SO HOW EXACTLY DOES A CDO Work?

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First, there are usually two coverage checks which CDO’s calculate: interest coverage (IC) and overcollateralization (OC). The IC test gets the total interest gained in the numerator, and the full, total interest cost of confirmed tranche and everything tranches senior as the fees plus denominator. 141%. Some cause is set for how high that number needs to be for every tranche and if the real number is lower than the trigger, some remedy is required.

For example, it might be that money that would have attended the equity is used to pay down some of your debt tranches. Because the size of the guarantee collection is the same however the size of your debt is lower, the IC calculation improves. The OC test is similar, except the numerator is the main value of the profile, and the denominator is the outstanding amount of confirmed tranche and everything bonds mature. 118%. Again Here, some cause level is made when the deal comes, and if the OC falls below that result in, some remedy is necessary.

The causes are usually higher for more senior tranches. So the top tranches aren’t just guarded by the extra cashflow of the offer, but also by the fact that if anything begins to go wrong, cash movement will be diverted from other tranches. The trigger levels also tend to be higher in deals with riskier collateral. A deal with all BB-rated loans will have higher IC and OC tests weighed against an investment-grade resin ABS deal. Now you can observe how freakin’ complicated the money movement can get. It becomes difficult to know what default level would sink a given tranche.

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Another problem is the recovery rate. It is true that the weaker credits in the offer also recovery at a lower rate. For example, you might have a deal that is 50% primary RMBS and 50% B/C Home Equity. The thing that matters is the recovery on the bonds that truly default. The eye pass on is uneven as well probably.

So CDOs can get fairly complicated and its own impossible to say how many defaults it shall try sink confirmed tranche. The concern should be with buyers of BBB and A-rated tranches of sub-prime residential deals. When there is a sizable default spike in 2007-2008, and recovery rates come in much lower than expected, these tranches will probably perform badly.

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