Alex Tabarrok Does the Arithmetic on CDOs

May 13th, 2010

Update: I erroneously attributed the following post to Tyler Cowen instead of Alex Tabarrok. Fixed in the title.

Marginal Revolution: The Dark Magic of Structured Finance.

I’ll let you read it yourself, but here’s the takeaway. If the chance of underlying mortgages’ defaulting goes from 5% to 6% (a 20% increase),

the probability of default in the 10 tranche[s] jumps from p=.0282 to p=.0775, a 175% increase.  Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!

These securities don’t just leverage the risk; they massively leverage the risk of risk.

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  1. Leroy Dumonde
    February 28th, 2011 at 05:04 | #1
    Reply | Quote

    Yep, CDOs are tailor made for blowing up clients.

    I’ve heard that people in the finance industry refer to them as “hand grenades”. (I made that up but I wouldn’t doubt if it were true)

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