in Marginalia

Benz on Collateralized Debt Obligations

A chocolate fondue fountain is used as a metaphor for the kind of debt — called CDOs — that precipitated the 2008 global meltdown. (www.itsrainingchocolate.com)

A CDO is a bundle of debt you can buy. In the sense of loans, it works like this: An underwriter, or investment bank, buys many loans, and pools together everyone’s first few payment, then their next few payments, and calls these tranches. Each tranche is sliced up and sold as CDOs, and each tranche carries an increasing degree of risk. The highest quality rated tranches get the first dibs on payment from the loan pools. However, because they are less risky, the interest rates they earn are not as high as those for tranches that are later in line.
Think of it as one of those tiered chocolate fondue fountains that’s shaped like upright, stacked satellite dishes. The top bowl has to overflow to fall into the next bowl. If the chocolate stops running (think default, early repayment), the first cup gets filled with what’s still in the system, and maybe some of the second tier, but people at the bottom, who otherwise would have had the most chocolate are instead stuck there holding their toothpicks and wishing they’d just ordered the cheesecake.

— Chris Benz, one of five of McSweeney’s interns who prepared the glossary found in Michael LewisPanic: The Story of Modern Financial Insanity

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