By: GZ on Sabato 01 Settembre 2007 05:13
You have a CDO that's divided into three tranches. Let's call them high risk, medium risk, and low risk. Everyone knows that the high risk CDO will lose money, the question is how much. You do the calculation and it shows that the low risk tranche has a 2% chance of losing money.
So hedge fund manager comes along and asking, got anything for me to buy. Bank says sure, here are some risky CDO's, I'm selling these cheap, be careful with them. Hedge manager says "no problem, we are all adults here, I like risk." Manager buys CDO's. Bank collects commission.
Now a pension fund or overseas bank comes along and asks got anything for me? Bank says sure, I got these great low-risk CDO's, I did the calculation and they say that you only have a 2% chance of losing money on them. Pension fund says, I don't understand 2% risk what that means, can you translate for me? Goes to rating agency. Rating agency says "according to our calculations, a AAA corporation has a 2% chance of going bust, so that 2% means that the CDO is equivalent to a AAA bond." Pension manager says great, I can buy AAA stuff. Goes to bank. Bank gets a small fee for selling these things.
Now time passes. Mortgages default as people expected. The in fact default exactly according to calculation. Hedge fund blows up, but that's not a big problem, since everyone knows that Mr. Daredevil the hedge fund manager had to coming. No problem so far.....
Here is the problem.....
Now that the high risk CDO went bust, the mid-risk CDO is next in line to go bust and then becomes high-risk. The low-risk CDO now becomes mid-risk. That AAA CDO now has a risk that is the same as a AA.
At this point the pension manager gets angry. You *told me that this was AAA*. Bank says, it was. We did the calculations, the calculations were correct, and it was AAA. Pension manager says, but AAA corporate bonds never get reranked unless something bad happens, and here I am, and my AAA CDO's just got reset to AA even though I didn't do anything. Just who do you think I am, a hedge fund manager???? Listen, I've had enough of this crazy stuff, I'm just going to sell my CDO's to whoever will buy them and just and buy nice safe treasuries.
Note that at no time here was any lying to anyone else, and also note that nothing in the low-risk tranche has actually defaulted, nor has anything happen concerning defaults that were not predicted by the models.