Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.
I think I got the profit chain of the CDO game:

Each mortgage refinancing gave the old loan - and the CDOs covering them - immediate and safe profit, while shifting the risk to a new loan - and new CDOs.

Wall Street was probably betting on continuous refinancing. In that case subprime loans in CDOs were very attractive because they were "guaranteed"  to be refinanced soon, ending all risk.

Here we see a classical element of a pyramid scheme: profit of one item is based on a generation of new items.

Exponential branching appears to be missing on the mortgage level, though typically greater size of new loans alone may be generating a commulative effect. The "slicing and dicing" routine with CDOs probably make a pyramid "complete", through a mathematical model is welcome.

Pyramid elements are floating around, and they make the CDO scheme very unstable. Like in a straight pyramid scam, looks excitingly fine until a logically unavoidable limit is met. In the CDO case, the limit is met when the real estate inflation and refinancing tricks must stop. More generally, broad economic models conspiciously lack clear acknowledgment everything  of positive feedbacks, as Michael Hudson notes. We are left then with Ponzi/pyramid frazeology with every hurting runaway boom and bust.

by das monde on Tue Aug 21st, 2007 at 06:18:25 AM EST
[ Parent ]
Here we see a classical element of a pyramid scheme: profit of one item is based on a generation of new items.

... but the profit is not generated by the refinance of the loans ... indeed, the investment grade tranches are protected from pre-payment risk, as well as default risk.

What the refinance of the loans did was obscure the systematic risk faced by the holders of the higher return junk grade tranches.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Tue Aug 21st, 2007 at 09:03:08 PM EST
[ Parent ]
It is indeed principally risk that is being transfered.

But it can be said that the profit is "in effect" generated by the refinance: the books are closed for the old loan and in parts of the related CDOs. Those parts in CDOs get a final profit margin, "at expense" of new CDO items.

Although the profit before refinance is supposed to be small (since interest is low until refinance is "forced" by high interest rates kicking in after a fixed time period), the tranching trick may give the lower CDOs higher than the nominal profit: If I understand right, the lower tranches are first to take any gain or pain. In this picture, it is the senior tranches that look like total suckers: they get meager profit in good times, and they are not really protected in bad times anyway. But I may need to learn (if I would dare) all details of CDO slicing to be sure.

by das monde on Wed Aug 22nd, 2007 at 05:16:55 AM EST
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