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but by year of default

So the tranching is done a posteriori, the loans are not pre-sorted?

Say you have a CDO with three loans and three tranches. One of the loans default now, it is automatically assigned to the last tranche owner who now have a foreclosed house, right?

by Laurent GUERBY on Mon Aug 20th, 2007 at 02:27:07 AM EST
[ Parent ]
CDOs don't transfer ownership of house : they are insurance contracts. The owner of the equity tranche pays a pre-decided amount of money while the first n% of the basket of loan takers default ; and indeed the tranches aren't pre-sorted, which is the whole point of CDOs : it was supposed that if you took a bunch of loans, even though they were bad, it was unlikely that more than 50% of them would default, thus AAA rating for the senior tranches.

The problem in valuing such CDOs being that in a crisis, like a bursting of the housing bubble, the probabilities of individual subprimes loan takers to default become highly correlated rather than independent events ; if one underestimated that correlation, one overvalued the senior tranche of the CDO, which is why some end up being hit unexpectedly, having to pay premiums they didn't think they'd have to.

Un roi sans divertissement est un homme plein de misères

by linca (antonin POINT lucas AROBASE gmail.com) on Mon Aug 20th, 2007 at 03:02:30 AM EST
[ Parent ]
Do you know what the pre-decided amount looks like relative to the estimated value of the houses?

Assuming the institution holding the loans bought CDO when defaults happens they get both the house and the CDO pre-decided payment, right?

by Laurent GUERBY on Mon Aug 20th, 2007 at 03:54:48 AM EST
[ Parent ]
The amounts are not directly related to the value of the houses. CDO funds are pretty large, they pool thousands of mortgages and the total debt before slicing will typically run into the billion $ (you need to amortize a lot of fixed bureaucratic costs). And then, defaults are cumulated by value of coupon and capital lost to determine what tranche they hit. The "watermarks" for the tranches can be surprisingly low. e.g. for corporate debt CDOs, the "equity" tranche ends at around 3%. Then the mezzanine tranche ends at 5-7% of defaults. And then you hit the senior tranches of various ratings, but in any case you'll be hitting (and eating) into AAA+ before 30-50% depending on the initial quality of the loans agregated. And this will definetely be hit with funds of fraudulent subprime loans.

Pierre
by Pierre on Mon Aug 20th, 2007 at 04:01:26 AM EST
[ Parent ]
And then, defaults are cumulated by value of coupon and capital lost to determine what tranche they hit.

Ok so it's not purely time of default based, and capital lost plays a role according to you, so not exactly what I understood from linca.

I guess the devil is in the details of each CDO but it's hard to judge what's going on. My questions resolve around wether the holder of loan+CDO can make money in case of default or not (payment of CDO + payment from selling the house > original price of loan + original price of CDO).

http://en.wikipedia.org/wiki/Collateralized_debt_obligation

by Laurent GUERBY on Mon Aug 20th, 2007 at 04:19:46 AM EST
[ Parent ]
My questions resolve around wether the holder of loan+CDO can make money in case of default or not

I don't think this is possible. Actually, the holder of a CDO tranche security will never get a house back. The fund has a contract with a realtor for day to day management of the pool of houses, and when there is a default, this manager will arrange for a refi settlement, a foreclosure, a rental, or an auction to try to make the best money out of it. But in any case, it is only money that is funneled back to the owner of the security. There is a default as soon as the coupon (interest payment) is not 100% of what is was meant to be (there can be partial payments) and/or the nominal has lost value (because it is already known that a house has been auctioned off for less than what had been loaned for it, and the borrower is bankrupt).

So for the owner of a risky tranche will never make a capital gain. In the extremely unlikely event that a defaulted house becomes fund property, is rented while the market is depressed, and may be sold at a gain much later, the excess money will be used to offset other losses in the fund. And if there was a total surplus (which would require the housing market to skyrocket next year), the remainder would go to the funds sponsors (a bank), not the CDO holder.

Because remember: a CDO belongs to the realm of "fixed income" securities, like a bond, and the nominal paid at maturity is agreed at the beginning. There is a coupon to pay a premium for a risk of default, but rarely a performance bonus !! this is in the realm of corporate/venture stock only ...

Note that a local boost in housing is not impossible: if a godzilla hurricane destroys all of florida and 10 million have to be relocated, funds that are geographically focused (on other areas) would benefit. But for the banking system as a whole, it's still a disaster, whatever happens now.

Pierre

by Pierre on Mon Aug 20th, 2007 at 05:13:18 AM EST
[ Parent ]
Ok then the buyer of the CDO does own the loan and so the house in case of default: detail of property management is just outsourced and only cash flows go out. This is not what I understood from linca comment above.

Thanks for the precisions!

by Laurent GUERBY on Mon Aug 20th, 2007 at 06:31:50 AM EST
[ Parent ]

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