playing faux naif again (except it’s not faux).
What is the point of bundling securities into a special purpose entity and issuing debt tranches with various levels of seniority and issuing (or keeping) an equity tranche which doesn’t promise a fixed payment ? This was a very profitable operation until recently. How could that be ?
I wonder after the jump. I conclude that the point of tranching was to weaken the effects of rules and regulations which could have been weakened directly — that it did not serve a socially useful purpose which couldn’t have been achieved directly.
First try explanation 1 — it generates assets suited to investors with different risk tolerance. Extremely risk averse investors will rationally buy the senior tranches. More risk tolerant investors will buy the mezzanine tranches. The investors with the highest risk bearing capacity will buy the equity tranches.
Explanation 1 does not make any sense. Consider a standard simplest model of financial markets. Agents consume, save and invest aiming to maximize the present discounted value of a CRRA function of consumption (c^(1-sigma))/(1-sigma). All assets are traded. There are no transactions costs. Absolute risk tolerance is proportional to the wealth of the investor. The result is that each investor divides his wealth in equal proportions among different investments. Market clearling implies that each investor owns an equal share of the senior, mezzanine and equity tranches of each CDO. There is no point in tranching.
OK so add more diversity and make consumer i maximize the expected present discounted value of (c^(1-sigma_i))/(1-sigma_i). Now the proportions of all *risky* assets held by each investor have to be the same. Highly risk averse investors will put more of their money in TIPS. Aside from that no difference. This is a well known result in simple math (a first order condition). There is still no gain from tranching.
So what is the point of tranching ? Well in the real world, demand for different kinds of assets is not based on expected return and the contribution to total risk born by the investors. In the real world the letters assigned by ratings agencies have real effects. For example, banks have to satisfy minimum capital requirements which depend on total holdings rated AAA, C and in between. The rules of private entities might be even more important than public regulations. If you are managing an endowment set up by a crazy rich person whose will dictated that the money can be invested only in AAA debt, then you care about the ratings of specific assets not the portfolio level risk.
It seems to me that the only explanation of pooling and tranching was to get around rules and regulations.
Now I’ve written this at angrybear before. No commenter has told me another explanation of the profitability of pooling and tranching. Now I am pleading (challenging) can anyone think of another explanation ?