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Gregory chpt 10: super senior tranches, default/counterparty risk


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Just to check if I understand this correctly.

The more senior the tranche the less default risk... the more you have to rely on the counterparty of the cdo to not default? wouldn't these tranches be in a default remote vehicle in the first place?

Also, i'm not really clear on why one would want protection on super senior tranches. I don't understand what is meant by "potentially not being able to recognize PL on a transaction" (page 109 of the notes)

I kind of get that you would buy protection for gamma exposure, but then i would think it makes more sense to have protection on less senior tranches.


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I would like to revive Pfliks question above, because I completly failed to understand the part about Collaterialized Debt Obligations in Gregory Chapter 10 (chapter 13 of GARP core readings).

First Gregory divides CDOs in synthetic CDOs and structured finance securities. Intuitivly I thougth, that the difference is, that synthetic CDOs are not backed by real securities but instead by CDS or other credit derivatives. But Gregory says, the main difference is that structured finance securities are more complex. What the hell does that mean?
Why can synthetic CDOs be traded in tranches and structured finance securities not?

Why does issuers of CDOs need to buy protection on their tranches? Aren't the CDOs backed by the underlying securities or credit derivatives in case of a synthetic CDO, and all these underlyings are placed in a default remote vehicle? (I think that's also Pfliks question above)

Has anybody gained some understanding of this part? I really would appreciate any kind of insight.
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Synthetic Cdos is a product of structured finance. Cdos have only debt as a collateral like b/s debt can be sold off through tranches so that b/s debt position can be improved and debt acts as a collateral for investors of tranches. But if we talk of strucured finance things become complex because now the structure of tranches is as it is but the collateral payouts becomes complex like collteral can be credit cards,house mortgages ,automobiles loans etc,i mean i think gregory wanted to point out this differrence only,cdo is also a structured finance but payout is simplevlike a debt but when we talk of structured finance in general things gets complex because of payout structure of collateral.


Active Member
Hi Shakti,

What I understood now is, that Gregory wanted to say, that issuing a CDO is like buying credit protection, because you go short credit risk.
With an issued synthetic CDO you can hedge some credit risk on your balance sheet or non-synthetic you're selling the risky assets directly to the remote default vehicle, which also removes the debt from your balance sheet?

Shakti, do I understand you correctly?


Active Member

Thank you, you're answer made me understand the basic idea of Gregory. The are still a lot of his remarks, that are mysterious to me, but understanding his basic ideas makes me happy for now.

Maybe its me, but i found Gegory confusing in a lot of chapters. I wasted a lot of time trying to understand relative simple thoughts that seem just weirdly worded to me. But as I said, maybe I'm just not compatible with his line of thinking.

Tarun Kaushal

New Member
Reviving the thread. Not able to understand the following:

Therefore, issuers of CDOs are super senior protection buyers, not necessarily

because they think super senior tranches have value but rather because:

 They need to buy protection or place the super senior risk in order to have efficiently

distributed the risk. Failure to do this may mean holding onto a very large super

senior piece and potentially not being able to recognize P&L on a transaction.
I'm also confused by the difference. I *think* I got the idea behind synthetic CDOs thanks to one of David's youtube videos (bottom), but "structured finance securities" are still not clear to me.

1. My understanding of synthetic CDOs:
A bank wants to buy protection for its credit portfolio. It buys protection from an intermediary. The intermediary then packages the credit protection it sold to the bank and sells that to investors via tranches. The investors in the tranches make an upfront payment to the intermediary to invest, in return they receive a premium. The premium is actually paid by the bank to the intermediary and the intermediary passes it onto the investors. If there is a default in the bank's portfolio it has purchased protection for, the intermediary will use the upfront finds the investors paid to cover these. If those funds are not enough, the intermediary will use the premium payments the bank paid to cover the defaults, thus the investors don't get their premium. The bank may even invest in the equity tranche of the CDO the intermediary has created so they have an incentive not to give may to the hazard risk of insurance and give out poor loans simple because they are insured (sounds like this isn't optional).

2. I *think* the structured finance securities Gregory speaks of are your more typical CDOs/ CMOs/ CLOs where they are backed directly by group of loans/mortgages and not an intermediary's insurance deal with a bank i.e. the bank has sold off the assets to a SPV and you invest with the SPV who owns the loans.

@David Harper CFA FRM CIPM, how close is my understanding?


Can anyone explain what "the more senior a tranche, the more counterparty risk it creates" means? (P2.T6. Gregory; p32 of BT video slides). Is the statement based on the fact that the width of the most senior tranche is typically much wider than lower tranches? Wouldn't a protection buyer be more concerned about counterparty risk of a protection seller for a lower rated tranche since there is a much greater likelihood that they will need to pay in a default scenario? What am I missing. Thanks