one thing I didn't get from "The Big Short"

Why would only an 8% default rate make the CDOs (not the sythetic CDOs) become worthless? I don’t understand why it wouldn’t just mean the demise of the crappy tranch. There is still 92% of the the mortage payments coming in… why would the top tranches go bad too? Are mortage based CDOs leveraged somehow?

EDIT— is it because the CDOs are made out of MBS (that don’t have tranches aimed to tackle default risk?) so the whole MBS defaults, causing all the tranches of the CDO to default? or is it because the CDOs are made out of the crappy MBS tranches only so the 8% default rate is whipping out all the CDOs and CDO derivatives? this is killling me.

“or is it because the CDOs are make out of the crappy MBS tranches only so the 8% default rate is whiping out all the CDOs and CDO derivatives?”

Yes, they turned junk into gold by putting a bunch of sub-prime mortgages into AAA CDOs.

^thanks for the point in the right direction. It is still so incredulous. I mean, if only an 8% default rate took out these CDOs…they must have been made entirely of really really crappy MBS tranches. There is only so many of those bottom tranches that would be taken out at as low at 8% default rate (even after they started giving mortgages to anyone). Seems like there would not be enough CDOs based on them to cause the damage that they did. Must have been all the synthetics based on those CDOs that really did the whole system in…yes?

^ Also keep in mind that many that held to maturity didn’t lose much. It’s not necessary for all CDOs to go belly up. If a handful do, then the market freezes and no one can trade other than at massive discount to opportunists. If you need the money for liquidity, you’re forced to sell at a loss to the guy with cash and time. Many CDOs and MBS did go to zero or took big haircuts but there were also many that lost money just on liquidity.

Simple answer: leverage

^Do you mean the entire system was effectivly leveraged (due to the effect of the synthetic CDOs)… or that the instruments themselves were leveraged?

“You can tell that leveraged super senior synthetic collateralized debt obligation tranches are fun because they are called leveraged super senior synthetic collateralized debt obligation tranches, and anything with that many words in its name is up to something”

Bloomberg writers are the best!

This leveraging technique explains more of the liquidity issue banks got themselves in (like geo siad) rather than why 8% mortgage default rate lead to the collapse of the bond to begin with… but interesting none the less.

also… hats off to igor for finding this random 2013 article.

Not bloomberg writers, just Levine. Guy knows shit, and yes leverage is the key to the massive losses and forced panic. A ton of funds made a ton of money buying these securities on the cheap in 07-08 and they are just holding them. Made a killing.

P.s. KmD if you have a question about topical finance in the last 4 years or so just google what it is and Levine and he probably wrote a badass article on it.

Someone told me once that the way these special-purpose-vehicles got AAA rating was that the rating was for the special purpose vehicle’s ability to meet its payment obligations. If the underlying securities defaulted, then the special purpose vehicle’s contract said they didn’t have to pay anything because the waterfall rules were already spelled out in the contract. As a result, the underlying securities could be big heaping smelly turds, but the SPV was AAA since its payment obligation would go down if the turds defaulted. Simply put, they couldn’t default on an obligation/tranch they were no longer required to pay because, the waterfall already specified the order of payout and the possibility of defaults on the underlying securities.

I don’t know if this is true, and I haven’t heard it confirmed from a second source. Most people believe that the AAA was just ratings agencies being lazy and greedy (believable), and that this was somehow plausible by the idea that real estate was uncorrelated sufficiently to provide default-shield-magic. The explanation above does sound hard to believe but I wouldn’t be too surprised if some marketers and lawyers managed to do this, thus passing the stupidity buck to those who simply relied on credit ratings.

it was AAA bc ratings agencies used historical prime delinquency and default assumptions on sub prime loans

I’ve heard that explanation a lot more frequently than the one I mentioned. I brought the first one up to see if anyone else could confirm it.

It may well be that igor’s explanation is the before-the-fact explanation, and the other explanation was the ratings agencies’ legal teams’ after-the-crash justification for giving them AAAs.

Couldn’t stand it. I watched it for free and only got like 30 mins in before falling asleep. Terrible writing. This feeling might have been exaggerated by the fact that I already understand whats going on but all of the stupid explanatory monologues and metaphors were unecessary.