Illiquid loans are converted into liquid bonds, which can easily be sold. Many investors are happy to have credit risk in their portfolios for better diversification. But they do not want to manage individual credits, and they also want liquidity in their investments. They therefore appreciate the securitised products. In recent years, however, it has become increasingly common for securitised loans (which have been converted into bonds) to be repackaged into various so-called structured credit instruments. An impressive variety of this type of structured product has arisen in a short period of time. Perhaps the most common form are those known as CDOs, Collateralised Debt Obligations. With a CDO it is possible to put together bonds from many different securitised loan portfolios and even to add other assets if desired. The idea is that the portfolio that has been put together is structured in different parts (tranches) with different credit risks (this is in practice often done by the large international investment banks). When interest income from the underlying assets starts coming in, it is distributed according to the order of priority of the tranches, or their seniority. First, the most senior tranches receive their allocation. After that the income is distributed to the second most senior tranches, and so on. Investing in a junior tranche thus entails greater risk than investing in a senior tranche, but on the other hand the earnings are higher. At the bottom is an equity-like part, which is only paid when all the others have received their share.
The banks’ investment companies had also done so to a great extent. The buyers of the investment companies’ certificates are usually risk averse investors who are choosing between buying short government securities and corporate certificates. When it became clear, or even when there was reason to suspect, that subprime loans were among the investment companies' assets, the demand for certificates fell drastically. Investors instead chose to buy short government securities, which meant that interest rates on these fell. One could say that the investment companies suffered a classic bank run. The parent banks were now forced to fulfil the liquidity guarantees they had made earlier. At the end of July the German bank IKB announced that it had suffered major losses through an investment company that had invested in subprime loans. Some weeks later another German bank, Sachsen Landesbank, experienced similar problems. 1  See also the Committee on the Global Financial System (2006): “Housing Finance in the Global Financial Market”, CGFS papers, No 26. 2  Subprime loans comprised an estimated 13 per cent of the total mortgage stock in the United States in 2006. BIS Review 136/2007  3  The banks then began to hoard liquidity and distrust spread throughout the bank system. Banks that had investment companies did not want to lend money as they might need it themselves to meet their own guarantee obligations. Even banks without investment companies were unwilling to lend money as it was uncertain where in the bank system the credit risk was actually located.