Dear Patrick. You make me wish I were back in graduate school and you were my teacher. How you manage to make such complex subjects seem so clear and simple, when they are anything but, is a true gift. Thank you for sharing!
Very clear explanation, first I saw where CDOs are not described as only a tool for evil and greed. It makes much more sense that these got so popular, when you see the potential usefulness.
FYI for those of you thinking back to 2008; The worst of these assets, the "toxic waste" class were often held by the banks issuing the CDOs since no one wanted to buy them. So before you make wild allegations understand the guys making the CDOs suffered the heaviest losses.
I'm looking into a company that currently has 17% CDO liability increase. Does the fact that the CDO shows up on their balance sheet mean they created CDOs and sold them for cash and now the debt obligation is owed or am i misunderstanding what it means to have CDOs as a liability on the balance sheet?
Hello Patrick, thanks for the great content. On min 9:20 you explain that the effect between correlation of the loan borrowers and the risk of the Sr and Jr tranches. Why if there is low correlation the Jr tranches are more risky than with a high correlation? I couldn’t understand that concept.
The idea behind these products is that you benefit from being exposed to a diversified basket of loans (diversification really just comes from low correlation). If correlation is high, investing in one of these products is like being exposed to one borrower, and that borrower by nature of the product has bad credit. If that one borrower defaults, it hits all tranches at once. Hopefully that makes sense to you.
Patrick Boyle Thank you, now I have a better understanding of the concept. Also I watched the video on the correlation topic minutes ago, it was very helpful!
let's say there's a CDO with 2 tranches, AAA and junk, priced assuming 0 correlation when in fact the correlation is 1 (i.e. AAA too expensive, junk too cheap). Knowing the CDO has been priced with the wrong assumption, how'd a smart hedge fund profit from that? In order to long the junk tranche and short the AAA tranche the fund'll buy and sell the appropriate CDSs for the underlying mortgages/bonds? I wonder if anyone did that during the financial crisis.
That's essentially what Michael Burry (and others) did. He figured out that most of the bonds in the CDOs were junk and bought CDSs for them (which paid big time when everything defaulted/collapsed).
