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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
funds in the country, whose CDO management unit was one of the nation’s largest in
. Early in , it announced that it would not manage any new deals, in part be-
cause of the deterioration in the credit quality of mortgage-backed securities. “There
is an awful lot of moral hazard in the sector,” Scott Simon, a managing director at
PIMCO, told the audience at an industry conference in . “You either take the
high road or you don’t—we’re not going to hurt accounts or damage our reputation
for fees.” Simon said the rating agencies’ methodologies were not sufficiently strin-
gent, particularly because they were being applied to new types of subprime and Alt-
A loans with little or no historical performance data. Not everyone agreed with this
viewpoint. “Managers who are sticking in this business are doing it right,” Armand
Pastine, the chief operating officer at Maxim Group, responded at that same confer-
ence. “To suggest that CDO managers would pull out of an economically viable deal
for moral reasons—that’s a cop-out.” As was typical for the industry during the cri-
sis, two of Maxim’s eight mortgage-backed CDOs, Maxim High Grade CDO I and
Maxim High Grade CDO II, would default on interest payments to investors—in-
cluding investors holding bonds that had originally been rated triple-A—and the
other six would be downgraded to junk status, including all of those originally rated
triple-A.
Another development also changed the CDOs: in and , CDO managers
were less likely to put their own money into their deals. Early in the decade, investors
had taken the managers’ investment in the equity tranche of their own CDOs to be
an assurance of quality, believing that if the managers were sharing the risk of loss,
they would have an incentive to pick collateral wisely. But this fail-safe lost force as
the amount of managers’ investment per transaction declined over time. ACA Man-
agement, a unit of the financial guarantor ACA Capital, provides a good illustration
of this trend. ACA held of the equity in the CDOs it originated in and
, and of two deals it originated in , between and of deals
in , and between and of deals in .
And synthetic CDOs, as we will see, had no fail-safe at all with regard to the man-
agers’ incentives. By the very nature of the credit default swaps bundled into these
synthetics, customers on the short side of the deal were betting that the assets would
fail.
CREDIT DEFAULT SWAPS: “DUMB QUESTION”
In June , derivatives dealers introduced the “pay-as-you-go” credit default swap,
a complex instrument that mimicked the timing of the cash flows of real mortgage-
backed securities. Because of this feature, the synthetic CDOs into which these new
swaps were bundled were much easier to issue and sell.
The pay-as-you-go swap also enabled a second major development, introduced in
January : the first index based on the prices of credit default swaps on mortgage-
backed securities. Known as the ABX.HE, it was really a series of indices, meant to act
as a sort of Dow Jones Industrial Average for the nonprime mortgage market, and it
became a popular way to bet on the performance of the market. Every six months, a
