Explaining CDOs

I got this from a post by doggydoggy world on an IV stock board I frequent -- what a clear explanation!

These CDOs were just silly attempts to circumvent mathematics. Think about it, you put a billion dollars worth of mortgages into a pool and issue 800m of AAA tranches and 200m of CCC. Securitizing didn't really change the overall risk profile, it just redistributed risk away from the 800m and concentrated it in the 200m. Fair enough.

Now let's drop a little acid, and take the 200m of CCC from five different MBS pools and make a billion dollar CDO. Once again we'll issue 800m of AAA and 200m of CCC. Hey, it worked before! (If something seems awry you clearly didn't drop enough acid).

The MBS merely redistributed risk, but the CDO actually ERASED risk! Now that's something Wall Street can sell. CDO every mortgage security in the US and 4/5ths of the risk disappears. Do it again (with CDO-squareds) and get risk down to 1/25th of the original level. Then again with CDO-cubeds. By the time you reach the sixth power all risk in the entire US mortgage market is concentrated in a single 200m CCC tranche. It's magic!

Wall Street knew this was a scam, of course. The running joke was the debt of the entire free world was supported by a single low grade CDO tranche sold to a guy in a mud hut in Tonga. Ha ha.