Alex Tabarrok Does the Arithmetic on CDOs

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.






One response to “Alex Tabarrok Does the Arithmetic on CDOs”

  1. Leroy Dumonde Avatar

    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)