from Naked Capitalism on Demand for Sub Prime

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Let us step through some simple math. If a hedge fund invested $50 million in shorting MBS via an equity investment in a CDO, it would lead to the creation of a $1 billion mezzanine ABS CDO (note this 5% assumption is conservative). In 2006, 80% of that CDO would consist of BBB or BBB- tranches of subprime bonds; remarkably, as much as 10% of that CDO could (and often did) consist of the lower-rated tranches of OTHER unsold CDOs, which would make the picture even worse, so for simplicity’s sake, let’s stick with the 80% figure.




So of that $1 billion deal, $800 million is composed of BBB rated bonds. $800 million also happens to be a not-bad number for the size of a typical residential mortgage backed security, meaning from the AAA tranches down to the so called equity layer of that first generation securitization. The CDO, the second generation, would be composed of about 100 BBB MBS bonds created out of these securitizations, and the deals in aggregate would reference about $84 billion worth of mortgages (note that in this example, the $1 billion CDO would take down or if it was synthetic, “reference” $800 million of BBB bonds out of total RMBS issuance of $80 billion. The reason the total amount of bonds issued was $80 billion while the mortgage amount was $84 billion was that the bonds were “overcollateralized” as a form of protection to investors. But as we have seen, this “overcollateralization” fell vastly short of actual losses).
Now even though that ratio is eyepopping, a $50 million investment versus $84 billion of mortgage loans ultimately referenced, it is hard at this level to ascertain the impact in any tidy way. The BBB tranche was hardest to sell and only 3% of the total value of the RMBS. It had served to constrain demand. But the dynamic flipped. In tail wag the dog manner, the pipeline started demanding crappy loans to get that BBB slice. There was a chronic perceived shortage of AAA paper, so the bulk of the subprime could be sold, and the other less prized parts could be dumped into other CDOs, which were also big fee earners to the banks.

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