Wednesday, August 5, 2009

Are tranches of CDO rated on the underlying pool?

Banking system in India. Why banks in India are facing difficulty in getting deposits?

Tranches of CDO are not rated on the underlying pool. The underlying pool consists of tranches and different tranches from different securities are pooled together in a CDO. In a nutshell, CDO's are made up of tranches of different securities for example a CDO may be made up of a AAA rated tranch such as a leverage loan or an agency loan and a BBB rated tranch like a sub prime loan and lower-rated tranch like junk bonds, so CDO's are made up of parts of different ABS pooled together for various risk profiles.

As for ABX index, I agreed to that. Basically I did a small reading up to understand what it was made of and was precisely based on housing mortgages or not, making it something which you cud use to cover your systematic risk. I also agree that defaults were way higher than expected but the problem was not defaults, but the CDO which were based on sub prime mortgages were mainly market value structures where the payoff does not depend on the interest earned on the underlying pool but on the appreciation of the underlying pool, mortgages being very liquid are very difficult to values, mainly because you don't know what rate to use for discounting (value of the mortgage can be measured in terms of its present value for which you need a rate) with the housing market at boom a lot of people took up mortgages even when the mortgage rates were very high and much beyond there normal paying capacity hoping for significant capital gains and overall economic growth, but when suddenly the housing market crashed, the CDO's which were based on such values collapsed leading to sudden crisis.

People panicked and started looking for sell off but no buyers, and then they started defaulting and banks/lenders were left with nothing but liquid properties, could do nothing but write them down which further increased the crisis.

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