The inside story: Decoding the CDO black box
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The inside story: Decoding the CDO black box

2006: In the approach to the 2008 global financial crisis, Euromoney became concerned about hidden risks and complications in the structured credit markets (from the imagination of Jon Macaskill).

O'Neal's isolation_780

Euromoney was keen to examine the structured credit production line that had come to dominate debt market activity, so in 2006 accepted a temporary job as an analyst at rating agency Moody’s.

The market for collateralized debt obligations (CDOs) was booming, and increasingly complex structures were being used to add leverage to asset-backed deals. 

CDO squared bonds, which used existing CDO tranches to create new deals, were already common and on Euromoney’s first day at Moody’s a group of bright-eyed young bankers from ABN Amro arrived to ask for a triple-A rating on an even more esoteric structure – the constant proportion debt obligation.

“This looks frightfully complicated,” said the head of Moody’s London office, an elderly gentleman with a slide rule behind his ear and five pens in his shirt pocket. “Where are those young fellows from the university today?”

The latest crop of graduate hires had in fact recently finished their probation and gone to work for investment banks, so Euromoney volunteered to cast an eye over the structure.

“This looks like it will work perfectly well as long as the leverage never has to be adjusted in a period of volatility, so we might want to run some extended testing,” Euromoney said.

The ABN bankers were becoming impatient. “The key aspect of this structure is that we will pay you a fee today for a rating and it already has a triple-A from Standard & Poor’s,” said the team leader. 

“Do you understand?” he asked, raising his voice and speaking slowly.

The Moody’s manager nodded and retreated unsteadily to his office, emerging some time afterwards with his triple-A stamp clutched in both hands.


Euromoney had heard that structured credit was effectively a pay-to-play market where bankers and hedge fund managers ran rings round rating agency analysts, but this was still a shock.

And if European structures were testing limits, what was happening in the US – the home of the sub-prime mortgage? Euromoney used the cover of our rating agency status to drop in on some of the banks that were most active in packaging asset-backed securities.

Merrill Lynch’s gleaming HQ in downtown New York was as alarming in its own way as the shabby Moody’s offices.

Chief executive Stan O’Neal was showing increasing signs of isolation, hitting golf balls out of his office window into the Hudson below, trying and failing to reach the Statue of Liberty in the distance, while a silent Ahmass Fakahany teed up his balls.  

If you polish a mortgage-backed security does it become a mirror? What is the sound of one bond defaulting? - Dow Kim

O’Neal had appointed debt specialist Dow Kim as co-president and head of global markets, but Kim’s gnomic comments did not give much more useful direction to the thundering herd of Merrill sales staff.

“The world is vast and wide,” Kim said at one town hall meeting. “If you polish a mortgage-backed security does it become a mirror? What is the sound of one bond defaulting?”

Chris Ricciardi, a CDO salesman from Westchester County, had learned to communicate with the head of markets. “What is the way we must tread, master?” he asked.

“Ramp up sales,” replied Kim. “And warehouse where necessary, for only then shall we surpass Goldman in revenues.”

A visit to the UBS campus in Stamford, Connecticut did not provide any more comfort. UBS had built the largest trading floor in the world and marketed the fact that it was bigger than a football field. 

This encouraged the dealers to set up goals at either end of the floor and compete for yardage as in a real American football game, with unfortunate consequences for the Chinese walls that were supposedly in place to restrict insider dealing.

Market madness

There were some voices of sanity amid the credit market madness, but they struggled to be heard.

Euromoney arranged to visit Deutsche Bank’s New York headquarters at 60 Wall Street and discuss ways to short the mortgage-backed bond market with Greg Lippmann, later to be made famous in the book and film of ‘The Big Short’. But at the last minute Lippmann sent his apologies and cancelled the meeting.

“I’ve been told I have to go to our derivatives conference in Barcelona and serve tapas to clients,” he said. “Plus Anshu Jain [head of global markets at Deutsche] has booked the Rolling Stones to play at dinner for €5 million and he wants me to take profits on my short CDO positions so we can pay Mick Jagger in cash.”

It was with a growing sense of foreboding that Euromoney returned to London, just months before the global credit markets began to crack.