We need to talk about alchemy. Alchemy, okay.
You mean like the old medieval pseudoscience?
Exactly. People in robes, you know, dusty labs
trying to turn lead into gold. Right. But I'm
not talking about that kind. Not the potions
and wizards kind. I'm talking about modern alchemy.
Okay. The kind that happens in a glass office
in Manhattan, 50 stories up. The kind where you
take a pile of absolute garbage, I mean, loans
that are never, ever going to be paid back, and
you wave a mathematical wand over them, and suddenly...
They're gold. They're gold. They're AAA rated.
They are, on paper, the safest investment in
the entire world. And then, inevitably, the spell
breaks. And the world blows up. Welcome to the
Deep Dive. Today, we are tackling the villain
of the 2008 story, the smoking gun. The three
letters that just keep coming up in every single
documentary, every book, every lawsuit. Every
angry conversation about the financial crisis.
The CDO. The collateralized debt obligation.
Warren Buffett didn't mince words about these
things. He famously called derivatives like these
financial weapons of mass destruction. He did.
And it's a phrase that gets quoted all the time.
And usually when people use phrases like that,
they're being dramatic, right, for headlines.
But in this case, looking at the source material
we have, the Financial Crisis Inquiry Report,
the really deep investigative work from journalists
like Michael Lewis, Bethany McLean, I mean, he
was barely scratching the surface. It is the
defining acronym of a decade. But what's so fascinating,
I think, is that the reputation, that villain
status. it often obscures what the thing actually
is. Totally. It's so easy to just call it a weapon.
It is so much harder to understand the mechanics
of why it was built in the first place. And that
is our mission today. We are going to move past
the buzzwords. We're going to ignore the stigma
for a minute and just look at the mechanics because
and this is where it gets really interesting.
This wasn't designed to destroy the economy.
No, not at all. It was designed to manage risk.
To manage risk. Precisely. It was a genuine attempt
to use math and financial structure to make investing
safer, more efficient. And the tragedy or maybe
the irony is how a tool designed to disperse
risk ended up concentrating it. Concentrating
it to the point of. Well, systemic failure. Global
systemic failure. It really is a story about
alchemy. We have these documents and they all
paint this picture of bankers, rating agencies,
investors, all sort of holding hands and agreeing
to believe in a fantasy because the money was
just too good. It's a story about incentives.
It's a story about a blind faith in models. And
maybe most importantly, it's about what happens
when you completely separate the person lending
the money from the person who's actually taking
the risk. OK, so let's start at the very bottom.
Before we get into the crash and the drama, we
have to define the beast. If you're listening
and you've heard CDO a thousand times but never
really looked under the hood, what in the most
basic sense is a collateralized debt obligation.
OK. At its heart, a CDO is a type of what's called
a structured asset -backed security. Now, that
sounds technical, but just think of it as a promise.
A promise. It is a promise to pay investors back,
but in a very specific sequence. And that payment
is based on the cash flow that's collected from
a big pool of assets. Okay, pool of assets. That's
the collateral part of the name, right? That's
the C. Correct. A CDO is essentially a box. You
take a whole bunch of debt. And originally, this
was things like corporate debt, bank loans, stuff
relatively. But as we'll see, it eventually became
completely dominated by mortgage backed securities
or MBS. You put all these loans into the box.
Those loans pay interest every month. That interest
is the cash flow. So if I'm an investor, I give
you money. You put it in this box with a bunch
of other people's money. You go out and buy a
thousand mortgages. And when those homeowners
pay their bills. That is the basic idea, yes.
But there's a crucial twist. If it were just
a pool where everyone shared the risk equally,
it would just be a mutual fund, basically. Right.
A CDO is different. It's sliced into sections.
And these sections are called tranches. Tranches.
That's the French word for slice, right? Like
a slice of cake. It is. And to understand why
these exist, we have to use the analogy that
comes up in almost every single explanation because
it is just so accurate. We have to talk about
the waterfall. Ah, yes. The water flowing into
cups analogy. I want to slow down here because
this is really the mechanism. This is the piece
of financial engineering that fooled everyone.
