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CDO Managers now largely specialised third-party

i.e. NOT originating bank

Own the Equity tranche

Generate excess spread

Moral Hazard

Will the managers restructure portfolio to own advantage

And to detriment of other tranches?

Senior tranches want higher diversification=lower correlation of assets

Higher chance of smaller loss

Absorbed by Equity tranche (etc)

Equity tranche wants lower diversification=higher correlation of assets

Lower chance of higher loss

Answer:

Reserve pool accumulates excess spread

Offsets excess credit losses

Only excess spread NET OF LOSSES accrue to Equity tranche

Static vs.. Managed CDOs

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