Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
However, the default rate overall is a quite different thing from the default rate in a particular Collateralized Debt Instrument ... since of course the primary means of meeting the demand for these instruments was in granting mortgages that otherwise would not have existed, some of them will contain a far higher concentration of that 10% default rate.

If the instrument is divided into four equal tranches, and you hold the 25% riskiest tranche a 10% default in the pool is a 40% loss for you ... a 20% default in the pool is an 80% loss. A 40% loss in the pool, which is certainly likely to be seen in many of the instruments that have concentrated the systematic risk of a downturn in the housing market, and the riskiest tranche is wiped out, and the second riskiest tranche has 60% of its backing in default ... and the remaining 40% is the absolute worst risk remaining in the pool.

And consider the higher quality tranches now ... someone bought the second best tranche for slightly better returns than the top tranche while still expecting, absent a meltdown in the housing market, low default risk and low pre-payment risk ... indeed, given that this was rated as an investment grade instrument, you were focusing on the pre-payment risk when deciding between the first and second tranche. But now you are, in effect, mostly holding the junk tranches of the mortgages still standing.

The top quality tranche, which is the best sheltered from default risk, was bought by an institution looking for a rock solid, steady stream of income for a number of decades, and all of a sudden is holding an asset with a clear pre-payment risk, when the returns available to pre-payments is lower than when the top quality tranche was originally lost.

Its lost value across the board ... sure, loss of value in the lowest quality tranches, loss in quality in the highest quality tranches, but still, lost value as financial assets.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Mon Dec 17th, 2007 at 05:58:42 AM EST
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