It absolutely is. So imagine the cash coming
from all those mortgages, all those monthly payments
is water. It flows out of the pool of loans and
it hits a stack of cups. But the cups aren't
side by side where they'd all fill up at the
same time. They're stacked vertically. One on
top of the other. Exactly. So you've got a top
cup, a middle cup, and a bottom cup. And gravity
does all the work. The water flows from the pipe
and it goes into the top cup first. Always the
top cup. Always. This represents the senior tranches.
These are the investors who are first in line
to get paid. Because they get the water first,
they are the safest. Even if the flow of water
slows down a little bit, say a few homeowners
stop paying their mortgages, the top cup will
probably still get full. So cup A, the top cup,
is safe. It's boring. This is for, I don't know,
grandma's pension fund. Precisely. Because it's
so safe, it pays the lowest interest rate. But,
and this is key, it gets that coveted AAA rating
from the credit agencies. It is the last to lose.
Okay, so my boring cup is full of water. What
happens next? Well, once that top cup is completely
full, the water spills over the rim and starts
to flow into the next cup down. This would be
the mezzanine tranches. Right. The middle ground.
These are rated anywhere from AA all the way
down to BB. Now, these investors only get paid
if the senior guys are fully satisfied. So they
take on more risk. Because if the water flow
slows down a lot, it might run out before it
ever reaches their cup. Exactly. It might just
trickle in or not get there at all. So because
they're taking more risk, they demand a higher
yield. They want more profit for that uncertainty.
Makes sense. And then at the very, very bottom
of the stack. You have the equity tranche. The
toxic waste. Or the gold mine, I guess, depending
on your perspective. Both are accurate descriptions.
It's sometimes called the residual or the first
loss piece. This is the bottom cup. It only gets
water if everyone above it is completely full.
So if the water flow slows down, even a tiny
bit, if just a few percent of homeowners default,
this cup stays bone dry. You're wiped out. These
investors get wiped out first. It's designed
that way. But there's always a but. But if the
water is flowing at full force, if everyone pays
their mortgage on time, this bottom cup gets
everything that's left over. And the upside can
be uncapped. You could make 20, 30 percent returns
in a world where safe government bonds are paying
5 percent. So theoretically, you've created a
product for everyone. You have this super safe
senior slice. for the pension funds who are legally
required to hold safe assets. You've got the
middle slices for people with a bit more appetite
for risk. And then you have the equity slice
for the hedge funds who really want to gamble
for those massive returns. That is the theoretical
brilliance of the CDO. You take one big pool
of loans, which might be a mix of good and bad,
and by prioritizing the payments through this
waterfall structure, you create a safe asset
out of it. You're not eliminating risk. No, you're
not eliminating it. You are slicing it up and
selling it to the people who theoretically want
to hold that specific amount of risk. It sounds
so logical when you say it like that. It sounds
like it creates efficiency in the market. It's
supposed to. But obviously got complicated. Let's
talk about the cast of characters involved here,
because it's not just a bank and an investor.
It's a whole ecosystem of people. And they're
all taking fees at every single step of the way.
It is a highly specialized assembly line. And
you have to understand all the players to see
where things went wrong. First, you have the
issuer. This is usually what's called a special
purpose entity or an SPE. A separate legal robot.
Essentially, yes. The bank doesn't issue the
CDO directly from its own balance sheet. They
create a shell company, usually incorporated
in the Cayman Islands. I always see the Cayman
Islands mentioned in these stories. Is that just
because of... bankers like the beach? It would
be a nice perk, but no. It's purely for tax neutrality
and what's called bankruptcy remoteness. Okay,
break that down. Tax neutrality. By setting up
in the Caymans, the CDO avoids paying U .S. federal
income tax on its global income. It's a pass
-through vehicle. It makes it cleaner for global
investors. And bankruptcy remoteness. That means
if the parent banks say Merrill Lynch goes bankrupt,
its creditors can't come after the assets inside
the CDO. The CDO is legally separate. It's remote.
It protects the CDO investors from the bank's
problems. And it protects the bank's balance
sheet from the CDO. That's the idea. It holds
the assets so the parent bank doesn't have to.
OK, so we hear the Cayman robot who's actually
running the show. Who's picking the loans? That
would be the asset manager. This is the person
or the firm who is responsible for selecting
the loans or the bonds that go into the box.
