Ed Harrison of Credit Writedowns alerted us to the impact on collateralized debt obligations, which have been crowded out of the headlines as a source of worry by other credit market train wrecks, like the failure of Libor to show much movement despite heroic central bank interventions.

Note that the Iceland-related damage applies to a subset of CDOs, the the so-called synthetic CDOs. Synthetic CDOs bundled cashflows from premium payments on credit default swaps and then tranched them, like CDOs that (more conventionally) held tranches from other securitizations, such as pieces of subprime securitizations (they also could hold whole loans, but they tended to be a small part of the mix) Even in this sector, there was a great deal of heterogeniety in the structures and underlying assets. Many were called “trades” and never intended to be resold.

Many had also had tremendous embedded leverage, This hit mainly the lower tranches, but even with the top tranche, if you crossed a magic threshold in loss expectations, you often see very sudden, dramatic decay in value.

From Bloomberg: