Wall Street walked in the door with an amazing deal. Investment bankers should spin speculative-grade credits — whether corporate debt and loans from a buyout deal or mortgages from financially challenged home buyers — into investment-grade credits. By bundling together groups of credits, or pools of loans, corporate debt or mortgages, the investment banks said, you'd lower the risk that an investor would take a hit if any one loan or mortgage went bad.
And then, by cutting up those pools and putting the riskiest deals together in one segment, called a tranche, and the less-risky deals in other tranches, you could insure the less-risky tranches against loss. The riskiest tranches might get wiped out, which is why investors who bought them got a higher yield, but they created a kind of buffer for investors in the less-risky tranches, the investment banks said. Investors in those less-risky tranches wouldn't take a hit until the more risky tranches were wiped out, the banks promised. And it follows, the banks argued, that the less-risky tranches met the standards for investment-grade credit ratings.
Jubak has a more in-depth explanation here.
In other words, a lot of bad investments are starting to come home to roost in a lot of places.
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