They're the stock pickers, essentially. They're
the bond pickers. Yeah. Their job is to manage
a portfolio. And for that, they earn fees. They
get senior fees, subordinated fees. They're supposed
to be the experts, the ones picking the winners.
Supposed to be. But as we'll see later, they're
often just picking whatever the bank told them
to pick to get a deal done. Or whatever was available,
which became a huge problem. Next, you have the
underwriter. The big investment bank. Usually,
yes. A Merrill Lynch, a Citigroup. a bear stearns
they are the architects they structure the deal
they decide how big the slices are what the interest
rates will be and most importantly they sell
those slices to investors they are the salesmen
and we can't forget the gatekeepers the ones
who made the alchemy seem Ah, yes. The rating
agencies, Moody's, S &P, Fitch, they are absolutely
critical to this entire process. Why so critical?
Because they look at the tranches and they assign
a grade. AAA for the top cup, AA for the next,
all the way down to junk for the very bottom.
Without their stamp of approval, especially that
AAA stamp, the senior tranches could not be sold.
Because many of the biggest investors, like pension
funds and insurance companies, have rules. They
are only allowed to buy assets that are rated
AAA. So without that rating, the biggest pool
of money in the world is off limits. So the rating
agencies held the keys to the kingdom. They did.
And finally, you have the trustee. The trustee
sounds important. They're basically the accountant,
a bank usually. They hold the legal title to
the assets in the pool, and they are the ones
who run the waterfall models every month to figure
out who gets paid what and in what order. So
that's the anatomy. It's a machine. A machine
designed to process debt and spit out securities.
But before it became this weapon of mass destruction,
it was actually seen as a good thing, right?
Let's get into the origin story. Yeah, it wasn't
always evil. In fact, the precursors to the CDO
were actually government -sponsored programs.
We have to go back to the 1970s. Okay. You have
Ginnie Mae in 1970 and Freddie Mac in 1971. They
created the very first mortgage -backed securities.
And the goal there was noble, right? It was to
help. liquidity in the housing market. Exactly.
The idea was if a local bank in Ohio can sell
its mortgages to Ginnie Mae, it gets cash back
immediately. And with that cash, it can then
lend to more people to buy homes. It was all
about expanding the American dream of homeownership.
It greased the wheels of the housing market.
It did. But of course, the private market wanted
in on the action. In 1977, Salomon Brothers created
the first private label, MBS. It actually failed
at first. It was a bit ahead of its time. And
this is when those famous names get involved.
Yes. You have legends like Louis Ranieri at Salomon
Brothers and Larry Fink, who is now, of course,
the head of BlackRock, the biggest asset manager
in the world. They are credited with really inventing
the business of securitization as we know it,
pooling mortgages and slicing them up. So when
did the first official CDO with that name appear?
That showed up in 1987. It was issued by Drexel
Burnham Lambert. Oh, Michael Milken's firm, the
Junk Bond Kings. It's the very same. They issued
it for a bank called Imperial Savings Association.
1987. So this technology, this basic idea, was
around for a full 20 years before the crisis.
It wasn't some new invention in 2005. Not at
all. And through the 1990s and the early 2000s,
we had what you might call the good CDO era.
And the key word during this period was diversification.
Right. Because early on, they weren't just stuffing
these things with mortgages from one place. No,
absolutely not. They were multi -sector CDOs.
The collateral pools were incredibly diverse.
They'd have aircraft lease debt in there. So
loans to airlines to buy planes. Exactly. They
had loans for manufactured housing. They had
student loans, credit card debt, corporate bonds
from all different industries. And the theory,
the sales pitch, was that... All these things
were uncorrelated. Precisely. The safety theory
was if the airline industry crashes because of,
say, a pandemic, people are probably still paying
their student loans. If the manufacturing sector
in the Midwest slows down, people in California
are still using their credit cards. One part
of the economy might be weak, but the others
will be strong. Right. If one sector takes a
hit, the others buoy the ship. Diversification
was the primary selling point. And for investors,
this was a fantastic deal. Why? Because these
CDOs offered returns that were two, sometimes
three, percentage points higher than regular
corporate bonds, even though they had the exact
same credit rating. So I could buy a AAA -rated
CDO tranche and get, say... 7 % interest when
a AAA -rated corporate bond from General Electric
was only paying 5%. Exactly that. It felt like
a free lunch. The magic word on Wall Street,
arbitrage. A free lunch. But then something shifted.
