“Investors may be forced to settle contracts covering the mortgage giants’ $1.6 trillion in outstanding debt because the government seizure constitutes a credit event that triggers the payment or delivery of their bonds.”
Uhm... Unintended (or intended) consequences?
Still all the same money despite the “tranches”.
Here’s an example of how it works:
Tranch A gets 80%
Tranch B gets 10% if there’s anything left after Tranch A.
Tranch C gets 4% if there’s anything left after Tranch B.
Tranch D gets 1% if there’s anything left after Tranch C.
So let’s take a hypothetical $1 million dollar home.
If the buyer defaults and the foreclosed house sells for 90% of the lending price, both Tranches A and B get paid. Tranches C and D get hosed.
If the foreclosed house sells for 80% or less, all Tranches but A get hosed.
But buyers who bought Tranches B, C, and D payed relatively little given ungodly risk that they took in buying in these tranches in the first place.
I. M. Prudent (IMP) is a low-income homeowner who bought a $110K home with a zero-down mortgage from Sleazy Banker who bundled and sold a derivative tranched as you suggested. IMP defaults and walks away having paid off $10K. The Fed Bailout Bullies (FBB) purchase the remaining debt ($100K) for $25K. The holder of Tranch A gets it all, with a $5K loss and the holders of Tranches B-D get nothing. Everybody updates their balance sheets. The sheets aren't pretty but the 'toxic paper' is resolved.
Now FBB need to either sell the property for (hopefully) more than $25K or end up eating management/security costs until they can. Some of these sell reasonably quickly and FBB recovers their costs and maybe makes a small profit. Others are in depressed areas and are vacant for a long time. Vandals break in and strip out all the copper from IMP's former house. It then becomes a crack house. Finally, FBB decides to cut their losses and bulldoze the house, sell the land for $10K and have lost $50K in other costs for a net loss.
Is this a reasonable way to view the situation?