Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low. In normal times, the correlation between residential mortgage defaults is low, because people default only because of personal circumstances such as ill health or because they lose their jobs (for cause, rather than as part of a general layoff). No one really
Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low. In normal times, the correlation between residential mortgage defaults is low, because people default only because of personal circumstances such as ill health or because they lose their jobs (for cause, rather than as part of a general layoff). No one really knew what that correlation would be in bad times, when many people might lose jobs because of the poor economy and house prices might fall across the country, making refinancing hard. If the correlation was still low, then the ratings were appropriate. If the correlation was high, then all bets were off— if, for example, the correlation was 1, then the senior securities would default as often as the junior securities, that is 10 percent of the time. The AAA-rated tranches of mortgage-backed securities looked very attractive because they offered a higher return than similarly rated corporate securities. But some should have paid a far higher return because they were in fact very risky. Default correlations were much higher than the rating agencies or investors anticipated. First, the quality of the originated mortgages was low, and many borrowers relied on refinancing as house prices ...
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mortgage securitization bundling and tranching can convert risky mortgages into truly AAA investment. but:* loans were crappy and risk of default more like 90% than 10%* models used historical data (when lending was more responsible)* mortgages usually default due to independent personal financial trouble rather than trend across the whole country* mortgages were bundled without nearly enough diversification and they failed in unison, defaults within single bundle were nowhere near independent of one another
