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THE CDO MACHINE 

COMMISSION CONCLUSIONS ON CHAPTER 8

The Commission concludes declining demand for riskier portions (or tranches)
of mortgage-related securities led to the creation of an enormous volume of col-
lateralized debt obligations (CDOs). These CDOs—composed of the riskier
tranches—fueled demand for nonprime mortgage securitization and contributed
to the housing bubble. Certain products also played an important role in doing
so, including CDOs squared, credit default swaps, synthetic CDOs, and asset-
backed commercial paper programs that invested in mortgage-backed securities
and CDOs. Many of these risky assets ended up on the balance sheets of systemi-
cally important institutions and contributed to their failure or near failure in the
financial crisis.
Credit default swaps, sold to provide protection against default to purchasers
of the top-rated tranches of CDOs, facilitated the sale of those tranches by con-
vincing investors of their low risk, but greatly increased the exposure of the sellers
of the credit default swap protection to the housing bubble’s collapse.
Synthetic CDOs, which consisted in whole or in part of credit default swaps,
enabled securitization to continue and expand even as the mortgage market dried
up and provided speculators with a means of betting on the housing market. By
layering on correlated risk, they spread and amplified exposure to losses when the
housing market collapsed.
The high ratings erroneously given CDOs by credit rating agencies encour-
aged investors and financial institutions to purchase them and enabled the con-
tinuing securitization of nonprime mortgages. There was a clear failure of
corporate governance at Moody’s, which did not ensure the quality of its ratings
on tens of thousands of mortgage-backed securities and CDOs.
The Securities and Exchange Commission’s poor oversight of the five largest
investment banks failed to restrict their risky activities and did not require them
to hold adequate capital and liquidity for their activities, contributing to the fail-
ure or need for government bailouts of all five of the supervised investment banks
during the financial crisis.