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THE CDO MACHINE 

tranches of mortgage-backed securities, growing from a bit player to a multi-hundred-
billion-dollar industry. Between  and , as house prices rose  nationally
and  trillion in mortgage-backed securities were created, Wall Street issued nearly

 billion in CDOs that included mortgage-backed securities as collateral. With
ready buyers for their own product, mortgage securitizers continued to demand loans
for their pools, and hundreds of billions of dollars flooded the mortgage world. In ef-
fect, the CDO became the engine that powered the mortgage supply chain. “There is a
machine going,” Scott Eichel, a senior managing director at Bear Stearns, told a finan-
cial journalist in May . “There is a lot of brain power to keep this going.” 
Everyone involved in keeping this machine humming—the CDO managers and
underwriters who packaged and sold the securities, the rating agencies that gave
most of them sterling ratings, and the guarantors who wrote protection against their
defaulting—collected fees based on the dollar volume of securities sold. For the
bankers who had put these deals together, as for the executives of their companies,
volume equaled fees equaled bonuses. And those fees were in the billions of dollars
across the market.
But when the housing market went south, the models on which CDOs were based
proved tragically wrong. The mortgage-backed securities turned out to be highly cor-
related—meaning they performed similarly. Across the country, in regions where
subprime and Alt-A mortgages were heavily concentrated, borrowers would default
in large numbers. This was not how it was supposed to work. Losses in one region
were supposed to be offset by successful loans in another region. In the end, CDOs
turned out to be some of the most ill-fated assets in the financial crisis. The greatest
losses would be experienced by big CDO arrangers such as Citigroup, Merrill Lynch,
and UBS, and by financial guarantors such as AIG, Ambac, and MBIA. These players
had believed their own models and retained exposure to what were understood to be
the least risky tranches of the CDOs: those rated triple-A or even “super-senior,”
which were assumed to be safer than triple-A-rated tranches.
“The whole concept of ABS CDOs had been an abomination,” Patrick Parkinson,
currently the head of banking supervision and regulation at the Federal Reserve
Board, told the FCIC. 

CDOS: “WE CREATED THE INVESTOR”
Michael Milken’s Drexel Burnham Lambert assembled the first rated collateralized
debt obligation in  out of different companies’ junk bonds. The strategy made
sense—pooling many bonds reduced investors’ exposure to the failure of any one
bond, and putting the securities into tranches enabled investors to pick their pre-
ferred level of risk and return.
For the managers who created CDOs, the key to profitability of the CDO was the fee
and the spread—the difference between the interest that the CDO received on the
bonds or loans that it held and the interest that the CDO paid to investors. Throughout
the s, CDO managers generally purchased corporate and emerging market bonds
and bank loans. When the liquidity crisis of  drove up returns on asset-backed