Here is an interactive showing the steps the mortgages took from beginning to end; it also has pictures and tells who gets paid. http://www.washingtonpost.com/wp-srv/business/interactives/frenzy/
In case the link doesn't work for some:
1. Wall Street loaned money to lenders to make mortgages. Wall Street then bought the pools of mortgages.
2. Wall Street then used the payments from the pools to create mortgage-backed securities, which were rated into tiers of risk. Top tiers were less risky, were protected from losses by the bottom tier and were paid a lower interest rate. The bottom tiers paid the highest return and absorbed the risk if the homeowner defaulted.
3. Fannie and Freddie bought many of the top tier (AAA), Wall Street bought many of the BBBs and used them to create trusts to issue CDOs (collateralized debt obligations). The top tier was again rated AAA due to protection by the lower tiers and is often protected by credit default swaps. This insured tier is called "super senior AAA".
4. When buyers stopped showing interest in BBBs, some Wall Street firms repackaged them once again (see a pattern here?)
5. These lower-level bonds went into a next generation CDO, called a CDO squared. They were once again rated, with the top layer being protected from losses until all the bottom layers are wiped out.
6. As defaults rose, the mortgage securities in the original pools experienced shortfalls in cash greater than the ratings firms had projected. The ratings firms then began downgrading the mortgage pools. The interest shortfalls and downgrades triggered provisions in CDO contracts that declared them in default.
7. As ratings fell to C (considered to be junk), CDO prices plummeted and buyers disappeared. Some firms that sold insurance (credit default swaps) didn't have enough cash to cover the claims. Banks that held big stakes in CDOs had to take huge losses.
In case the link doesn't work for some:
1. Wall Street loaned money to lenders to make mortgages. Wall Street then bought the pools of mortgages.
2. Wall Street then used the payments from the pools to create mortgage-backed securities, which were rated into tiers of risk. Top tiers were less risky, were protected from losses by the bottom tier and were paid a lower interest rate. The bottom tiers paid the highest return and absorbed the risk if the homeowner defaulted.
3. Fannie and Freddie bought many of the top tier (AAA), Wall Street bought many of the BBBs and used them to create trusts to issue CDOs (collateralized debt obligations). The top tier was again rated AAA due to protection by the lower tiers and is often protected by credit default swaps. This insured tier is called "super senior AAA".
4. When buyers stopped showing interest in BBBs, some Wall Street firms repackaged them once again (see a pattern here?)
5. These lower-level bonds went into a next generation CDO, called a CDO squared. They were once again rated, with the top layer being protected from losses until all the bottom layers are wiped out.
6. As defaults rose, the mortgage securities in the original pools experienced shortfalls in cash greater than the ratings firms had projected. The ratings firms then began downgrading the mortgage pools. The interest shortfalls and downgrades triggered provisions in CDO contracts that declared them in default.
7. As ratings fell to C (considered to be junk), CDO prices plummeted and buyers disappeared. Some firms that sold insurance (credit default swaps) didn't have enough cash to cover the claims. Banks that held big stakes in CDOs had to take huge losses.