David Manheim

A Take On What's Ailing The Markets

The explanation is pretty good; the trances work like a set of waterfalls - if the top pool (tranche) get filled, the next one will start filling as well. The bottom trances get now money before the tyop ones are affected at all. (In a typical deal. Of course, deals can be set up any way the participants want, but CDOs typically try to give all of the risk and reward to the lower tranches in order to sell off the top tranches to super risk averse investors like Insurance companies and Banks.)

The other issue, (not quite as big but ignored because it is complex) is that everyone assumed that there was low correlation between defaults - if Bob in Idaho defaulted, that would mean very little about the likelyhood of Sam in New York doing so. Generally, this is true - peoples financial situations are complex, and unless there is a general problem with the market, the risks are lowly correlated, and everyone is fine - very few people on average will default. The oppsite side of the coin is that when something does go wrong in the market, like a recession, which the doomsayers are particular keen on right now, many people default at the same time, for the same reason - the economy starts tanking, or the interest rates go up pulling peoples floating rate morgages with it, or anything similar.

The higher tranches of a CDO are essentially short correlation - they bet that correlation is low, becuase the higher the correlation is, the more likelty they get hit - despite the low likelyhood of an event! For instance, the extreme case: if all morgages were perfectly correlated, than the tranches all have the same value, because the CDO is either going to pay out in full, or not at all. This is because perfect correlation means that everyone will either default, or not, together. More likely, however, is that correlations i a .3 instead of .03, and the highest tranche investors get hit even on their nicely rated, AAA "safe" CDO tranche. This upsets the market, since we want people who plan to have no risk to actually have no risk.