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As far as my knowledge goes, a "collateralized debt obligation" (CDO) restructures existing bonds into "layers" of debt whereby each layer has similar kinds of bonds with similar kinds of features in it. So, for example, the lowest layer could be the riskiest layers where borrowers are expected to default the most and the uppermost layer would be one where borrowers with relatively higher credit scores would be placed. These are then sold forward to willing investors. These CDO's can be further restructured into a synthetic CDO but lets not get into that.

So now, a "credit default swap" (CDS) could be placed against a CDO thereby insuring against a loan default. So, for example, if a collective bunch of loans in the bottom most layer go bad within the stipulated time, then the insurer (bank) would be forced to pay back to the insuree (any third party).

Now, lets take the scenario of a hospital with cancer patients from Stage 0 to 5. A third party comes up to the hospital and asks the hospital to restructure the cancer patients files into "tranches" such that Stage 5 patients would be at the bottom most layer and Stage 0 at the top. He would then like to buy an insurance against the bottom most layer for a period of 1 month. So, if the insured layer goes bad in that month (which basically means a certain number of people in that layer die), the hospital would have to pay him back 50X the premium amount. The hospital could even create a separate financial subsidiary to carry out the above task.

Of course, this is completely unethical and really sad. My question is: What stops this from happening? Why is it seemingly okay to do this on a housing loan but not medical patients?

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    $\begingroup$ Your description of how tranching works is not correct. Tranching is the prioritization of cash flows, and does not apply to individual loans. $\endgroup$ – dismalscience Jan 26 '17 at 15:39
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In the United Kingdom, your death bonds would be prohibited by the Life Assurance Act 1774, which still says in its entirety:

Whereas it hath been found by experience that the making insurances on lives or other events wherein the assured shall have no interest hath introduced a mischievous kind of gaming:

  1. From and after the passing of this Act no insurance shall be made by any person or persons, bodies politick or corporate, on the life or lives of any person, or persons, or on any other event or events whatsoever, wherein the person or persons for whose use, benefit, or on whose account such policy or policies shall be made, shall have no interest, or by way of gaming or wagering; and every assurance made contrary to the true intent and meaning hereof shall be null and void to all intents and purposes whatsoever.
  2. And it shall not be lawful to make any policy or policies on the life or lives of any person or persons, or other event or events, without inserting in such policy or policies the person or persons name or names interested therein, or for whose use, benefit, or on whose account such policy is so made or underwrote.
  3. And in all cases where the insured hath interest in such life or lives, event or events, no greater sum shall be recovered or received from the insurer or insurers than the amount of value of the interest of the insured in such life or lives, or other event or events.
  4. Provided always, that nothing herein contained shall extend or be construed to extend to insurances bona fide made by any person or persons on ships, goods, or merchandises, but every such insurance shall be as valid and effectual in the law as if this Act had not been made.

and there are similar laws in other places.

There were two bases for this prohibition and regulation:

  • it amounted to a particularly distasteful form of gambling on people's deaths
  • it was dangerous for an individual to be more valuable dead than alive to another individual; insurance should solely be about compensating for losses

Housing loans are not as distasteful as human death, and there is no suggestion that purchasers of Credit Default Swaps could have acted in a similar way to murderers, though the reference in section 3 to events might also apply to their use for speculation

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  • $\begingroup$ Your answer is good, so rather than submitting my own I'll comment. What is described in the question is known as "stranger originated life insurance" and is illegal in the US (and many other places) as well as in the U.K.: en.m.wikipedia.org/wiki/… $\endgroup$ – dismalscience Jan 26 '17 at 15:42
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The description of a "CDO" that you lay out as the premise of your question is not accurate. A CDO should be thought of in terms of credit tranching, which is as you describe where more 'senior' bonds are higher up the food chain in terms of NOT taking losses until the tranches below are completely wiped out. However, this is achieved not so much by segregating the underlying risk into safe and less safe groups but by assuming that the risks are largely uncorrelated. If they are (and that is a rebuttable presumption) then safer tranches can be created and the extent of the tranching will depend on the underlying correlation.

Imagine a situation where the correlation between risks was 1.0 - either no one defaulted, or they all defaulted. In this case, no CDO could be (or I should say) should be created since there are states of the world with a high enough probability where the entire notional could be wiped out. This was essentially what happened when Wall Street packaged junior and mezzanine securities from subprime RMBS and created CDOs backed by them. Once defaults on the loans backing the RMBS increased rose high enough, the RMBS tranches acted as one - they were perfectly correlated, leading to massive losses for the holders of the CDO seniors.

There, in a nutshell, is what the subprime crisis was all about!

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