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THE MADNESS 

consortium of securities firms would select  credit default swaps on mortgage-
backed securities in each of five ratings-based tranches: AAA, AA, A, BBB, and BBB-.
Investors who believed that the bonds in any given category would fall behind in their
payments could buy protection through credit default swaps. As demand for protec-
tion rose, the index would fall. The index was therefore a barometer recording the
confidence of the market.
Synthetic CDOs proliferated, in part because it was much quicker and easier for
managers to assemble a synthetic portfolio out of pay-as-you-go credit default swaps
than to assemble a regular cash CDO out of mortgage-backed securities. “The beauty
in a way of the synthetic deals is you can look at the entire universe, you don’t have to

go and buy the cash bonds,” said Laura Schwartz of ACA Capital. There were also
no warehousing costs or associated risks. And they tended to offer the potential for
higher returns on the equity tranches: one analyst estimated that the equity tranche
on a synthetic CDO could typically yield about , while the equity tranche of a
typical cash CDO could pay . 
An important driver in the growth of synthetic CDOs was the demand for credit
default swaps on mortgage-backed securities. Greg Lippmann, a Deutsche Bank
mortgage trader, told the FCIC that he often brokered these deals, matching the
“shorts” with the “longs” and minimizing any risk for his own bank. Lippmann said
that between  and  he brokered deals for at least  and maybe as many as
 hedge funds that wanted to short the mezzanine tranches of mortgage-backed
securities. Meanwhile, on the long side, “Most of our CDS purchases were from UBS,
Merrill, and Citibank, because they were the most aggressive underwriters of [syn-

thetic] CDOs.” In many cases, they were buying those positions from Lippmann to
put them into synthetic CDOs; as it would turn out, the banks would retain much of
the risk of those synthetic CDOs by keeping the super-senior and triple-A tranches,
selling below-triple-A tranches largely to other CDOs, and selling equity tranches to
hedge funds.
Issuance of synthetic CDOs jumped from  billion in  to  billion just
one year later. (We include all CDOs with  or more synthetic collateral; again,
unless otherwise noted, our data refers to CDOs that include mortgage-backed secu-
rities.) Even CDOs that were labeled as “cash CDOs” increasingly held some credit
derivatives. A total of  billion in CDOs were issued in , including those la-
beled as cash, “hybrid,” or synthetic; the FCIC estimates that  of the collateral was
derivatives, compared with  in  and  in . 
The advent of synthetic CDOs changed the incentives of CDO managers and
hedge fund investors. Once short investors were involved, the CDO had two types of
investors with opposing interests: those who would benefit if the assets performed,
and those who would benefit if the mortgage borrowers stopped making payments
and the assets failed to perform.
Even the incentives of long investors became conflicted. Synthetic CDOs enabled
sophisticated investors to place bets against the housing market or pursue more com-
plex trading strategies. Investors, usually hedge funds, often used credit default swaps
to take offsetting positions in different tranches of the same CDO security; that way,