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'CDO Squared Senior Tranche' Prompts Bank Woes

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For the third time in just a few months, Merrill Lynch has taken a huge, multi-billion-dollar "writedown" on its investments in mortgage-backed securities. Banks are suffering big losses because of one particular financial instrument: the CDO-squared senior tranche. What is it?


From NPR news, this is ALL THINGS CONSIDERED. I'm Michele Norris.

The investment bank Merrill Lynch has taken another $9 billion write-down related to mortgage investments. Tomorrow, we expect Citigroup to announce its own huge losses. In the past few months, global banks have estimated their losses at well over $200 billion. The largest chunk of this losses relate to an obscure and little-understood financial instrument with an odd name - collateralized debt obligation, or CDO. Sound like mumbo jumbo?

Well, NPR's Adam Davidson is here to help explain what a CDO is and why it has played such a large role in our financial turmoil. Hello, Adam.


NORRIS: So what in a world is a CDO?

DAVIDSON: Well, let me explain it by explaining the problem a CDO solved. Let say you're investment bank and you owned a whole bunch of subprime mortgages - mortgages owned by people who don't make a lot of money, who have a really high risk of defaulting or foreclosing.

And then you have all these customers who don't want risk. You have insurance companies, pension plans, people who want very safe, very sober investments. How are you going to match these two things? Well, you use something called a CDO, this collateralized debt obligation.

NORRIS: So how does it work?

DAVIDSON: What a CDO does is it pulls a whole bunch of these really high-risk assets together and what you know is - if you have thousands of subprime mortgages, you know some people are going to default, some people are going to miss payments, but you know at least some of them are going to pay on time. The estimate was, you know, something like 90 percent will pay on time each month.

So you go to those pension funds and those insurance companies and you say you're first in line for the money. No matter who pays it, you'll get the money first. And so you tell them, we have converted that pool of risky assets into a very reliable, very safe, very sober stream of money, at least that was the theory. It turned out not to work.

NORRIS: Well, what happened? Why didn't it work?

DAVIDSON: Ninety percent didn't pay on time, 80 percent paid on time. And that difference is a big, big difference. We had foreclosure rates far higher than anyone had ever seen.

And so the banks had to turn to their customers and say, you know, we promised you some money, were not going to be able to deliver you that money. Worst than that, the banks had held on to a lot of these themselves. They saw it as almost a risk-free way to make money. It turned out it was a high risk way to lose money.

NORRIS: Did they lose all their money? Did these CDOs hold any value?

DAVIDSON: We have absolutely no idea. And it's not that I have no idea, nobody has any idea. And the reason is this, as recently the year ago, these CDO assets were traded very freely. It was - you know, people wanted them, people were selling them and buying them. Today, you couldn't sell this for anything. Nobody wants to buy them. And when there's no market for something, there's no price for something. Nobody knows how much they're worth. So when it's earning season - when, by law, they have to say how much money they have, they take a guess. That's all they can do.

NORRIS: So a case in the news may help us understand this a bit. Merrill Lynch reported another write-down at $9 billion today. Is that the same as a $9 billion loss?

DAVIDSON: No, its not. They're saying we are guessing that our assets today are worth $9 billion less than they were last quarter.

NORRIS: Is it a conservative guess?

DAVIDSON: Yes. It's in an over-conservative guess, some would say. They want to show that they're taking the problem very seriously. And there's a decent chance that in a year or two, they'll actually say, right up and say, we are worth billions of dollars more than we thought.

NORRIS: So what role did this play in the widespread financial turmoil?

DAVIDSON: It was supposed to spread risks so widely that nobody would be hit. It did the opposite. It spread risks so that everybody was hit. I mean, banks in Kazakhstan, banks in China and all over Europe bought these CDOs, and now that they are losing value, suddenly you have billions and billions of dollars of - in capital just disappearing from the world market overnight.

NORRIS: Adam, thank you. I think we're all much clearer on this now. That's NPR's Adam Davidson. Thanks so much, Adam.

DAVIDSON: Thank you, Michele.

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