Inquiring Mind

Back to the Future in the Credit Derivative Time Machine

This is a pretty minor point, but the rating agencies don't actually pronounce 70% of the CDO collateral to be AAA -- they determine(d) that 70% of the bonds issued by the CDO and backed by that collateral deserve AAA ratings. And they do that based on their assumptions about the collateral performance, which in the last two years were disastrously wrong.

More to the point, another reason we haven't seen the end of this is that the major CDO underwriters often held onto large chunks of the supersenior classes of their CDOs and used those bonds as collateral for other deals -- swaps, loans, etc. -- for which there's a certain collateral rating requirement. So when the formerly AAA supersenior CDO class gets torched, they have to pull it back and put up other collateral in the same face amount, forcing them to book the loss on the CDO. This process is still just beginning to happen as the AAA CDO classes get downgraded.