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There is one small problem with this. If you know or should know that you are not correctly pricing your balance sheet or if you knowingly sell overrated securities, you must disclose that, and you must be specific about it. If you know something is rated super-safe AAA; but it deserves a near-default rating of CCC, you cannot keep silent about it when you sell it.

When I pointed out to an investment banker that this is a classic situation for fraud, he told me: “Our internal OGC [Office of General Counsel] disclaims virtually all liability for [our investment bank] and its bankers in small print fully disclosing the risks in the prospectuses.” I knew what he meant, but he sounded like a smart 10-year-old parroting an adult.

“I did not attend law school,” I responded, “but I am pretty damn sure that just because you disclosed serious conflicts of interest, it does not protect you if you fail in your duty of care to investors.Your lawyers can’t give you a license to kill.”

The moral hazard swamped any risk the rating agencies’ models could capture. One investment banker crowed to me that the rating agencies are eager for fees and the investment bank’s structurers seeking ratings for their CDOs are “shrewd bullies.”

One synthetic CDO deal with a notional amount of more than $2 billion went into liquidation, and less than 3 percent of investors’ money was recovered. Even the investor in the top-most “AAA,” the super senior tranche, lost principal. Perhaps everyone involved with this deal, including the CDO manager, was just very unlucky. But do you want to do business with unlucky people?7

CDO managers are supposed to be selling securities backed by actual assets—not imaginary assets.

In November 2006, I told Asset Securitization that CDO managers are unregulated, and only a handful of managers provide good value for the fees charged. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies rarely ask for background checks on CDO managers.

Chris Ricciardi, CEO of Cohen & Company, read my commentary and wrote me: “I LOVED it.” He had been thinking about how to be “the best CDO manager in the business,” had independently come to the same conclusions, and found my “insight very compelling.” Yet in April 2008, Cohen & Company’s CDO management arm, Strategos Capital Management, led managers with CDOs in default. The total original amount of the CDOs it managed that had events of default (with as yet undetermined recoveries) was $14.2 billion.8

On December 7, 2007, I wrote Warren that many asset-backed securitization CDO prospectuses are finance comic books. For example, Adams Square Funding I closed December 15, 2006. It was an “asset-backed” deal, a collateralized deal. It was rated by Moody’s and S&P. Yet, before 2008 ended, the CDO unwound, meaning all of the underlying assets were sold in an attempt to pay investors back. Unfortunately, there was not enough cash after selling the loans to go around. According to S&P, investors in Adams Square Funding I got less than 25 percent of par value—more than a 75 percent loss—on average. Investors were wiped out, except for the investor in the seniormost AAA tranche.9 Since the prospectus shows that the seniormost tranche made up 29 percent of the deal, it appears those investors may have lost some money, too. It is reminiscent of the opening scenes of the movie Cliffhanger, in which a climber’s supports snap one-by-one ending in a spectacular steep fall. That last plastic buckle was AAA rated. Adams Square Funding I is not an isolated example, just a handy one, because it unwound. It is not even close to being the funkiest deal I have seen.

Warren’s ability to say “no” when the risk is not priced correctly is a tremendous advantage to any investors.

The prospectus for Adams Square Funding I disclosed the conflicts of interest