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Thursday, December 18, 2008

Step IV...The Killer.

This nice graph from Bob Carpenter shows how CDOs crumbled. If a collateralized debt obligation was constructed out of BBB residential mortgage backed securities, the CDO had a number of different mezzanine levels. The higher up you go the sooner you get paid. But note, when a CDO was constructed out of the 3% of Residential Mortgage Backed Securities in an investment portfolio (on the left side, purchased with borrowed money), if one percent of the BBB (and BBB means risky) mortgages began to defalut, that would gobble up 33% of the payments waterfall in the CDO (on the right side). One percent default and we are already way up the cash waterfall into the AAA region (and AAA means not so risky). Would you like to do the math on 2% default?