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THE MADNESS 

breakdown of the standards, . . . because you break down the checks and balances
that normally would have stopped them.” 
Synthetic CDOs boomed. They provided easier opportunities for bullish and
bearish investors to bet for and against the housing boom and the securities that de-
pended on it. Synthetic CDOs also made it easier for investment banks and CDO
managers to create CDOs more quickly. But synthetic CDO issuers and managers
had two sets of customers, each with different interests. And managers sometimes
had help from customers in selecting the collateral—including those who were bet-
ting against the collateral, as a high-profile case launched by the Securities and Ex-
change Commission against Goldman Sachs would eventually illustrate. 
Regulators reacted weakly. As early as , supervisors recognized that CDOs
and credit default swaps (CDS) could actually concentrate rather than diversify risk,
but they concluded that Wall Street knew what it was doing. Supervisors issued guid-
ance in late  warning banks of the risks of complex structured finance transac-
tions—but excluded mortgage-backed securities and CDOs, because they saw the
risks of those products as relatively straightforward and well understood. 
Disaster was fast approaching.

CDO MANAGERS: “WE ARE NOT A RENTAMANAGER”
During the “madness,” when everyone wanted a piece of the action, CDO managers
faced growing competitive pressures. Managers’ compensation declined, as demand
for mortgage-backed securities drove up prices, squeezing the profit they made on
CDOs. At the same time, new CDO managers were entering the arena. Wing Chau, a
CDO manager who frequently worked with Merrill Lynch, said the fees fell by half

for mezzanine CDOs over time. And overall compensation could be maintained by
creating and managing more new product.
More than had been the case three or four years earlier, in picking the collateral
the managers were influenced by the underwriters—the securities firms that created
and marketed the deals. An FCIC survey of  CDO managers confirmed this point. 
Sometimes managers were given a portfolio constructed by the securities firm; the
managers would then choose the mortgage assets from that portfolio. The equity in-
vestors—who often initiated the deal in the first place—also influenced the selection
of assets in many instances. Still, some managers said that they acted independently.
“We are not a rent-a-manager, we actually select our collateral,” said Lloyd Fass, the

general counsel at Vertical Capital. As we will see, securities firms often had particu-
lar CDO managers with whom they preferred to work. Merrill, the market leader,
had a constellation of managers; CDOs underwritten by Merrill frequently bought
tranches of other Merrill CDOs.
According to market participants, CDOs stimulated greater demand for mort-
gage-backed securities, particularly those with high yields, and the greater demand
in turn affected the standards for originating mortgages underlying those securities. 
As standards fell, at least one firm opted out: PIMCO, one of the largest investment