What are CDOs in The Big Short? Explained

During the 2008 crisis, the main problem was the mortgage back-securities, which were filled with risky and worthless loans. But bigger than mortgage-backed securities were the CDOs, which were the nuclear bomb that brought down the whole world economy. A CDO is a collateralized debt obligation. It was similar to the mortgage-backed securities product but much worse.

In the movie, you can see Mark Baum getting very angry after meeting with the CDO manager, Wing Chau. This is because these CDOs were designed in such a way that they were bound to fail.

So, before we understand how a CDO is created, you need to know how mortgage-backed securities are created. In one of our previous article, we explained it in detail. You should read it first.

Mortgage back securities

In the mortgage back security, the loans are arranged in layers, which are also known as tranches, and each layer is given ratings such as AAA, BBB, and CCC. If the mortgage back security has more AAA type loans, then it is considered a safe bond.

However, investors could bet money on each layer or tranche separately.
For example, if an investor does not want to take much risk, he would bet his money on the AAA type safest tranche, and the returns on these tranches were very minimal. If the investor bets on the BBB tranche, which is riskier than the AAA tranche, then they would get a much higher return on their investment. And if an investor wanted to bet their money on the CCC tranche, then their return on the investment was much higher as they had the riskiest loans. This was the normal mortgage-back security bond.

Creating a CDO

To create a CDO, banks use another trick. As investors were investing billions of dollars into these bonds, they mostly used to invest in the safest tranches of the MBS product, which are usually AAA or BBB tranches. The majority of these CCC tranches in these mortgage-backed securities would remain unsold.

Let’s say there are two MBS products, M1 and M2. Each product has AAA, BBB, and CCC tranches. Investors now invest in AAA and BBB tranches of M1, and in M2, they only invest in AAA. So, the CCC tranche from M1 is unsold, and the BBB and CCC tranches from M2 are unsold.

So, banks used to combine these unsold tranches from both MBS bonds into a product known as a collateralized debt obligation, or, in short, a CDO. In the CDO, the loans from the unsold tranches were arranged in different tranches. These tranches were typically labelled as senior, mezzanine, and equity tranches.

The Senior Tranche was the least risky and considered the safest. The mezzanine tranche is riskier than the senior tranche but offers higher potential returns. The equity tranche was the riskiest, and it offered the highest potential returns but was the first to absorb losses if the underlying assets in this tranche performed poorly.

Ratings of the CDOs

As explained earlier, these CDOs were made up of BBB and CCC unsold tranches from MBS. So, the rating of the overall CDO should not be more than BBB. However, the rating agencies gave AAA ratings to such CDOs. As you know, these CDOs were completely filled with tranches investors did not want, but the rating agencies still gave them higher ratings. Because of this, the investors thought these CDOs were also safe investments.

CDO of a CDO

Similarly, if the lower tranches of these CDOs are not sold, banks would combine the unsold tranches of other CDOs and make a new CDO that was just a CDO of a CDO. There was another type of CDO, which was known as synthetic CDO. These synthetic CDOs were so crazy that even the swap contracts that Michael Burry bought were added to these CDOs. When Michael Burry found out this, he bought more swaps against these CDOs, basically increasing his odds of winning. 

All these CDOs were managed and created by banks and promoted to investors by CDO managers like Wing Chau.

Why CDOs caused global crisis?

Investors from all over the world, such as German banks, Japanese farmer unions, and insurance companies around the world, had invested in these CDOs. These pension funds and insurance companies usually invest in safe investments as they have a pool of money from the common people. So basically, these investors had been lied to by these banks and CDO managers.

The mortgage-backed securities were already filled with riskier loans; on top of that, the riskiest of the loans were converted into the CDO and given AAA ratings. All the big investors around the world invested in these CDOs. Because of that, these CDOs were just a nuclear bomb waiting to explode. When people started defaulting on their loans, which were added to the MBS, it triggered a chain reaction that failed the MBS and CDOs, ultimately causing the global recession because investors around the world lost billions of dollars.

Conclusion

These CDOs are the primary reason why the 2008 crisis had a global impact, causing a worldwide recession. We hope you understood everything about CDOs. While betting his money, Michael Burry chose only credit default swaps rather than any other method. To know why Michael Burry chose only credit default swaps, you should read this article and subscribe to our YouTube Channel.

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