One thing that I think we are overlooking a bit on this site…Most folks around here understand, but the nuance seems to be getting a bit lost: The subprime CDO market is in a bit of a tailspin. That said, and undeserved AAA ratings notwithstanding, the majority of the subprime tranches will weather even a severe pop of the housing bubble.
This is a bit oversimplified, but Returns on a CDO roughly equal (Interest + repayment of principal – management fees -expenses for dispositions of defaults + collections from sales of defaulted properties)/(initial investment).
There will no doubt be a bloodbath in the “toxic waste” tranches (little interest, little repayment of principal, big disposition expenses, and sales on defaulted properties with a significant haircut).
Assume the following scenario, though: Market Dives 30%, and subprime REO’s go to 20%. Also assume it costs 10% to dispose of a property.
Let’s just talk principal (interest collected further reduces the impact): If you start with $100 of CDO, you still collect $80 (REO’s at 20%). Then, of that $20 you didn’t collect on, you can sell the houses in that $20 for $14 (30% market drop), and you have to pay $2 to dispose of the assets.
In this oversimplified Scenario, then, you still have $80 of principal + $14 from the REO’s – $2 from the REO expenses = $92. Now if the toxic waste segment takes that entire loss, you are probably looking at a complete wipeout of that tranche, and some creep into the tranches above. Not a good thing. That said, there are a lot of holders of the higher tranches still getting paid even in a pretty bad scenario.
This would still cause a substantial disruption; The higher rated segments aren’t so highly rated any more, pension funds have to drop them automatically raising the spread over treasures and decreasing the value. Hedge funds go belly up because of leverage, overexposure, fear. The cost of subprime mortgages skyrockets because banks have to sell that toxic waste tranche very cheaply, etc. Maybe the subprime market isn’t even viable for a time.
What doesn’t happen unless you consider the absolute worst, though is huge losses throughout all the tranches. There is a lot of money that will be lost here, but lets remember that when you hear that there were $300B in subprime originations, it’s only a small fraction of that where losses are actually likely to occur.