The machine went into overdrive. We enter the
engine of growth. Why did these things explode
in popularity? How did we go from this niche,
diversified product to a global obsession that
brought the system to its knees? It comes down
to two massive, powerful forces colliding at
the same time. Bank incentives and investor demand.
Okay, let's start with the banks. Why were they
so utterly obsessed with making more and more
CDOs? It's all about capital requirements. Banks
are regulated. They have to keep a certain amount
of their own money capital in reserve against
the loans they hold. on their books. As a cushion
in case things go bad. As a cushion, exactly.
So if a bank holds a billion dollars in mortgages
on its balance sheet, that ties up a lot of their
capital. That's capital they can't use for anything
else. But if they can securitize those loans,
turn them into a CDO and sell them off, those
loans are gone. They are off the books. Capital
is freed up. It's totally freed up. They can
immediately turn around and lend that same money
out again to a new borrower. And every time they
originate a loan, they get a fee. So the whole
model shifted. Completely. It shifted from what
was called originate to hold, where the bank
makes a loan and holds it for 30 years. So they
really care if you pay it back. Right. To originate
to distribute. Volume over quality. They didn't
care if the borrower could pay the loan back
in 30 years. They only care if they could sell
that loan to a CDO manager next week. It turned
banks from vaults into pipelines. Just keep the
product moving. Okay, so that's the supply side.
The banks are incentivized to create as much
of this stuff as possible. What about the demand
side? Who was buying all of this? Well, you had
this massive, massive wall of money that was
sloshing around the globe looking for a home.
Economists call it the global savings glut. A
glut of savings. Between the year 2000 and 2007,
global fixed income investments, that's the bond
market, doubled. It went to $70 trillion. $70
trillion. That is a staggering amount of money.
Where was it all coming from? It was coming from
everywhere. You had emerging market economies,
especially China, running huge trade surpluses.
They were selling us goods and getting paid in
dollars and they had to invest those dollars
somewhere. You had oil producing nations in the
Middle East that were just flush with cash as
oil prices skyrocketed. All of this money needed
a safe place to go to earn interest. But U .S.
Treasury bonds, the safest investment in the
world, were paying peanuts at the time. Exactly.
You have to remember the context. This is the
period after the... bubble burst. It's after
9 -11. The Federal Reserve, under Alan Greenspan,
had slashed interest rates to historic lows to
stimulate the economy. So investors were desperate.
They were desperate for yield. They needed profit.
At the same time, they were scared. They'd just
been burned by the stock market crash. So they
also wanted safety. They wanted that AAA rating.
So you have this paradox. I want high returns,
but I also want zero risk. Which is impossible,
usually. But the CDO seemed to be the perfect
solution. It offered the yield of a riskier asset.
Remember, it pays better than regular bonds,
but it had that triple A stamp of safety from
Moody's or S &P. It looked like a safe Treasury
bond, but it paid like a much riskier corporate
bond. It was the perfect product for that exact
moment in time. And that insane global demand
drove the machine. Wall Street had to feed the
beast. But then. They hit a problem, a supply
problem. This is where the story turns. This
is the big shift to subprime. Because eventually,
you just run out of good collateral. You run
out of aircraft leases and high -quality corporate
debt. You do. By 2003, 2004, the supply of prime
mortgages and diverse loans was basically exhausted.
But the investors, the Chinese sovereign wealth
funds, the German pension funds, they were still
screaming for more CDOs. So the bankers on Wall
Street started to substitute the collateral.
They started using subprime mortgages. Correct.
The assets inside the box changed. The recipe
changed. By 2004, mortgage backed securities
already accounted for more than half of all CDO
collateral. By late 2005, some of these portfolios
were 85 % subprime mortgages. So the diversification,
that whole safety net we talked about earlier,
was just gone. It evaporated. It was all betting
on one thing and one thing only, the U .S. housing
market. Wait, this is the part that always gets
me. If you fill a box with really risky subprime
loans, how do you still get a AAA rating on the
top slice? I mean, if I fill a box with dynamite,
I can't write safe on the lid just because I
packed it really tight. This is the alchemy.
