The “special investment vehicles” or conduits
The ” special investment vehicles ” or conduits are structures securitization.
These are special, unregulated structures in which pools of credits are bought from their initiators by investment banks. Credits are often in the form of RMBS
Securitization will be on several stages, with the issuance of tranches of securities which are subject to subordination creating a cascade of tranches. Income is assigned to the payment of the tranches in reverse order of rank, each tranche corresponding to a graduated risk profile.
Tranches are rated, with AAA, AA, A, BBB, BB and equity ratings
Buyers of CDOs are insurance companies, hedge funds, banks and fund managers.
In 2007, insurance companies held 295 billion CDOs, hedge funds 1,396 billion, banks 746 billion and fund managers 564 billion.
The more the securities move away from the initial credits, the more illiquid the products, with increasingly non-linear risks. The assumptions of the banks and rating agencies, which had an interest in selling as many securities as possible and therefore giving them high ratings, were based on a very low probability of a fall in property prices.
Given the leverage effect, a reversal in financial conditions affects the subordinate tranches first, but quickly spreads along the cascade of tranches.