From “The Crunch”, by Alex Brummer, pages 42-43:
To get an idea of how all this worked in practice, and to understand why it was built on such shaky foundations, take the fictional example of Mr and Mrs Jerome Smith of downtown Cleveland. They are persuaded by Fast Talking Mortgage Brokers Inc. (FTMB) to buy their shabby clapboard property with a $100,000 mortgage. The interest rate of 10 per cent is being waived for the first two years. In fact, interest has not been forgiven but is being rolled up with the original mortgage, increasing the debt to $120,000. FTMB, having taken an arrangement free from the Smiths, then sells on the mortgage to Grasping Investment Bank (GIB) of New York, which pays the broker a commission for the mortgage. GIB wraps up the Smiths’ loan with dozens of other loans to other Smiths from poor neighbourhoods around the country and renames it Smith Mortgage Obligation (SMO), and then pays its favourite credit rating company, Stamped & Correct, to certify the SMO as good quality debt. The attraction of this SMO is its 10 per cent return at a time when government bonds are getting between 2 and 3 per cent.
But rather than selling SMO directly to clients, GIB takes another route. It creates a new company — a special purpose vehicle called GIB Capital — and this borrows from other banks cheaply and uses the money to buy Smith Mortgage Obligation. GIB then offers shares in GIB Capital, now the proud owner of SMO, to clients, who lap up the shares because of the high return.
Grasping Investment Bank benefits from the process in several ways. It has collected profits and commission on the sale of the SMO and also benefits from leverage (borrowing) because it is using someone else’s money. GIB has also cleverly placed the SMO off its balance sheet in the special purpose vehicle, which it does not have to disclose on its accounts as a liability. It can stretch its capital further and will not have the regulator on its back.
Thus not only are mortgages given to people who are likely to find it difficult to pay them, but they are rated on a dubious basis, responsibility for them is diffused amongst several players, proper accounting of the debt is obscured by creating the special purpose vehicle and extra borrowing from banks is used to facilitate the whole process. It seems to me this process was bound to hide the riskiness of the mortgages from the investors.
Note that SMO in this scenario is an example of a collateralized debt obligation.