This is the magic trick. And it involves a very
specific mechanism called mezzanine recycling.
This is arguably the single most important concept
to understand, and it's the one that usually
gets skipped over in the movies. Okay, let's
break this down slowly. Mezzanine recycling.
This sounds like some eco -friendly initiative
at the office, but I have a feeling it's not.
Far from it. Okay, so think about a regular mortgage
-backed security. an MBS, not even a CDO yet,
just a plain vanilla pool of mortgages. OK. When
you slice up that pool of mortgages, it's actually
pretty easy to sell the top AAA slice. Everyone
wants that safety. Right. It's also surprisingly
easy to sell the bottom super risky equity slice
because hedge funds love the gamble. They love
the high potential return. But the middle. What
about the slices in the middle? The mezzanine
slices, the stuff that's rated BBB. It's the
unloved middle child of the capital structure.
It's too risky for the conservative pension funds.
Their rules say they aren't allowed to buy it.
But the yield isn't high enough for the aggressive
hedge funds. They can't be bothered with it for,
you know, 8 % return when they're looking for
30%. So Wall Street had this glut. They had a
problem where these BBB rated mortgage bonds
were just piling up in their warehouses. Exactly.
It was a law jam in the system. And if you...
can't sell the middle part of the deal. You can't
do the deal at all. The entire assembly line
was jamming up. So what did they do? They got
creative. They gathered up all these unwanted
BBB rated mortgage bonds from dozens of different
deals and they put them into a brand new CDO.
A CDO made entirely of the leftovers of the stuff
nobody else wanted. Entirely. It's what was sometimes
called a CDO squared because it was a derivative
of a derivative. But here's the magic. They applied
that same waterfall logic to this new pool of
junk. Even though it was all junk. Even though
it was all junk. They said, OK, even though these
are all BBB rated bonds, surely they won't all
default at the exact same time. They're from
different parts of the country. A default in
Florida doesn't automatically mean a default
in Ohio. So they took this pool of leftovers
and they sliced it up again. Yes. They created
a new senior tranche on top of this pool of BBB
rated bonds. And the rating agencies, they looked
at that new structure, ran their models, and
they said. That's AAA. Correct. That is just,
it's insane. You take a pile of BBB bonds stuff
that was explicitly defined as medium risk that
nobody wanted. You put them in a box and then
you claim that 70 or 80 percent of that box is
now the safest investment on Earth. That is exactly
what happened. It was called ratings arbitrage.
Gretchen Morgenson, a fantastic journalist who
covered this, called it turning gross into gold.
They were literally manufacturing AAA assets
out of subprime risk. And this is where the math
has to come in, right? Yeah. Because they couldn't
just do this on a whim. They had to have a model,
a formula to justify this to investors, to regulators.
You can't just wave a wand and say it's safe.
You need a spreadsheet. And they have one. Enter
David X. Lee. In 2001, he published a paper introducing
the Gaussian copula model. That sounds like something
out of a sci -fi movie. The Gaussian Copula.
It was, in its field, a massive statistical breakthrough.
Before this model, pricing these complex correlations,
trying to figure out how likely it was that two
different loans would default at the same time,
was incredibly difficult and slow. It took massive
computing power. And Laya's formula simplified
it. Drastically. It used a single elegant parameter,
the price of a credit default swap, a CDS, as
a proxy for the correlation between any two assets.
