For background, please read this and this. I want to first point out that in order for the most senior tranche in most CDO deals to default, a hell of a lot has to happen. High-yield Collateralized Loan Obligations (or CLOs, which is the green line above) normally have 25% or so of subordination. So in order for the AAA senior tranche to fail, at least 25% of the collateral has to default.
But wait, there's more!
You assume you'll recover something in bankruptcy, so defaults have to be even higher.
But wait, there's more!
The deal has triggers, which divert cash away from junior tranches for the benefit of senior tranches. So when defaults start rising, interest that would have gone to a junior tranche is actually used to pay down the AAA tranche.
The fact is that AAA rated CDOs with no sub-prime exposure are showing no sign of distress.
Now, let's turn to ABS deals, which is where the sub-prime problem is. There are two basic types: High-grade (red and yellow lines above) which invest in investment grade pieces of ABS. Most of these deals I've seen have average ratings of A. The other type is Mezzanine (or Mezz, blue line above). These invest in BBB and BB ABS pieces.
Remember that a CDO of ABS is structure on top of structure. By this I mean, ABS are often tranched, where there are junior and senior bonds. So let's assume you build a portfolio of ABS, all of which are junior tranches rated BBB. Then you make a CDO out of that portfolio. The junior tranche of your CDO is backed by junior tranches of a ABS deal. Structure on top of structure.
Both the CDO structure and the ABS structure cause defaults to hit your junior tranches first and your senior tranches only after the junior tranches have been wiped out. So let's say that 10% defaults wipes out a BBB-rated ABS tranche. If that's held in a CDO portfolio, that's a defaulted bond in the CDO. What if the same thing happens to all the BBB-rated CDOs within the CDO? Suddenly 10% sub-prime defaults nationwide turns into 100% defaults in the CDO!
Now, that's not going to happen to many CDO deals, because few are actually 100% sub-prime RMBS, and you'd never see exactly the same defaults in every ABS piece you hold. So no one is going to suffer 100% defaults. But this does serve as an example of how defaults get amplified when you have structure on top of structure.
Consider how different the situation is if the CDO owns all A-rated bonds. Maybe those need 20% underlying defaults before they fail. While 10% might seem pretty reasonable, 20% is far less likely. This is why the senior AAA tranche in high-grade structured finance CDOs are performing just fine, while the junior AAA tranche isn't.
Presently few (if any) AAA CDOs are getting downgraded in the wake of this sub-prime mess, but the market is telling you that many will be. Whether defaults actually turn out to be bad enough to sink any AAA tranches remains to be seen.