1.A security is created from the cash flows of subprime mortgages. This portfolio of subprime mortgages is sold by the originators of the mortgage assets to a Special Purpose Vehicle (SPV) and the cash flows of the mortgages are allocated to tranches. The way the security works is illustrated in Figure 1 along with the three tranches. The tranches are the senior tranche, the mezzanine tranche, and the equity tranche. The mortgage portfolio has a principal of $100 million. This is divided as follows: $65 million to the senior tranche, $25 million to the mezzanine tranche, and $10 million to the equity tranche. Cash flows are allocated to tranches by specifying what is known as the waterfall model. An approximation to the way the waterfall model works is in Figure 2. The securitization is carried further with a CDO being created from the mezzanine tranche of the subprime MBS as illustrated in Figure 3.

Figure 1: Creation of a mortgage backed security from a portfolio of subprime mortgages

Senior Tranche Principal: $65 million Return = 6% Asset 1 Asset 2 Asset 3 Mezzanine Tranche SPV Principal: $25 million Return = 10% Asset n Principal: $100 million Equity Tranche Principal: $10 million Return =30%