pretty informative. The brief story is, there is no simple relationship between Joe’s mortgage and the CDO/CMO held by a fund. The mortgage is sliced into “Tranches” and reassembled with similar and dissimilar debt intruments. It is these new synthetic securities that are bought by the funds. As you can see, the risk computation on these synthetic securities is very complicated, and hence it is done based on computer simulations of various combinations of price appreciation, interest rate increases and (debt) default rates and other probabilities. The problem in the CDO industry now is that these models have been found to be incorrect and were based on a shallow horizon of past few years with increasing home prices, low interest rates and low defaults. Once those conditions are reversed, the models are collapsing and are basically telling that these CDOs are not valuable. That is the root cause of the whole mess now. In the absence of securitization and resultant market for them, there is no secondary market. Without secondary market, the only mortgages are those sellable to GSEs (Fannie/Freddie/Ginnie etc.,).
So, the final answer to your original question is that there is no direct correspodence between the interest rate the borrower pays at any time and what the CDO holder gets because they get decoupled during the securitization process. It is like your cow may eat some spoiled grain but you will still get drinkable milk. But that model fails if the cow dies due to food poisoning. We are seeing a lot of cows sick or dying because the dairy farmers got greedy and started to think cows can convert any thrash into milk and started feeding them more thrash and less grain. That is now causing a rise in milk prices.
