Tranche warfare

Class warfare exists in the world of subprime mortgages and bonds, yes it does. Let me explain.

Thousands of mortgages get packaged into a bond. The various risk levels of the mortgages are separated into what are called tranches. The top tranche, the AAA level, is presumably the highest quality while the lower levels are much riskier and more toxic.

You didn’t think they’d stop there, did you? A CDO (Collateralized Debt Obligation) is a debt instrument comprised of possibly hundreds of tranches from any number of bonds. Through the miracle of modern financial fraud alchemy, the top tranche in a CDO may appear pristine and unsullied, even if it too is toxic.

When the pyramid of debt and leverage starts to collapse – what we’re seeing now – then the class warfare comes into play. If it looks like not everyone will get their money back, the terms of a CDO generally dictate that the AAA level gets all the money first. Thus holders of AAA tranches might actually want the CDO to get downgraded because then they get first dibs to all the income. Truly, there is no honor among thieves.

(There are also bizarre debt instruments called CDO squared which are, you got it, CDOs of CDOs. But wait, there’s more! Yes, CDO cubed, CDOs of CDOs of CDOs.)