Hi,I'm having a little bit of difficulty understanding the concept of fungible subordination among the inner CDOs in a CDO^2 structure.Let my master CDO consist of two inner CDOs both with a notional $1000mm that are tranched at 5%-10%. That means my master CDO has a notional of $100mm (2 * (10%-5%) * $1000mm), i.e. the master CDO notional is the sum of the inner CDO tranche notionals. So far so good.Let this master CDO be tranched at 10%-15%. The master CDO will begin to suffer subordination erosion when:1. Normal subordination - there is 5% loss on the inner CDOs regardless of how the loss occurs2. Fungible subordination - there is no loss unless both inner CDOs experience a 5% lossIn the case of the latter, what happens if one inner CDO continues to suffer losses while the other does not? For example, let's assume CDO1 suffer 10% of loss thereby reaching its tranche detachment point. This means that the master CDO would have suffered $50mm loss (5% * $1000mm). Also let's assume that CDO2 suffers no losses whatsoever.This loss on CDO1 would have eroded all the subordination on the master CDO (10% * $100m = $10mm) and the tranche being protected (5% * $100m = $5mm) if the subordination was normal.However, with fungible subordination no losses are passed on to the master CDO until CDO2 also experiences some loss. So my question is: who/what absorbs the additional loss on CDO1?Thanks in advance,Anuj

Hi,Let's consider amounts rather than %. My understanding of Fungible subordination would be that only losses in excess of 100m (but not necessarily 50m from CDO1 and 50m from CDO2; the extreme case would be 100m losses from CDO1 and no loss from CDO2, of course assuming 0% overlap) are transfered to the master CDO level. Given your example of a 10-15% tranche, there is another 10m of protection before the investor is hit. So his exposure of 5m is given by the combined losses between 110-115m in the inner CDO reference portfolios.I don't remember where I saw a definition of fungible subordination. So please let me know if my understanding is wrong.CD

Hi,You're right in that the losses will only start transferring to the master CDO after a $100mm in the inner CDOs if the subordination is fungible. However, the notional of the master CDO is a sum of the inner CDO tranche notionals.Therefore, if there is zero % overlap and inner CDO1 suffers $100mm and CDO2 suffers zero loss, then at a minimum 50% of the master CDO notional should be wiped out, which would definitely breach both the attachment and detachment points of the master CDO tranche.However, because the subordination is fungible, the losses from the CDO1 will not be transferred over to the master CDO after $50mm. However, there is another $50mm of realized loss (since CDO1 loses $100mm). Who absorbs this $50mm?Thanks,Anuj

Hi,I think we should agree on what fungible (cross) subordination means.How I see it, in a simple example. Ass. 70m loss for the CDO1 portfolio. Given CDO1's 50m attachment point this would imply that 20m are transfer to CDO1 level. Also ass. less than 50m loss (for further use consider just 25m) in the CDO2 pool, i.e. no loss at CDO2 level. Now consider the 2 subordination types:1. Normal subordination: the 20m loss from CDO1 go to the master CDO level. Given his 10m subordination (10-15% tranche), the CDO squared investor loses everything (5m) (moreover 5m loss hits whoever is senior to him).2. Fungible subordination: the 20m loss from CDO1 is completely absorbed by the CDO2 subordination (which has 50-25=25m buffer left). So no loss affects the master CDO (moreover 5m of protection is still left there) and consequently the CDO squared investor is not hit at all (he also has his 10m buffer untouched).You see what different implications the subordination type has on the CDO squared investor.Hope this helps.CD

Hi creditderivative,OK - I get it now. In regular subordination, the only subordination available to the CDO square investor is the subordination of the tranches that are junior to the one being protected on the master CDO.Whereas, in fungible sbubordination, the surbordination available is a sum of the subordination on the master CDO as well as the subordination on the inner CDOs.Therefore, once the inner CDO attachment point gets breached in the inner CDOs the master CDO will start seeing loss if the subordination is regular. This may not necessarily be the case if the subordination is fungible.Does that sound right?Anuj

Hi,Your last statement is perfectly right.But in the beginning you are confused. In both cases the CDO squared investor is protected by the attachment point of the tranche purchased and the attachment points of the inner CDOs. The difference between the two subordination types is in how/when the breach of some of the inner CDOs attachment points translates into losses at the master CDO level (see your conclusion which, as already said, is correct).Hope it's clear now.CD

QuoteOriginally posted by: creditderivativeHi,I think we should agree on what fungible (cross) subordination means.How I see it, in a simple example. Ass. 70m loss for the CDO1 portfolio. Given CDO1's 50m attachment point this would imply that 20m are transfer to CDO1 level. Also ass. less than 50m loss (for further use consider just 25m) in the CDO2 pool, i.e. no loss at CDO2 level. Now consider the 2 subordination types:1. Normal subordination: the 20m loss from CDO1 go to the master CDO level. Given his 10m subordination (10-15% tranche), the CDO squared investor loses everything (5m) (moreover 5m loss hits whoever is senior to him).2. Fungible subordination: the 20m loss from CDO1 is completely absorbed by the CDO2 subordination (which has 50-25=25m buffer left). So no loss affects the master CDO (moreover 5m of protection is still left there) and consequently the CDO squared investor is not hit at all (he also has his 10m buffer untouched).You see what different implications the subordination type has on the CDO squared investor.Hope this helps.CDFor fungible subordination, what if CDO2 has *** 45m losses; Since 45m<50m, it doesn't hit CDO2's attachement point; However, 45m + 70m > 100M, will this loss count in outer tranche? Thanks.

Yep. The inner tranches will continue to bleed. What you are doing is quite literally combining the subordination of the inner CDOs (hence the term fungible), plus the subordination of the outer attachment point to give you a sort of "compound" subordination of the CDO^2 structure.In classic subordination, the only subordination available to the outer structure is that offer by the outer CDO attachment point.