Wall Street bankers create products like any other manufacturer seeking to sell goods or services for a profit. The products those bankers create are financial instruments and the services they sell include advisory services, which they provide to investors and use to sell their financial products. And being the shrewd businessmen and women they are, Wall Street’s bankers also make a habit of being both buyers and sellers of their own products. All the better to serve their customers who wish to trade their products.

The uniqueness of Wall Street’s products is that simply by buying any of their products, purchasers own an opportunity to make money. If bankers can manufacture products that have greater moneymaking potential, it stands to reason that they can sell them for a greater profit. And like in any other business, the more products and services bankers sell with higher profit margins, the more they make.

The ingenuity of Wall Street is on full display when it comes to packaging products that incorporate mortgages. Banks assemble large numbers of individual mortgages into pools and sell pieces of those pools as securities.

The buyer of one of these securities owns a piece of the cash flow that comes into the pool every month when the actual mortgage holders send in their monthly payments. In order to manufacture higher-margin mortgage-related products, bankers amassed pools of subprime mortgages, where the underlying mortgages were debts of less than high quality but where the borrowers were willing to pay higher interest to qualify for that mortgage.

The underlying higher-interest-rate mortgages in the new pools meant that the subprime-mortgage-backed securities would pay investors a greater return, so Wall Street charged more for these products. And, in an effort to further boost the yields on these subprime-mortgage-backed securities, bankers “structured” pools into “collateralized mortgage obligations.”

Structuring is a method by which the cash flow from a particular pool of mortgages does not simply “pass through” to the investors, but is actually re-routed to different investors who pay a higher price for a preferred directed cash flow. Again, the ingenuity of these products is that they offer different potential earnings opportunities for the purchasers, and have higher profit margins for the bankers who manufacture, sell and trade them.

Source: How Wall Street Manufactures Financial Services Products