This was such an easy to understand explanation, it deserves repeating as it is buried in another thread...might help out a lot when evaluating the current market conditions...and illustrate why a credit "panic" is highly unlikely if there are defaults in R/E. (give credit by all means to the author...)
"Just to give anyone not that knowledgeable about MBS securities, I will give you a VERY BASIC rundown of how they work....
Assume you have a million mortgages that have a rate of 6% (or they all could be an ARM, but they are usually all of similar type)
assume that the principal about is about 1 billion dollars... an example of the way the deal could be structured is:
Class A - 600mil AAA paying 5% (2 year expected term)
Class B - 175mil BBB paying 6% (4 year expected term)
Class C - 125mil B paying 6.5% (6 year expected term)
Class D - 100mil Junk paying 15% (10 year expected term)
Every month a Servicer collects all those monthly mortgage payments (principal and interest), out of that monthly collection, the Servicer will pay a principal and interest payment to Class A and just an interest payment Class B, C and D. If someone did not pay their mortgage payment that month there may not be enough $$$ for everyone, so Class C will be short changed....
This continues until Class A is completely paid off and retired... They then start paying Principal and Interest to the Class B Tranche... Once that is paid off, on to the Class C and finally to the Class D.
So, It is almost a guarantee that the Class A will be paid and full, Class B is very good bet, and Class C is a Good bet to be paid off.
Now Class D will probably not get all their principal back, but they will have been making 15% interest on their money.
The way the size of the tranches, interest rates and term are decided is using historical models or prepayment, defaults and interest rate risk.
Most pension plans and high quality investment vehicles invest in the Class A and maybe the Class B tranches, The "High Yield" funds are the ones investing in the Class C and Class D."