Being On Top Just Got A Lot Less Fun

A Wall Street Journal article you can read here explains the way banks shuffle and deal the debt that makes up Collateralized Debt Obligations (CDO's).

"When Citigroup disclosed that the bulk of its U.S. subprime-mortgage exposure lies in super-senior tranches of asset-backed collateralized debt obligations, investors were supposed to be reassured," said the Journal.

To critically analyze what's going on here, it helps if you think about it terms of two consecutive games of cards.

In the first game, you are dealt a subprime hand. In the second, you are feeling a bit more lucky. What you are forgetting at this point is: the deck stays the same.

The cards are subprime mortgages. In the first round they are shuffled into pools which are used to back new debt securities (bonds) issued into the market.

The pools are tranched, grading the debt issue into different risk ratings.A queen of diamonds is less likely to default than a ten of clubs. Much like a AAA rated bond is "safer" than a BBB rated bond.

At this point, the dealer reshuffles the cards. The bonds are redistributed into new vehicles, where they are pooled with other types of debt and tranched, which issue CDO's.

Looking at your hand the second time around, you might think that a top tier, super-senior CDO is safe.

A top tier CDO, after all, is made from the top tier subprime bonds, which are backed by the top tier of the subprime mortgage pool.

Vertigo is a good sign at this point, your body is telling you that the house of cards is vulnerable.

The second hand may seem better, but, as I said earlier, the deck it self stays the same. You are still dealing in subprime mortgages, which are servants to their default rates.

While top-tier CDOs are the last in line to default, that line moves mighty fast in the subprime debt sector.

So, when banks parade the best of a bad bunch under fancy names like "super-senior" and "top tier," hold fast to your skepticism.