It made the math clean. It allowed banks to price
and structure these complex CDOs with incredible
speed. It became the industry standard almost
overnight. The traders must have loved it. They
adored it. They could value a complex deal in
minutes instead of days. But there was a flaw
in the model. A fatal flaw. A huge one. The model,
like all financial models, relied heavily on
historical data to predict correlation. And here
is where we need to talk about the difference
between a house fire and a forest fire. I love
this analogy. Let's walk through it. Okay. If
I'm an insurance company and I insure your house
against fire, the risk is unique to you. It's
uncorrelated. Just because your kitchen catches
fire doesn't mean your neighbor's kitchen will
suddenly catch fire. Right. So it's safe for
the insurance company to insure the whole neighborhood
because the odds of every single house burning
down at the same time are practically zero. Unless
there is a forest fire. An external systemic
event. A strong wind. A drought. The Gaussian
Copula assumed that mortgage defaults were like
individual kitchen fires. It assumed that housing
markets in different cities were largely independent
of each other. It looked at all the historical
data and said, we have never had a nationwide
decline in U .S. housing prices, not since the
Great Depression. It assumed the forest fire
was impossible. Exactly. But when lending standards
collapsed nationwide and when teaser interest
rates all reset higher at the same time nationwide.
Correlation went to one. It was a forest fire.
Everyone defaulted at once. And the model just
couldn't handle that scenario. It wasn't programmed
for it. Okay, but what about the rating agencies?
Why didn't they catch this? Why were they handing
out AAAs like candy if the model was so obviously
fragile? This was their only job. Well, this
is where it gets really ugly. It's about the
conflicts of interest. We have to look at the
fee structure. The rating agencies, Moody's,
S &P, Fitch, they are paid by the issuers. So
they're paid by the banks creating the CDOs.
Yes. So if I'm a bank and I want my brand new
CDO to be rated, I go to Moody's and I pay them
a fee. And if Moody's looks at my deal and says,
hmm, this is only worth a double A. I just take
my business down the street to S &P and see if
they'll give me the triple A I want. And if they
do. They get the fee. It was a race to the bottom.
And it was an incredibly profitable business.
At its peak, Moody's structured finance division,
the part that rated these CDOs, accounted for
44 percent of all their sales. Their profit margins
were over 50 percent. That's higher than Exxon
or Microsoft at the time. It was one of the most
profitable businesses on the planet, so they
had zero incentive to be tough. In fact, they
had every incentive to look the other way, to
be flexible with their models. If they started
saying no to the banks, they would lose market
share and their stock price would fall. Joseph
Stiglitz, the Nobel winning economist, he later
blamed them for performing alchemy. He said they
converted F -rated risk into A -rated paper.
That's a perfect summary. And what happened was.
investors, even sophisticated ones, they stopped
doing their own homework. They just bought the
rating. They saw the AAA stamp and bought it
blindly. They completely outsourced their due
diligence to the very agencies that were being
paid by the people selling the product. It seems
like we have all the ingredients for a complete
disaster. We've got bad loans, a flawed structure,
broken models, and conflicted referees. But wait,
there's more. We haven't even talked about synthetics
yet. This is where it goes from a bad idea to...
Total insanity. Synthetic CDOs. Yeah. This is
where we really leave the realm of actual lending
and we enter the realm of pure betting. So what
is the fundamental difference between a cash
CDO and a synthetic one? A cash CDO owns actual
things. It goes out and buys real bonds, which
are backed by real mortgages on real houses owned
by real people. You buy a cash CDO, you are,
in a very indirect way, funding a homeowner's
loan. Okay. And a synthetic. A synthetic CDO
doesn't own anything. It doesn't buy a single
bond. It just references those bonds. And it
does this using credit default swaps or CDS.
OK. How does that work in simple terms? A CDS
is basically an insurance contract. Let's say
I'm an investor and I sell you a CDS on a particular
mortgage bond. I'm selling you insurance. I am
betting that bond will not default. Okay. In
exchange for taking that risk, you pay me a premium,
like an insurance premium, every quarter. If
the bond pays out fine, I just collect the premiums
and I'm happy. If the bond defaults, I have to
pay you the full face value of the bond. So in
a synthetic CDO, the assets aren't bonds. The
assets are these insurance bets. Exactly. The
investors are selling insurance, betting the
bonds won't default, and the cash flow is the
premiums they collect. And here's why that distinction
is so unbelievably important. Go on. In the real
world, there is a limit. There is a finite number
of bad mortgages that exist in America. There
are only so many subprime borrowers. You can
only package the actual loans once in a cash
CDO. But with synthetics. There is no limit.
