Bernard Guerrero, from the comments

Funny, I had this exact conversation over lunch with a colleague. For our clients (large insurance companies) the risk profile of the AAA tranches they hold aren’t drastically different, it’s only when you move down the ladder that it becomes an issue. It’s the mispricing (or mis-rating in hindsight) of the lower tranches that funds will get killed on, and frankly, there aren’t too many widows and orphans out there picking up z-tranches. Should funds get bailed out for taking these positions? For one, it’s favouring short term liquidity over long-term liquidity in the sense that a bailout today will, while helping clear the logjam today, distort the long-term valuations of these bonds away from the fundamentals. Second, there’s a fund on either side of each transaction, so for every fund that’s getting killed today, someone else read it correctly. The downside is that people aren’t packaging new bonds until they can price them accurately. Is this a negative turn of events, certainly, but is it a systemic crisis, I think not.

Bernard makes a nice point, but I think he’s missing some other important points. It appears that a lot of the models that informed these debt ratings had overly optimistc assumptions about housing prices.

If you have housing price declines (which we have had and will continue to have), then you start to have problems even up into the AA tranches.

In other words, it isn’t just the “high-risk” tranches that have problems, although admittedly their problems are far more spectacular.

Can we really put these reputational costs to the side? I would say that they are very big factors in most peoples’ minds, and disregarding them is very unrealistic.

I would suggest that the reputational costs would be one of the things feeding the “we buy ugly houses” industry. They may actually be buffering the entire downturn, altho in my case they only offered 75 for a house which brought me 137.

Two recent good books :

1.Credit Derivatives by Erik Banks , Morton Glantz and Paul Siegel
Worth reading for chapter 3 , structured and synthetic credit products , best introduction to CDOs.

2.Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments by George Chacko , Anders Sjöman , Hideto Motohashi and Vincent Dessain
Does exactly what it says on the tin :no credit derivatives experience necessary.

CDOs are a very interesting debt instrument. I lack complete understanding of how they are administered, but is the reason someone buys into a CCC tranche on margin because the fees of entering the tranche are insanely low? Did the industry take a hit because the credit raters did such a poor job of assessing these CDOs? Do I understand correctly that the senior tranche is the first to gain and the last to lose, but they have to pay very very high fees to sustain the CDO? And lastly, since the lower tranches are not investment grade derivatives, who in god’s name buys them?

Another interesting thing that has entered the market fairly recently are Cat Bond CDOs.

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