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triple-A rating made those products appropriate investments. Rating agency fees
were typically between , and , for CDOs. For most deals, at least
two rating agencies would provide ratings and receive those fees—although the views
tended to be in sync.
The CDO investors, like investors in mortgage-backed securities, focused on dif-
ferent tranches based on their preference for risk and return. CDO underwriters such
as Citigroup, Merrill Lynch, and UBS often retained the super-senior triple-A
tranches for reasons we will see later. They also sold them to commercial paper pro-
grams that invested in CDOs and other highly rated assets. Hedge funds often
bought the equity tranches.
Eventually, other CDOs became the most important class of investor for the mez-
zanine tranches of CDOs. By , CDO underwriters were selling most of the mez-
zanine tranches—including those rated A—and, especially, those rated BBB, the
lowest and riskiest investment-grade rating—to other CDO managers, to be pack-
aged into other CDOs. It was common for CDOs to be structured with or
of their cash invested in other CDOs; CDOs with as much as to of their
cash invested in other CDOs were typically known as “CDOs squared.”
Finally, the issuers of over-the-counter derivatives called credit default swaps,
most notably AIG, played a central role by issuing swaps to investors in CDO
tranches, promising to reimburse them for any losses on the tranches in exchange for
a stream of premium-like payments. This credit default swap protection made the
CDOs much more attractive to potential investors because they appeared to be virtu-
ally risk free, but it created huge exposures for the credit default swap issuers if signif-
icant losses did occur.
Profit from the creation of CDOs, as is customary on Wall Street, was reflected in
employee bonuses. And, as demand for all types of financial products soared during
the liquidity boom at the beginning of the st century, pretax profit for the five
largest investment banks doubled between and , from billion to
billion; total compensation at these investment banks for their employees across the
world rose from billion to billion. A part of the growth could be credited to
mortgage-backed securities, CDOs, and various derivatives, and thus employees in
those areas could be expected to be compensated accordingly. “Credit derivatives
traders as well as mortgage and asset-backed securities salespeople should especially
enjoy bonus season,” a firm that compiles compensation figures for investment banks
reported in .
To see in more detail how the CDO pipeline worked, we revisit our illustrative
Citigroup mortgage-backed security, CMLTI -NC. Earlier, we described how
most of the below-triple-A bonds issued in this deal went into CDOs. One such CDO
was Kleros Real Estate Funding III, which was underwritten by UBS, a Swiss bank.
The CDO manager was Strategos Capital Management, a subsidiary of Cohen &
Company; that investment company was headed by Chris Ricciardi, who had earlier
built Merrill’s CDO business. Kleros III, launched in , purchased and held .
million in securities from the A-rated M tranche of Citigroup’s security, along with
junior tranches of other mortgage-backed securities. In total, it owned mil-
