CDOs explained

I saw this a few days ago on delicious, and it’s very good. It explains how collateralized debt obligations (CDOs) work, and how they caused a problem in the financial sector.

The only thing that I would add that Paddy doesn’t really mention is that when mortgages were sliced up to be sold, pieces of a single mortgage could end up in any tranche from a legitimate, first-tier AAA rating to the lower, second-tier BBB rating. That indicates that the ratings were meaningless because it’s logically impossible for one mortgage to be both low risk and high risk at the same time — yet this kind of thing happened regularly. Pension funds and other programs that are only allowed to invest in AAA-rated securities for stability reasons were severely hurt because it was impossible for them to know they were buying junk. The ratings agencies were not doing their job, possibly because they couldn’t understand what they were evaluating, and possibly because it was in their short-term best interest to look the other way for political reasons. I suspect it was a bit of both.

The creation and sale of these investment vehicles was so complicated and obfuscated it was almost impossible to know which were truly AAA, and which were junk. Several hedge fund managers spent a whole lot of time digging into the soft underbelly of these investments, and shorted the hell out of the lower-tier BBB CDOs. Even they had a hard time figuring out which were which. This short-selling activity was the only information being added into the marketplace that was any indicator that these investments were bad. (Which is why banning short-selling is a terrible idea.) Literally everyone else thought they were great, with the exception of a handful of contrarian analysts like Meredith Whitney. While many people say they “saw it coming!” — few actually did. Hindsight is always 20-20; informational cascade tends to wash out an individual’s own private misgivings which is why analysts like Whitney were castigated and short-sellers like Steve Eisman and Andrew Lahde were scorned during the subprime heyday.

You can read more about some of this in this superb Portfolio piece.

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