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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
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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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