which are magnified by the leverage in the tranche.