default correlation impact on Mezzanine tranche - plain English?


I’m trying to find a practical example or way to understand this statement:

The correlation of expected defaults on the collateral of a CDO affects the relative value between the senior and subordinated tranches; as default correlations increase, the value of mezzanine tranches usually increases relative to the value of senior tranches. Because he expects the correlation to be highly positive, he can try to profit by selling the lower yielding (or selling short) Class A and buying the higher yielding Class B.

If a company faces higher default risk and correlations among tranches increase, shouldn’t the mezzanine tranche loose even more than the more secure senior note? Selling A and buying B would result in selling a tranche that doesn’t fall in value as much as the purchased class B does.

High correlation --> if the senior debt gets paid, junior debt also gets paid --> junior debt valuable

Low correlation --> Only senior debt gets paid --> junior debt risky/less valuable

Junior debt is already considered left over fish from last night’s dinner (see Anthony Bourdain’s explanation of CDOs: The higher you believe it’s likelihood of ending up in a good soup (i.e. high correlation with senior debt, or the good fish), the more valuable it is.

Haha - great thank you!