Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
Yes, that is the systemic risk exposure.

If you structure a CDO into (for simplicity), five equal tranches, with prepayments to the juniormost tranche, then the juniormost tranche underperforms its 20% of the face value of the income stream by 5 times the default rate. That is normally junk.

So, now take CDO's representing the juniormost tranches of a range of different mortgages pools, form a pool of their income, and divide the income into five tranches.

You diversify against stochastic risks, but if you underestimate the systemic risk of rise in the general default rate, you underestimate how how up the ladder the risk extends.

A 2% default rate leads to 10% underpayment in the juniormost tranche, leading to 50% underpayment in the juniormost tranche in the second tier. A 10% default rate leads to 50% underpayment in the juniormost tranche of the first tier, wiping out the two juniormost tranches of the second tier and the middle tranche pays out at 50% of its total claim.

And of course, if the original under-estimate of systemic risk was used to size the tranches to get the maximum number of CDO's of investment grade, you've basically locked in a guarantee that the "investment grade" assets in the second tier will under-perform their rating, since optimizing means putting the boundary as close as possible to what is considered an acceptable risk.

Senior tranches in the first tier of a pool with genuinely decent quality mortgages are not the worry ... its when layers are used in cahoots with information on exactly what risk profile is needed to get an investment grade rating, and/or when the underlying pool is junk (when structuring is used to paint a pile of chickenshit white and call it a basket of eggs), that the multiplication of systemic risk really kicks in.

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 Thu Oct 9th, 2008 at 07:07:32 AM EST
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