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I've been reading a lot of about the "Magnetar trade" (see pro-publica article here and the links therein, as well as this paper), and I'm slightly confused by the argument about how Magnetar (and similar firms) spurred the creation of additional CDOs, which might be related to a deeper misunderstanding of how the individual tranches related to the whole CDO.

So my understanding of the argument is that Magnetar bought the riskiest equity tranches of the CDO (thereby being known as the "sponsor"), which few investors wanted, which then opened them up to buying the higher rated senior or mezzanine tranches. This was great for Magnetar since they held short positions (CDSs) in those particular asset classes, and by buying the (undervalued) equity tranche they helped spur the creation of a larger CDO market in which to short.

What I'm unclear about is why these CDO's needed the equity tranche sponsored. Why was it not profitable (or seem profitable) for the banks that were creating these CDOs to make products with only mezzanine and senior tranches? Since it seems investors were buying individual tranches anyway, it isn't like the equity portion of the CDO was driving the return. I.e. those buying the higher tranches weren't necessarily being directly exposed to the equity tranche and their interest rate was based only on the assets in their particular tranche.

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  • $\begingroup$ Every business has an entrepreneur who started it, makes decisions (what should the business be called?), and holds equity in it. For a CDO this is called "the sponsor". Sometimes it has been alleged that the sponsor is just an idiot who does the bidding of the investment bank (Bear Stearns, GS) that sells mortgage securities or CDS etc to the CDO, or that he has other conflicts of interest. Still the sponsor is supposed to be legally and ethically independent from the other parties in all these complicated deals, at least we hope so. $\endgroup$
    – Alex C
    Mar 9, 2018 at 15:28
  • $\begingroup$ By my understanding, a CDO (by definition) is structured so that any losses are taken by a certain tranch first, and if the losses exceed the value of that tranch, the next tranch takes the remaining losses, and so on. One tranch must take losses first, and that one is the riskiest tranch. You can't have a set of tranches such that none of them are riskiest. That would be like having a bunch of numbers without a smallest one. $\endgroup$
    – user253751
    Jan 23, 2020 at 19:12

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The sponsor of the CDO is the collateral manager. In order for a CDO to be issued, someone has to buy the assets that are underlying or backing the tranched default obligations. In other words, the sponsor is buying the loans which will be the source of the interest and principal which will be used to pay the promises of the tranched debt obligations that are sold.

In the situation you describe, you are describing a CDO squared. In this case, the assets supporting the default obligations are tranches of other CDOs. Someone still has to purchase and manage this portfolio of assets, which is the responsibility of the sponsor. As the underlying assets are themselves tranches of existing CDOs (which in this case is the equity tranche), those CDOs will also have a sponsor to manage the underlying collateral (which in this case will be the actual loans).

The equity tranche has the highest coupon given that it is the first loss tranche. As long as the assets underlying the CDO continue to pay, the equity tranche will be unimpaired and can itself be the source of high coupons for the CDO squared.

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  • $\begingroup$ Is this a way of saying the tranches are only about distribution of risk and coupon payment, but all tranches are exposed to the same underlying securities (either other CDOs in the case of CDO squared or actual debt assets in the case of the vanilla CDO)? $\endgroup$
    – Benjamin Horowitz
    Mar 8, 2018 at 19:22
  • $\begingroup$ Yes. The same pool of assets are the source of returns and risk for all tranches in the structure. The tranches are just a means to setting priority and seniority in making a claim on those assets. In the CDO market the tranches are relatively simple in that they just set the priority. In the mortgage backed securities market the tranching can get much more complex in that some tranches only receive interest, and others only principal, etc. $\endgroup$
    – AlRacoon
    Mar 8, 2018 at 19:30
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"Why was it not profitable (or seem profitable) for the banks that were creating these CDOs to make products with only mezzanine and senior tranches?"

As far as my understanding of the CDO market goes, in order to have senior tranches you need to have equity tranches: roughly speaking the equity tranche is there to absorb losses and protect the senior tranches.

When creating a CDO, or in general any securitized product with tranches, you are determining a series of "rules" to allocate losses if there are ever any. This is how you can create $\text{A}$-rated and $\text{C}$-rated securities from $\text{B}$-rated underlyings: by redistributing losses. Without the equity tranche, senior and mezzanine tranches would be less protected from defaults in the underlying basket and as such would have to offer higher returns.

I am unsure about the conventional terminology, but in this case the way I understand it is that Magnetar is the "sponsor" because, by accepting to hold the riskiest tranche, it enables the structuring of tranches with more seniority and therefore the creation of the CDO.

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    $\begingroup$ You are correct for cash CDOs. The equity and mezzanine tranches are the support tranches that enable the good ratings of the senior tranches. They provide the first and second losses for the structure before the senior tranches lose money. However, this is not necessarily the case for synthetic CDOs where the collateral is unfunded. $\endgroup$
    – AlRacoon
    Mar 8, 2018 at 19:16
  • $\begingroup$ @AlRacoon "this is not necessarily the case [...]" in that you can synthetically (i.e. CDS) create senior/mezzanine tranches without the need for an equity tranche? $\endgroup$
    – Daneel Olivaw
    Mar 8, 2018 at 19:43
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    $\begingroup$ In a synthetic CDO, you can create any tranches you want. The point of these structures is to offset risk and as such the junior tranches are usually the ones that are created and sold. The issuer of the tranches retains any unsold risk. If just the equity and mezz is created and sold, the implicit senior piece is retained by the issuer. There were structures that were issued that had senior pieces and the issuer retained a "super senior" unfunded tranche. $\endgroup$
    – AlRacoon
    Mar 8, 2018 at 19:52

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