They are in one underlying pool of assets, i.e., collaterals which are created through securing various assets. The pool can consist of various assets like commercial loans, mortgage back securities, retail mortgages, etc. Generally CDO'S have three level of tranching.
- Senior 20 - 100%.
- Subordinate 5 - 20%.
- Equity 0 - 5%
The above percentages are nothing but the attachment and detachment points, i.e., equity tranche consists of 5% of the total notional of the pool and will face the first 5% losses after which it would get wiped off, similar logic then applies for subordinate and then senior. The reason behind higher rating of the senior is not the risk profile of the underlying pool but the level of protection offered by the lower tranches.
Now how CDO ignited the sub prime crises, such CDO'S being dependent on market value pay back the amount invested by various parties through capital appreciation but in case the value depreciates they sell off the required amount from the underlying pool (thus referred as collateral). When the meltdown started, investor demanded back there money. The CDO manager started selling the assets thus adding oil to the fire and trust me these funds are huge, you must have read about Bears & Sterns supported hedge fund collapse and best thing is that the underlying pool doesn't necessarily need to really be with the CDO, so just imagine the amount of leverage being worked on!
The illiquid mortgages seized from the defaulters did not find any buyers and so they had to write down the debt, which was backed by such mortgages.
In fact, there was one bank which was Merrill Lynch which had forfeited the mortgage from the hedge fund (Bear Stearns) and had decided "fire sale" of the assets(sale at highly discounted prices) as a result of the high rate of defaults.
Exactly. Even after Bear Stearns bought it back from Merrill, they were not able to stop the fall and this was a lucky case and in lot of other cases, hedge funds have crashed down taking the market down with them.
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