You can create a thousand different synthetic
CDOs all referencing the exact same pool of bad
mortgages. It's like fantasy football. There's
only one Patrick Mahomes. But you could have
a million different fantasy leagues where people
are all betting on his performance. If he breaks
his leg, the Chiefs only lose one quarterback,
but a million fantasy owners lose their bet.
That is the perfect analogy. It allowed the amount
of money moving in the system, the amount of
risk, to vastly, vastly exceed the actual value
of the underlying real estate market. It multiplied
the risk exponentially. And it was faster and
cheaper to create, right? Yeah. You didn't have
to go out and actually find real borrowers and
originate real loans. Much faster. You could
create these things out of thin air in a conference
room in an afternoon. You didn't need to wait
for a bank in California to make a loan. You
just needed two guys on Wall Street willing to
take opposite sides. And as the supply of actual
subprime borrowers started to dry up, synthetics
took over to keep the fee machine running. OK,
so we have the broken structure, the bad incentives,
the flawed math, and now the infinite multiplier
of synthetics. Now comes the crash. The year
is 2006. Housing prices, which had been on this
incredible tear, they peak. They level off and
in some places they start to fall. The engine
is starting to sputter. And we start hearing
these incredible stories about the underwriting
standards. I mean, the warning signs were there
for anyone who bothered to look. Oh, they were
everywhere. Michael Lewis tells the famous anecdote
in his book of the Mexican strawberry picker
in Bakersfield, California. An individual with
a stated income of $14 ,000 a year who didn't
speak a word of English was lent $724 ,000 to
buy a house. And I'm guessing that was with a
teaser rate. Of course it was. A 228 or 327 adjustable
rate mortgage. You get a very low affordable
payment for two or three years. But when those
two years are up, the rate resets to a much higher
level. The monthly payment skyrockets. And in
a normal market, you would just refinance into
a new loan. But you couldn't because house prices
were now falling. Your house was worth less than
your loan. You were trapped. So the default start.
And if we go back to our water analogy, the water
stops flowing. The flow slows to a trickle and
then it stops. The bottom cups, the equity tranches,
they dry up immediately. Then the mezzanine cups.
But because of that mezzanine recycling we talked
about, where the senior tranches of many CDOs
were actually made of mezzanine risk from other
deals, the top cups, the safe AAA cups, started
to dry up too. The turning point, the moment
the market really woke up, seems to be the summer
of 2007. July 2007. Two hedge funds run by the
investment bank Bear Stearns completely collapsed.
They were highly leveraged in subprime CDOs.
They sent a letter to their investors telling
them they would get little to nothing back on
their investment. That was the tremor before
the earthquake. And then the downgrade started.
The referees finally changed the call. It was
an avalanche. It was too little, too late. In
the first quarter of 2008 alone, the rating agencies
announced 4 ,485 downgrades of mortgage securities.
4 ,000 in three months. Think about that number.
4 ,485 securities that were sold as safe investments
suddenly weren't. It's the forest fire. It's
the forest fire. And the numbers are just shocking.
By 2009, more than half of all the AAA -rated
CDO tranches that were issued between 2005 and
2007 were either downgraded to junk status or
had already lost principal. That's $300 billion
of safe money just gone. There's that famous
line from the big short movie. They describe
CDOs as... Can we say it? Dog shit wrapped in
cat shit. It's a graphic description, but by
the end, it was an accurate one for how the product
had evolved. It was toxic waste wrapped in more
toxic waste and sold with a gold -plated bow
on top. So the system collapses. Banks fail.
The government steps in with bailouts. But I
want to talk about the aftermath. The blame game.
Yeah. Because it wasn't just that a bunch of
investors lost money. It was the systemic impact
of these things. They were the engine. The Financial
Crisis Inquiry report makes this very clear.
Without the CDO machine, lenders would not have
pushed subprime loans so aggressively. They only
made those bad loans because they knew there
was a buyer. They knew they could sell them to
the CDO machine. The demand for the securities
created the supply of the bad loans. And the
whole idea of dispersing risk turned out to be
a fantasy. We didn't disperse it. We concentrated
it. Exactly. The risk didn't disappear. It just
got hidden. And where did it end up? It ended
up right back on the balance sheets of the biggest
banks in insurance. companies in the world. People
like AIG, Citigroup, Merrill Lynch. Why did they
end up holding it? Because they would often hold
on to the super senior tranches, the absolute
safest top of the waterfall slice. They thought
it was basically risk free and they could earn
a tiny bit of extra yield by keeping it for themselves
instead of selling it. When those supposedly
risk free tranches failed, the institutions themselves
failed. They choked on their own cooking. We
have to mention some of the specific villains,
or at least the specific examples of excess that
came out in the investigations. Because there
are stories here that sound completely illegal,
even if they were technically just business.
