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THE CDO MACHINE
lion of mortgage-related securities, of which were rated BBB or lower, A,
and the rest higher than A. To fund those purchases, Kleros III issued billion of
bonds to investors. As was typical for this type of CDO at the time, roughly of
the Kleros III bonds were triple-A-rated. At least half of the below-triple-A tranches
issued by Kleros III went into other CDOs.
“Mother’s milk to the . . . market”
The growth of CDOs had important impacts on the mortgage market itself. CDO man-
agers who were eager to expand the assets that they were managing—on which their in-
come was based—were willing to pay high prices to accumulate BBB-rated tranches of
mortgage-backed securities. This “CDO bid” pushed up market prices on those
tranches, pricing out of the market traditional investors in mortgage-backed securities.
Informed institutional investors such as insurance companies had purchased the
private-label mortgage–backed securities issued in the s. These securities were
typically protected from losses by bond insurers, who had analyzed the deals as well.
Beginning in the late s, mortgage-backed securities that were structured with six
or more tranches and other features to protect the triple-A investors became more
common, replacing the earlier structures that had relied on bond insurance to pro-
tect investors. By , the earlier forms of mortgage-backed securities had essen-
tially vanished, leaving the market increasingly to the multitranche structures and
their CDO investors.
This was a critical development, given that the focus of CDO managers differed
from that of traditional investors. “The CDO manager and the CDO investor are not
the same kind of folks [as the monoline bond insurers], who just backed away,” Adel-
son said. “They’re mostly not mortgage professionals, not real estate professionals.
They are derivatives folks.”
Indeed, Chau, the CDO manager, portrayed his job as creating structures that rat-
ing agencies would approve and investors would buy, and making sure the mortgage-
backed securities that he bought “met industry standards.” He said that he relied on
the rating agencies. “Unfortunately, what lulled a lot of investors, and I’m in that
camp as well, what lulled us into that sense of comfort was that the rating stability
was so solid and that it was so consistent. I mean, the rating agencies did a very good
job of making everything consistent.” CDO production was effectively on autopilot.
“Mortgage traders speak lovingly of ‘the CDO bid.’ It is mother’s milk to the . . .
market,” James Grant, a market commentator, wrote in . “Without it, fewer as-
set-backed structures could be built, and those that were would have to meet a much
more conservative standard of design. The resulting pangs of credit withdrawal
would certainly be felt in the residential real-estate market.”
UBS’s Global CDO Group agreed, noting that CDOs “have now become bullies in
their respective collateral markets.” By promoting an increase in both the volume and
the price of mortgage-backed securities, bids from CDOs had “an impact on the
overall U.S. economy that goes well beyond the CDO market.” Without the demand
for mortgage-backed securities from CDOs, lenders would have been able to sell
