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THE MADNESS 

It had long been standard practice for CDO underwriters to sell some mezzanine
tranches to other CDO managers. Even in the early days of ABS CDOs, these assets
often contained a small percentage of mezzanine tranches of other CDOs; the rating
agencies signed off on this practice when rating each deal. But reliance on them be-
came heavier as the demand from traditional investors waned, as it had for the riskier
tranches of mortgage-backed securities. The market came to call traditional investors
the “real money,” to distinguish them from CDO managers who were buying tranches
just to put them into their CDOs. Between  and , the typical amount a CDO
could include of the tranches of other CDOs and still maintain its ratings grew from
 to , according to the CDO manager Wing Chau. According to data compiled

by the FCIC, tranches from CDOs rose from an average of  of the collateral in
mortgage-backed CDOs in  to  by . CDO-squared deals—those engi-
neered primarily from the tranches of other CDOs—grew from  marketwide in
 to  in  and  in . Merrill created and sold  of them. 
Still, there are clear signs that few “real money” investors remained in the CDO
market by late . Consider Merrill: for the  ABS CDOs that Merrill created and
sold from the fourth quarter of  through August , nearly  of the mezza-

nine tranches were purchased by CDO managers. The pattern was similar for Chau:
an FCIC analysis determined that  of the mezzanine tranches sold by the 

CDOs managed by Chau were sold for inclusion into other CDOs. An estimated 
different CDO managers purchased tranches in Merrill’s Norma CDO. In the most
extreme case found by the FCIC, CDO managers were the only purchasers of Mer-
rill’s Neo CDO. 
Marketwide, in  CDOs took in about  of the A tranches,  of the Aa
tranches, and  of the Baa tranches issued by other CDOs, as rated by Moody’s.
(Moody’s rating of Aaa is equivalent to S&P’s AAA, Aa to AA, Baa to BBB, and Ba to

BB). In , those numbers were , , and , respectively. Merrill and
other investment banks simply created demand for CDOs by manufacturing new
ones to buy the harder-to-sell portions of the old ones.
As SEC attorneys told the FCIC, heading into  there was a Streetwide gentle-
man’s agreement: you buy my BBB tranche and I’ll buy yours. 
Merrill and its CDO managers were the biggest buyers of their own products.
Merrill created and sold  CDOs from  to . All but  of these—
CDOs—sold at least one tranche into another Merrill CDO. In Merrill’s deals, on av-
erage,  of the collateral packed into the CDOs consisted of tranches of other
CDOs that Merrill itself had created and sold. This was a relatively high percentage,
but not the highest: for Citigroup, another big player in this market, the figure was
. For UBS, it was just . 
Managers defended the practice. Chau, who managed  CDOs created and sold
by Merrill at Maxim Group and later Harding Advisory and had worked with Riccia-
rdi at Prudential Securities in the early days of multisector CDOs, told the FCIC that
plain mortgage-backed securities had become expensive in relation to their returns,
even as the real estate market sagged. Because CDOs paid better returns than did