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What does a CDO manager do? How much can CDO managers make? What role did one CDO manager play in The Big Short?
A CDO manager is someone who manages collateralized debt obligations. A CDO manager may also repackage original CDOs (themselves repackaged bundles of mortgages) into new towers of bonds.
We’ll cover what CDO managers do, how much they can make, and why one CDO manager was ridiculed in the book and movie The Big Short.
The Big Short’s CDO Manager
In January 2007, Deutsche Bank employee Greg Lippmann flew investor Steve Eisman and his team out to a giant annual convention of subprime lenders, speculators, investors, and CDO managers.
Lippmann had Eisman meet a CDO manager named Wing Chau. Eisman hadn’t even known that there was such a thing as a CDO manager (because what was there to manage?), but here was one in the flesh. Chau was a middleman whose job was essentially just to take triple-B tranches of original CDOs (again, themselves composed of subprime mortgage bonds) and repackage them into new towers of bonds. He would then pass them off to unwitting investors like pension funds and insurance companies. And by buying more and more mortgages to immediately repackage and resell, CDO managers like Chau directly contributed to the demand for these bonds and the subprime mortgages of which they were composed. It was like a machine that nobody knew how to turn off.
And, to the disgust of Eisman, who was becoming a major player in the “big short” leading up to the 2008 financial crisis, this CDO manager depicted in The Big Short was paid obscenely for doing nothing more than shuffling around stacks of useless debt. He received a 0.01 percent fee off the top of the total CDO portfolio he managed, before any of the investors he theoretically served got paid anything. This, of course, gave the CDO manager every incentive to grow the pile of CDOs as large as he or she could, no questions asked about the quality of the underlying loans. And 0.01 percent was a lot when you were talking about billions of dollars. In just one year, a CDO manager like Chau could take home $26 million.
Lippmann knew that figure like CDO managers embodied everything that Eisman hated about Wall Street. This CDO manager was arrogant, mediocre, wildly overcompensated, and had his clients’ worst interests at heart. He was a living representation of the dumb wealth that Eisman found so appalling. Meeting this CDO manager was just the sort of boost that Steve Eisman needed to continue shorting the subprime market. Not only did Eisman stand to make lots of money, but he would do so at the expense of the CDO managers of the world. That was a powerful enough motivation all by itself. After he left the dinner, Eisman pulled Lippmann aside and told him, “Whatever that guy is buying, I want to short it…I want to short his paper. Sight unseen.”
CDO managers weren’t concerned with the housing bubble: these loans had never defaulted in the recent past, so why should they now? They were using the statistically irrelevant past to predict the unknowable future. In fact, they underrated the chance of a catastrophe in the housing market precisely because it would be such a catastrophe. CDO managers had deluded themselves into believing that nothing so cataclysmic could actually happen. In thinking this way, they were no different than gamblers riding a “hot streak” at the roulette table, fooling themselves into thinking that the good luck on the last roll of the dice had anything whatsoever to do with what happened on the next roll.
It was a marvelous look inside the sordid world of the subprime mortgage-backed securities business. Eisman met all of the key players who did their part to keep this engine of financial doom going—the investment bankers at the big banks selling these poison bonds to unknowing investors, the people at the smaller banks who packaged the loans into those bonds, the intermediaries who reshuffled those bonds into new CDOs, the loan originators, the CDO managers, and the people at the ratings agencies who gave the whole process their stamp of approval.
What’s a CDO?
We know that CDO managers manage CDOs. But what’s a CDO?
According to The Big Short, the CDO was a product designed to conceal the true risks of mortgage-backed securities. A CDO bundled together the lowest-quality bonds into a whole new tower. It was a bundle of bundles. Bizarrely, the ratings agencies treated this repackaged product as an entirely new financial instrument and slapped a triple-A rating on it (the highest rating that can be given to an asset). These ratings defied market logic and common sense. The CDO wasn’t a new financial product at all—it was just a Frankenstein monster made up of the dodgiest tranches of the original mortgage-backed securities. Yet the ratings agencies treated it as a completely separate portfolio of assets. Apparently, to Moody’s, S&P, and Fitch (the Big Three ratings agencies), the CDO was greater than the sum of its parts.
If this sounds confusing or abstract, that’s because it was supposed to be. Complexity was baked into the design—Opacity was the point. These are the kinds of financial products, structured asset-backed securities, that CDO managers manage.
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Here's what you'll find in our full The Big Short summary :
- How the world's biggest banks contributed to the 2008 financial crisis, greedily and stupidly
- How a group of contrarian traders foresaw the bubble popping, and made millions from their bets
- What we learned from the 2008 crisis - if anything