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FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT
securities, Prudential Securities saw an opportunity and launched a series of CDOs that
combined different kinds of asset-backed securities into one CDO. These “multisector”
or “ABS” securities were backed by mortgages, mobile home loans, aircraft leases, mu-
tual fund fees, and other asset classes with predictable income streams. The diversity
was supposed to provide yet another layer of safety for investors.
Multisector CDOs went through a tough patch when some of the asset-backed se-
curities in which they invested started to perform poorly in —particularly those
backed by mobile home loans (after borrowers defaulted in large numbers), aircraft

leases (after /), and mutual fund fees (after the dot-com bust). The accepted wis-
dom among many investment banks, investors, and rating agencies was that the wide
range of assets had actually contributed to the problem; according to this view, the
asset managers who selected the portfolios could not be experts in sectors as diverse
as aircraft leases and mutual funds.
So the CDO industry turned to nonprime mortgage–backed securities, which
CDO managers believed they understood, which seemed to have a record of good
performance, and which paid relatively high returns for what was considered a safe
investment. “Everyone looked at the sector and said, the CDO construct works, but
we just need to find more stable collateral,” said Wing Chau, who ran two firms,
Maxim Group and Harding Advisory, that managed CDOs mostly underwritten by
Merrill Lynch. “And the industry looked at residential mortgage–backed securities,
Alt-A, subprime, and non-agency mortgages, and saw the relative stability.” 
CDOs quickly became ubiquitous in the mortgage business. Investors liked the

combination of apparent safety and strong returns, and investment bankers liked
having a new source of demand for the lower tranches of mortgage-backed securities
and other asset-backed securities that they created. “We told you these [BBB-rated
securities] were a great deal, and priced at great spreads, but nobody stepped up,” the
Credit Suisse banker Joe Donovan told a Phoenix conference of securitization
bankers in February . “So we created the investor.” 
By , creators of CDOs were the dominant buyers of the BBB-rated tranches
of mortgage-backed securities, and their bids significantly influenced prices in the
market for these securities. By , they were buying “virtually all” of the BBB

tranches. Just as mortgage-backed securities provided the cash to originate mort-
gages, now CDOs would provide the cash to fund mortgage-backed securities. Also
by , mortgage-backed securities accounted for more than half of the collateral in
CDOs, up from  in . Sales of these CDOs more than doubled every year,

jumping from  billion in  to  billion in . Filling this pipeline would

require hundreds of billions of dollars of subprime and Alt-A mortgages.

“It was a lot of effort”
Five key types of players were involved in the construction of CDOs: securities firms,
CDO managers, rating agencies, investors, and financial guarantors. Each took vary-
ing degrees of risk and, for a time, profited handsomely.
Securities firms underwrote the CDOs: that is, they approved the selection of col-