The investment banking activity known as ‘structured credit’ created a zoo of new tranched products. The last chapter looked closely at one particular example, a collateralized loan obligation (CLO) deal, and briefly reviewed other types of transaction, including the very dubious restructured deals employing as collateral the riskier tranches of other structured credit deals. These transaction deals made an immediate profit and also provided credit to many types of risky borrower who found it difficult to access normal bank credit.

Investment banks in effect began to compete directly with commercial banks in the provision of credit, at the lower end of the credit quality spectrum. They engaged in a ‘hunt for yield’ – that is, a search for high-yield credit assets that could be bought, packed in these arbitrage structures and yield an immediate accounting gain. This hunt for yield resulted in a massive credit creation, especially in three areas: sub-prime mortgages and home-equity loans, commercial property and the ‘leveraged loans’ used for private equity buyouts.

A common feature of all these transaction structures was their employment of leverage. Leverage was the reason for using similar tranching to that of the more established MBS and ABS. By creating a large proportion of safe AAA tranches (in retrospect not always so safe, especially in the case of the dubious restructured deals), the returns to the remaining higher risk tranches were enhanced. In an environment of strong economic growth and rising prices for property and other assets, these higher-risk tranches offered high returns and so appealed to some investors.