I-Banks use “cash flow waterfalls” (first senior tranches are paid, then mezzanine, then equity) and sometimes the flow of principal and interest is also separated.
I do assume that the overall pool is backed by $100 in equity, but when you get into the specific tranches, that concept gets a bit muddy because of the seniority structure of the tranches. You essentially buying cash flow streams of increasing risk-the lower tranches effectively have lower equity backing because the higher rated tranches get all the equity when things go south.
A 30% decline in home prices in and of itself, does nothing to the CDO. Its effect comes as the 30% drives up the default rates, so the impact there is real.
It’s true, then that a 30% decline in home prices would wipe many of the lower tranches out in their entirety (assuming it pushes defaults up)…my point is just that there are many that would not be wiped out-the impact is still huge, it just needs to be kept in perspective.
