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 F FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT

CDOs created by Goldman Sachs.  Because of such deals, when the housing bubble
burst, billions of dollars changed hands.
Although Goldman executives agreed that synthetic CDOs were “bets” that mag-
nified overall risk, they also maintained that their creation had “social utility” be-
cause it added liquidity to the market and enabled investors to customize the
exposures they wanted in their portfolios.  In testimony before the Commission,
Goldman’s President and Chief Operating Officer Gary Cohn argued: “This is no dif-
ferent than the tens of thousands of swaps written every day on the U.S. dollar versus
another currency. Or, more importantly, on U.S. Treasuries . . . This is the way that
the financial markets work.” 
Others, however, criticized these deals. Patrick Parkinson, the current director of
the Division of Banking Supervision and Regulation at the Federal Reserve Board,
noted that synthetic CDOs “multiplied the effects of the collapse in subprime.” 
Other observers were even harsher in their assessment. “I don’t think they have social
value,” Michael Greenberger, a professor at the University of Maryland School of Law
and former director of the Division of Trading and Markets at the Commodity Fu-
tures Trading Commission, told the FCIC. He characterized the credit default swap
market as a “casino.” And he testified that “the concept of lawful betting of billions of
dollars on the question of whether a homeowner would default on a mortgage that
was not owned by either party, has had a profound effect on the American public and
taxpayers.” 

MOODY’S: “ACHIEVED THROUGH SOME ALCHEMY”
The machine churning out CDOs would not have worked without the stamp of ap-
proval given to these deals by the three leading rating agencies: Moody’s, S&P, and
Fitch. Investors often relied on the rating agencies’ views rather than conduct their
own credit analysis. Moody’s was paid according to the size of each deal, with caps set
at a half-million dollars for a “standard” CDO in  and  and as much as
, for a “complex” CDO. 
In rating both synthetic and cash CDOs, Moody’s faced two key challenges: first,
estimating the probability of default for the mortgage-backed securities purchased by
the CDO (or its synthetic equivalent) and, second, gauging the correlation between
those defaults—that is, the likelihood that the securities would default at the same
time.  Imagine flipping a coin to see how many times it comes up heads. Each flip is
unrelated to the others; that is, the flips are uncorrelated. Now, imagine a loaf of
sliced bread. When there is one moldy slice, there are likely other moldy slices. The
freshness of each slice is highly correlated with that of the other slices. As investors
now understand, the mortgage-backed securities in CDOs were less like coins than
like slices of bread.
To estimate the probability of default, Moody’s relied almost exclusively on its
own ratings of the mortgage-backed securities purchased by the CDOs.  At no time
did the agencies “look through” the securities to the underlying subprime mortgages.
“We took the rating that had already been assigned by the [mortgage-backed securi-