From direction to correlation

The relationship between the creditworthiness of the hundreds of names that might be referenced in a CDO creates a new risk category. Default correlation risk is the risk that one default makes another default more likely. In a simple example, a default by a major supplier might increase the likelihood of a default by one of its customers. High default correlation in the underlying reference portfolio doesn't just make investing in a CDO more risky overall. It alters its payment profile. Higher default correlation means closer risk profiles for both junior and senior investors. Low default correlation should mean greater pricing differences between junior and senior tranches.