In today's senate hearing, there was a question how a portfolio of BBB rated securities can generate a AAA rated security. Ex-Goldman exec Dan Sparks basically said it was due to diversification. This is an incomplete answer. Diversification alone is insufficient. You also need to add an equity tranche, a first-loss position that is breached only in specified probabilities. This is modeled based on historical loss rates for the rated collateral, and the minimum amount of equity needed to imply the Senior securities have expected loss rates consistent with AAA ratings (expected loss is the expected default rate times the loss in event of default). This is modeled using Monte Carlo methods because these structures have waterfalls where reserves build-up and are paid down, so they don't assume 'gaussian' distributions.
So, turning B rated bonds into AAA rated bonds, involves both diversification and equity. You can't turn $100 worth of BBB bonds into $100 worth of AAA bonds. You turn it into $95 worth of AAA bonds (or something, depending on the time horizon).
And this was all farked because the ratings on the collateral were wrong, but that's a separate issue.
If Sparks tried to fully explain it to the Senators their collective heads would have exploded.
What bothers me about all these hearings is that the bankers look weak. Sure verbally slapping around the senators may mean the industry has to move to Singapore, but ultimately I think it would be worth it.
So the problem wasn't with the idea of converting some percentage of BBB bonds into AAA CDO tranches per se but with the equity tranche being way too small, because presumably, the BBB bonds never should have been considered BBB to begin with. But, theoretically, you could still make AAA-rated CDO tranches out of junk securities if your equity tranche was high enough (40%+, maybe?).
Dave, that is right ... but relies on the folks doing the ratings understanding what they rate. S&P and Moody's are experienced rating the default risk in corporate bonds. But rating a bundle of consumer loans? That was new to them.
I almost gagged when the Goldman guy evaded the question about whether he had ever heard of "barbelling" collateral in an RMBS. That's the oldest trick in the book. Underwriters like Goldman are experts at knowing exactly how to exploit the weaknesses of rating agency methodologies and mix as much crap as possible into a deal without causing adverse changes in subordination levels.
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