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8

THE CDO MACHINE

CONTENTS

CDOs: “We created the investor” .......................................................................
Bear Stearns’s hedge funds: “It functioned fine up until one day
it just didn’t function”.....................................................................................
Citigroup’s liquidity puts: “A potential conflict of interest” ..................................
AIG: “Golden goose for the entire Street” ...........................................................
Goldman Sachs: “Multiplied the effects of the collapse in subprime”..................
Moody’s: “Achieved through some alchemy”.......................................................
SEC: “It’s going to be an awfully big mess”..........................................................

In the first decade of the st century, a previously obscure financial product called the
collateralized debt obligation, or CDO, transformed the mortgage market by creating a
new source of demand for the lower-rated tranches of mortgage-backed securities.*
Despite their relatively high returns, tranches rated other than triple-A could be
hard to sell. If borrowers were delinquent or defaulted, investors in these tranches
were out of luck because of where they sat in the payments waterfall.
Wall Street came up with a solution: in the words of one banker, they “created the

investor.” That is, they built new securities that would buy the tranches that had be-
come harder to sell. Bankers would take those low investment-grade tranches, largely
rated BBB or A, from many mortgage-backed securities and repackage them into the
new securities—CDOs. Approximately  of these CDO tranches would be rated
triple-A despite the fact that they generally comprised the lower-rated tranches of
mortgage-backed securities. CDO securities would be sold with their own waterfalls,
with the risk-averse investors, again, paid first and the risk-seeking investors paid
last. As they did in the case of mortgage-backed securities, the rating agencies gave
their highest, triple-A ratings to the securities at the top (see figure .).
Still, it was not obvious that a pool of mortgage-backed securities rated BBB could
be transformed into a new security that is mostly rated triple-A. But math made it so.

*Throughout this book, unless otherwise noted, we use the term “CDOs” to refer to cash CDOs backed
by asset-backed securities (such as mortgage-backed securities), also known as ABS CDOs.
