Compounding Problems - Recursion: "the cause of and solution to all of life's problems"

While Crisis of Credit Visualized is a great and simple explanation of the fundamental problems with derivatives like CDOs, there are other issues at play here as well. The video glosses over how each "slice" is sold (while doing a great job describing waterfall tranches). However, it turns out that the problem becomes more complicated.

It briefly states that the Safe slice is sold to investment bankers, the Okay slice sold to "other bankers" and the Risky slice sold to hedge funds. While this is mostly true, there are additional problems that creep in when you look at the Okay slice. What does that mean?

The different slices and risk models are analogous to different investment vehicles (sound familiar? It should... It's a common theme in investment and the topic of my Asset Allocation post last month). They are as follows:

1. Safe - Senior Tranche (similar characteristics to Fixed Income)
2. Okay - Mezzanine financing
3. Risky - Junior Tranche (similar characteristics to Equity)

The problem was that in the CDO market, there wasn't really a market for the "Okay" slices. So what other "financial magic" could the banking wizards do? They recursively applied their previous solution and took the Okay slices and further cut them up into three layers: Okay - Safe, Okay - Okay, Okay - Risky. They also applied credit enhancements (like Credit Default Swaps) to achieve AAA ratings for the Okay - Safe products.

Very quickly you can see how this recursive solution compounds the problem while obfuscating the mechanics of the underlying equity vehicle. So even if you think you are buying one class of investment, you are really buying another.