The problem in valuing such CDOs being that in a crisis, like a bursting of the housing bubble, the probabilities of individual subprimes loan takers to default become highly correlated rather than independent events ; if one underestimated that correlation, one overvalued the senior tranche of the CDO, which is why some end up being hit unexpectedly, having to pay premiums they didn't think they'd have to. Auferre, trucidare, rapere, falsis nominibus imperium; atque, ubi solitudinem faciunt, pacem appellant.
Assuming the institution holding the loans bought CDO when defaults happens they get both the house and the CDO pre-decided payment, right?
And then, defaults are cumulated by value of coupon and capital lost to determine what tranche they hit.
Ok so it's not purely time of default based, and capital lost plays a role according to you, so not exactly what I understood from linca.
I guess the devil is in the details of each CDO but it's hard to judge what's going on. My questions resolve around wether the holder of loan+CDO can make money in case of default or not (payment of CDO + payment from selling the house > original price of loan + original price of CDO).
http://en.wikipedia.org/wiki/Collateralized_debt_obligation
My questions resolve around wether the holder of loan+CDO can make money in case of default or not
I don't think this is possible. Actually, the holder of a CDO tranche security will never get a house back. The fund has a contract with a realtor for day to day management of the pool of houses, and when there is a default, this manager will arrange for a refi settlement, a foreclosure, a rental, or an auction to try to make the best money out of it. But in any case, it is only money that is funneled back to the owner of the security. There is a default as soon as the coupon (interest payment) is not 100% of what is was meant to be (there can be partial payments) and/or the nominal has lost value (because it is already known that a house has been auctioned off for less than what had been loaned for it, and the borrower is bankrupt).
So for the owner of a risky tranche will never make a capital gain. In the extremely unlikely event that a defaulted house becomes fund property, is rented while the market is depressed, and may be sold at a gain much later, the excess money will be used to offset other losses in the fund. And if there was a total surplus (which would require the housing market to skyrocket next year), the remainder would go to the funds sponsors (a bank), not the CDO holder.
Because remember: a CDO belongs to the realm of "fixed income" securities, like a bond, and the nominal paid at maturity is agreed at the beginning. There is a coupon to pay a premium for a risk of default, but rarely a performance bonus !! this is in the realm of corporate/venture stock only ...
Note that a local boost in housing is not impossible: if a godzilla hurricane destroys all of florida and 10 million have to be relocated, funds that are geographically focused (on other areas) would benefit. But for the banking system as a whole, it's still a disaster, whatever happens now. Pierre
Thanks for the precisions!
