BBB to AAA, the CDO trick

After rereading the article below and help from wikipedia, I finally understood how to transform BBB debt into AAA debt, and the whole colateralized debt obligation (CDO) thing that seemed so magical and is supposed to have gotten us in the mess.

The trick is actually quite simple. It says put all your BBB together in a company (SPV or Special Purpose Vehicle) and redistribute payments from the lot to create a sub AAA tranche. The investors in that tranche are holding on to a AAA rated security.

By redistributing the cash flows, you can in fact extract 10% of AAA and leave 90% residue that is worse than the original BBB. Making up numbers here.

Investors awash in leverage, loved to consume the AAA tranche, plus some entities can only buy AAA securities. Bankers loved to make them.

Furthermore I am under the impression from reading this article that they in fact recycled the leftovers from the first CDO process into another CDO. Except at that level you are stretching to find a cash flow that are in fact alive in that cesspool and I guess it is easy to mis-rate these second derivative securities. Apparently rating agencies applied ratings to the various CDO tranches without much understanding of the underlying security.

Comments

Anonymous said…
I almost understand this stuff now, but I still can't see how even 10% of a BBB tranch gets to be rated AAA. This slicing also rakes of outright fraud. Is it that you actually pay off the top 10% first, even if they are all at the same risk of going under.

Forgive me here. I'm Hillary's age with a couple of tech degrees and this stuff is getting interesting.
November 27, 2008 at 10:12:00 PM PST
Anonymous said…
right - you take a BBB mortgage backed security and divide it up. let's say you make a 95% AAA tranche in your new CDO and the rest is BBB. if the risk of default per mortgage is 5%, then this works because if the BBB rating is correct, defaults will only stop 5% of the cash flow, only affecting the lower tranche.
December 2, 2008 at 11:18:00 PM PST
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