Securitization is a fabulous tool invented by the financial industry to survive and evolve under existing banking regulations.  As they were first envisioned, these transactions had -- and still have -- great potential as a safety net to insure healthy lender risk.  Unfortunately, and probably through lack of experience, the financial community has let them evolve into a monstrous money-making machine. Here's how it works.

1. A bank receives deposits, and its function is to lend that money out at a profit.  (We won't go into fractional reserve banking here, although this multiplies the problem when things go awry.  For now, however, let's just assume the bank lends a fixed multiple of what it takes in.)

2. The bank (or other type of financial institution with access to funds) finds good borrowers with at least a decent credit score to whom they lend the money for purchases, say for a house, a car, or whatever the borrower fancies.

3. Instead of following up on the repayments through their own loan department like they used to, the banks now transfer those loans to an agency that will fulfill this task.  At the same time, they package the loans according to the degree of risk, and then they sell the loans to the general marketplace.

4. The buyers of these packaged loans can then buy "insurance" to cover the risk, from individuals and companies who want to assume that risk for a price (a piece of the interest action) and who are supposedly able to come up with the cash should a default occur.  So far so good.

5. The bank now no longer has any loans on the books, so it is free to make a second set of loans based on the same fractional-reserve multiple of the deposits it holds -- but this time in effect using 100% of the loan-package buyers' funds to do so, i.e. so far, this is still a good thing; but as we'll see, it's good only up to a point.

6. As you can imagine, this doubling, tripling or quadrupling of loans allows for an expansion of the lending industry; and the market pool of good borrowers (and the good borrowers' credit appetite) eventually maxes out.  To palliate this inconvenience, and since the bank is no longer shouldering the risk from its own loans, the bank now lowers the bar for borrowing so that those with a lower credit score may become borrowers. This expansion has presently extended into what some believe is dangerous territory; but this is only half of the problem.

7. The other half occurs when the buyers of these packaged loans either do so with what is called leveraging, i.e. they buy on credit themselves; or they sell these loans to others who do the leveraging.  Hedge funds, for example, have sometimes been a source of unwisely leveraged funds that are not yet under industry control.  And hedge funds are very popular these days.

8. According to Doug, much of the credit risk involved at this higher level is also "insured" in the same manner as in Stage 4, only this time the insurers never actually pay for the loans they are "insuring."  As with real "insurance," they only need to pay in case of default.  And this so-called "credit derivative" process is repeated over and over again, in effect allowing the loan-package insurers to borrow to the degree of the "insurance" market's willingness to take on risk.