BUSINESS SNAPSHOT $6\mathrm{.}2$

A Trading Opportunity?

A few traders made a huge amount of money betting against the subprime mort$-$

gage market. Suppose that you are analyzing markets in $2005$ and $2006,$ but are

uncertain about how subprime mortgages will perform. Is there a trading oppor$-$

tunity open to you?

The answer is that Mezz ABS CDOs do present a trading opportunity. Fig$-$

ure $6\mathrm{.}5$ is a simplification of how tranches were actually created. In practice,

there were usually three $\frac{?}{\text{A}\text{B}\text{S}}$ tranches, rated $BBB+,BBB,$ and $BBB-.$ Each was

very thin $-$ about $1\%$ wide. Separate Mezz ABS CDOs were created from each

of the three types of tranches. Consider the Mezz ABS CDO created from BBB$+$

tranches. After analyzing the mortgages in the pools used to create the BBB$+$

tranches, a trader would conclude that the pools had similar risk profiles and that

there would be a tendency for either all tranches to be safe or all to be wiped out.

$($Because the tranches are only $1\%$ wide, it is unlikely that they would be only

partially wiped out.$)$ This means that all the Mezz ABS CDO tranches created

from ABS tranches rated BBB$+$ are either safe or wiped out. The Mezz ABS

CDO tranches are therefore much the same as each other and should have the

same rating $(BBB+$ in the case we are considering$).$

Having recognized this, what should the trader do$?$ He or she should buy

junior ABS CDO tranches $($which are inexpensive because of their rating$)$ and

short senior $\frac{?}{\text{A}\text{B}\text{S}}$ CDO tranches $($which are relatively expensive$).$ If the underly$-$

ing principal is the same for both trades, the trader can then relax knowing that

a profit has been locked in$.$

This emphasizes the point in Business Snapshot $6\mathrm{.}1$ that BBB tranches $($par$-$

ticularly very thin BBB tranches$)$ should not be considered equivalent to BBB

bonds when a securitization is planned.