The story of Magnetar is probably the most damning.
They were a hedge fund out of Illinois. They
figured out early on that the market was going
to crash. But instead of just shorting the market,
they actively helped create more bad CDOs just
so they could bet against them. This is the infamous
Norma CDO. That's the one. They worked with Merrill
Lynch to create a CDO called Norma. Magnetar
helped select the assets that went into it. And
guess what? They picked the absolute worst, most
toxic stuff they could find. One consultant called
it a hairball of risk. So they built a bomb,
helped Merrill Lynch sell it to unwitting investors
as a safe house. And then they went and took
out a massive insurance policy on the house blowing
up. That is exactly what they did. They would
buy the riskiest equity slice, the bottom cup.
just to get the deal off the ground that would
cost them a little money but then they would
take out huge bets against the upper slices of
the deal using credit default swaps when the
whole thing inevitably blew up Their small loss
on the equity was dwarfed by their massive gains
on the shorts. And Goldman Sachs had a similar
situation with their Abacus CDO deal. Right.
That led to the 2010 settlement with the SEC.
They paid half a billion dollars. They were accused
of not disclosing to the investors who bought
the Abacus CDO that a famous hedge fund, Paulson
& Co., had not only helped select the assets,
but was also simultaneously making a massive
bet that it would fail. It really paints this
picture of a rigged game. It wasn't just bad
luck or a flawed model. In some cases, it was
engineered failure. It does. Patrick Parkinson,
who is a senior official at the Fed, later called
the whole concept of these subprime -backed CDOs,
these EBS CDOs, an abomination. It wasn't just
a bad trade. It was a structurally flawed concept
from the beginning. It relied entirely on the
one assumption that could never break. that house
prices never go down. And yet people made fortunes.
And many of them kept those fortunes. So as we
wrap this whole thing up, what's the big takeaway?
If you're listening to this in 2026, why should
you care about the intricate mechanics of a CDO
from two decades ago? The takeaway for me is
about complexity. The CDO started as a genuinely
useful tool for diversification, a way to fund
aircraft and student loans. But complexity became
a hiding place. A way to hide risk. A way to
hide risk and a way to generate fees. The waterfall
structure, the mathematical models, it all looks
so sophisticated. But it only protected the senior
investors as long as defaults were low and uncorrelated.
The incentives, the origination fees for banks,
the desperate search for yield by investors,
the ratings fees for the... It's that old reminder,
if you don't understand it, you probably shouldn't
buy it. And if the person selling it to you relies
entirely on a model they can't explain without
a PhD in physics, you should probably run. And
remember the human element in all of this. These
weren't faceless machines destroying the world.
It was people. People at every level who convinced
themselves that house prices never go down. People
who didn't want the music to stop because they
were making too much money. It was a mass collective
willful blindness. So here's a final provocative
thought for you to chew on. We've just spent
this time looking at how CDOs turned into these
monsters. But financial engineering didn't die
in 2008. No, it didn't. Wall Street never sleeps.
It just rebrands. Today, we have things called...
called structured operating companies. We have
a boom in new forms of securitization in private
credit. We have CLOs collateralized loan obligations,
which are booming and look eerily similar to
CDOs, but are backed by corporate loans instead
of mortgages. We changed the acronyms, but have
we actually fixed the underlying incentive problem?
That is the multi -trillion dollar question.
Does financial complexity in the end actually
create risk rather than dispersing it? By trying
to engineer perfect safety, do we just end up
building a bigger, more complicated bomb? Are
we just inventing new ways to hide the same old
human greed and fear? Something to think about
next time you see a product that promises a guaranteed
high return. Thanks for listening to The Deep
Dive. Stay curious.