Study Guide

The Big Short: Inside the Doomsday Machine CDOs

By Michael Lewis

CDOs

If you're like us, then you still had some questions about the nature of a CDO, or collateralized debt obligation, after finishing The Big Short. That's no accident. These things were expressly designed to confuse the person looking at them, so we're going to have to take a deeper look to understand what's going on under the surface.

CDO 101

In its simplest terms, a CDO is a bond. When you buy a bond from someone, you're lending that person a specific amount of money, which he or she agrees to pay back over an agreed-upon period of time, with interest. Pretty easy so far, right?

Originally, CDOs contained a variety of different types of debts, from student loans to home mortgages to business leases. This is important, as having a variety of income sources means that the bond is insulated should one of those sources go bad. Housing market going south? No sweat—those student loans are still chugging along just fine.

Between the 1980s and 2000s, however, CDOs begin to be exclusively filled with home mortgages. For example, by 2004, "the 'consumer loan' piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to being 95 percent subprime mortgages" (3.25). Whoa.

That's a bad thing for the reason listed above: if the housing market takes a downturn, the entire bond will be affected, rather than just a portion of it. But when you consider the fact that these mortgages are primarily subprime (translation: really bad) the chance that those CDOs will lose their value rises exponentially.

Postmodern Finance

But we're not done, not by a long shot. Over the course of the 2000s, the banks manipulated CDOs even further, misguiding the ratings agencies into rating low-quality mortgages as if they were top-of-the-line. What's more, the actual content of those CDOs turned into a twisty labyrinth, with many mortgages being represented in multiple CDOs. That means you could buy five CDOs that contained 90% of the same mortgages. That's legit nuts.

Nothing compares to the synthetic CDO, however. Every time someone bet against a CDO using a credit default swap, the bond trader simply took that bet, packaged it together with a bunch of other bets, and created a brand new CDO. Really. To the outside viewer, these synthetic CDOs were indistinguishable from normal ones.

In practical terms, however, this process ballooned the amount of debt associated with the subprime market: "to make a billion-dollar bet, you no longer needed to accumulate a billion dollars' worth of actual mortgage loans" (3.39).

Causing a Crisis

Are you starting to understand what caused the 2008 stock market crash? Let's go step-by-step:

  • In the 1980s, CDOs become popular in the financial market.
  • In the early 2000s, CDOs start containing primarily subprime home mortgages.
  • In order to produce more CDOs, banks give out low-quality, subprime loans.
  • To pad their numbers further, individual subprime mortgages are placed in multiple CDOs, which means that a single bad mortgage can cause more debt than its actual value.
  • Once people start betting against CDOs, bond traders turn those bets into synthetic CDOs, which they buy and sell as normal ones.
  • In 2007, subprime mortgages start going bad, which starts off a domino chain of debt that collapses the economy.

Making more sense? Basically, the CDO system is an elaborate scheme of misdirection that obscures the fact that trillions of dollars' worth of CDOs are all pointing back to a handful of subprime mortgages. It's like building the Empire State Building out of Styrofoam and bubbles. If those mortgages go bad—or those bubbles pop—the whole building goes crumbling down with it.