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By Root 854 0

separate public offering that was not implicated in the case. Among other things, Cox wrote a letter for his client saying it “would unfairly and unreasonably harm the investors’ rate of return”5 to appraise pools of mortgages. Cox also wrote that suitability—a standard meant to ensure that naïve investors did not get saddled with risky product—should not apply: “Because all of the trust fund loans are secured and overcollateralized, there is relatively low risk.”6 Cox wrote his letter in 1985, and unbeknownst to Cox, his client’s fraud involving separate vehicles began in 1982 and continued until 1994. Appraisals may have stopped the fraud earlier. On July 29, 2005, Floyd Norris of the New York Times reminded his readers of Cox’s letter, yet the Senate Committee unanimously confirmed Cox later the same day. It was time to short CDOs, since the value added by the SEC’s Cox seemed likely to shrivel.

When I read prospectuses for CDO deals and CDO-squared deals, I felt as if I had opened a box of candies and found only one or two good pieces.The rest were either missing altogether, or had a bite taken out of them with someone else’s teeth marks. These were definitely not See’s Candies, a Berkshire Hathaway company. Some CDO-squared deals were so bad it left me thinking: Where is the candy?!

To use an extreme example, if you only use subprime-backed fraud-ridden mortgage loans as collateral for residential mortgage-backed security deals, and the RMBSs lose 60 percent of portfolio value, if you use investment grade tranches but with ratings lower than the top AAA of these RMBSs as collateral for a CDO, all of the collateral of your CDO will vaporize. If you use tranches of this defective CDO in yet another CDO called a CDO-squared, you are starting out with nearly worthless collateral, so the entire CDO-squared is nearly worthless on the day the deal is brought to market. It seems to me that some investment banks knowingly participated in predatory securitizations.

One does not need to read hundreds of pages of prospectuses or perform complicated modeling to know that. Warren looks at every investment as if it is a business, and the only “business” these investments have are the loans backing them. If the loans do not do well, the CDOs backed by them soon follow them down the tubes.

It will be too obvious if all of the collateral you use is this bad, so you might mix it in with some Alt-A or even some prime collateral in an RMBS. That way, if you use this collateral for a CDO, it won’t look so bad, and it will be devilishly difficult to analyze. For example, if you use BBB rated tranches of RMBS deals backed by a variety of types of loans, you can mix in 30 percent risky subprime loans. It sounds pretty safe, but losses will probably still eat through the BBB rated tranches. Now you take those doomed BBB rated tranches and combine them with A and AA rated tranches to create a CDO. All of the BBB rated tranches will disappear and probably some or all of the single A. If you buy the AAA tranche of this CDO, and it has around 25 percent subordination, your principal may or may not be in jeopardy, but most of the tranches below it are in trouble. Now if you use those lower tranches to make a CDO-squared, most of those tranches will probably lose principal. In some deals, all of the tranches below the senior-most triple A will lose the entire principal amount, and the senior-most triple A will lose substantial principal.

Credit derivatives enable a further level of gamesmanship and opacity. The documentation of many CDOs is dense with all sorts of cash flow tricks, and the contracts for the credit derivatives embedded in the CDOs are not included with the prospectuses. The ratings are completely meaningless.

In January 2007, I noticed that U.S. institutional investors curtailed their buying of CDOs. But investment banks had created new types of structured investment vehicles called SIV-lites, or structured investment vehicles with less protection (or lite protection). These vehicles invested in the overrated AAA tranches of