It starts with mortgage. Many Americans borrowed money to buy their own house. After the crash of the dotcom bubble in 2000s many countries including US were facing economic recession. To spur growth, they lowered interest rates. Everybody were lending much money to buy house because it is cheap (low interest rate), making real estate property sky rocketed during this period.

The lenders (example: Washington Mutual) did not have to worry very much about the risk of default, because they created a bond from bundling these mortgages called Mortgage-Backed Securities (MBS), which they then sold to hedge fund, pension funds, and other financial institution (example: Fannie Mae, Freddie Mac, Lehman Brothers). This is a called securitization – conversion of mortgages or loans into bonds. The idea was to reduce risk exposure and raising new fund. The man behind securitization was an Investment Banker of ‘Salomon Brothers’ - Lewis S. Ranieri. In 1980s Salomon launched MBS.

It is hard to sell MBS because of it’s high risk. So they slice the MBS into smaller bond called ‘tranches’ with various risk level from high risk, middle risk, and low risk. Of course higher risk will have higher returns, but if something went wrong, it will be lost first. Salomon used a special purpose vehicle known as Collateralized Mortgage Obligation (CMO). Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it. Monthly instalment from mortgage was used to pay the interest on these bonds. Lender can also minimize risk by insuring the mortgage to other companies like AIG.

When the Fed raise it’s rate until 5.25% in June 2006, people will pay more for monthly instalment. The rate stays there for a long time, making many people unable to pay the instalment. When these people fail, they will also drag financial institution into trouble. That’s why we have seen many troubled institution like Washington Mutual, Fannie Mae, Freddie Mac, and Lehman Brothers. Every institution buying these MBS and it’s derivative around the world will get into trouble.