What Are "Collateralized Debt Obligations?" Watch These Champagne Glasses.

There’s a lot of funky financial terms getting thrown as we try to explain how the money meltdown started in the first place, and one of the funkiest is a CDO or “collateralized debt obligation.” Luckily, Paddy Hirsch from Marketplace is here to explain it using just champagne glasses, a whiteboard, and a sexy British accent..

Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.Basically, the CDO manager has a champagne bottle filled with mortgages. Every month when the debtors pay their mortgages, it fills the bottle with payments. The cork pops off and he pours the bubbly over a tray of glasses, each one representing a tranche of increasing risk.

The glasses at the top, rated AAA, get paid first and the least amount, and the bubbly flows down to AA, BBB, BB and equity, the tray at the bottom.

The party gets bad when people stop paying their mortgages. Now the bubbly only reaches the first levels, and the BB and the equity don’t get paid at all. To make it worse, we have a SECOND CDO manager.

His bottle, instead of being filled with the mortgages, is filled with the BB-rated securities. When a few people stop paying on the first bottle, that means his bottle has no juice at all. He has a whole champagne glass tower with glasses rated AAA through BB like the first one, but it’s not getting filled up at all. Then the champagne towers fall over and crash and Wall Street evaporates and there’s runs on the bank some wisenheimer paints the Wall Street bull’s balls blue. That’s CDOs for you.

If you enjoyed that one, he also made another video explaining Credit Default Swaps, which are what brought AIG down.

Crisis explainer: Uncorking CDOs [Marketplace]


Edit Your Comment

  1. tande04 says:

    I love it when they figure out ways to dumb it down for the rest of us.

    I got a simlar power point presentation in the mail with stick figures explaining the sub-prime meltdown. All finaly came together.

  2. Gopher bond says:

    It seems like no matter what regulation is put in place, financial types will always find some kind of unique package that looks nicely wrapped but is filled with poop. I mean, isn’t that what a lot of them get paid to do, that is, repackage and reduce the perception of risk? How do you stop that?

    • ojzitro says:

      @testsicles: Educate the buyers, caveat being, most humans are greedy and love money for nothing. So education is fleeting at best. It will never end, greed trumps wisdom in the brightest of men sometimes.

      It’s like P.T. Barnum said: “Every crowd has a silver lining.”

      Somebody will always buy crap, and the more crap that is sold, the more the seller/packager can say, “Look at all the smart people buying my crap”. We think of ourselves as such lofty beings, but we’re just animals that still, and always will follow the herd mentality.

      • Gopher bond says:

        @ojzitro: That’s kind of my point. Government is going to bolster and gust about how they need to regulate CDOs just like they ranted about the accounting regulations after Enron’s masterpiece of book cookery. The only thing that will stop is people from putting together packages like this, there will be a new type of security package with same outcome no matter what.

        • ojzitro says:

          @testsicles: I understood, I was just lamenting upon the greed of man. I am true romantic when it comes to the faults of man. I love human nature, even at it’s worst, it’s still amazing.

    • nicemarmot617 says:

      @testsicles: In this case the ratings agencies should have realized what poopy poop they were rating, but they didn’t. Subprime mortgages only became common after Bush’s home ownership initiative, but the ratings agencies kept rating them like they were the pre-Bush subprime mortgages. It was a pretty huge failing on its part.

      Not that I have any solutions to any of this…

  3. Pious_Augustus says:

    Of course we dont blame Barney Franks and Chris Dodd here for letting them play without economy so how much did Grokster (parent company of this site) give to our lord and savior barrack obama?

  4. catcherintheeye says:

    If you want even more of a mind-fuck, check out CDOs-squared

    Nomura has decent writeups on CDOs and CDOs-squared

    • Ass_Cobra says:


      Since he keeps calling the first champagne bottle a CDO I was assuming that’s what he was trying to talk about but since the first champagne bottle was actually filled with mortgages, he’s illustrating a straight CDO. He’s going to need another set of glasses to show how a CDO^2 works.

      If you want access to most of the Nomura stuff it’s here:


      I don’t think they publish much any more.

  5. Mr_D says:

    This is the perfect time to bring up my name for CDOs: Collateralized Debt Ordnance.

  6. mannyv says:

    Abstraction gone awry! Oh my!

    • humphrmi says:

      @mannyv: Abstraction and exotics have lived in our financial system for years without trouble. Look at options trading – it’s all about abstraction from the underlying asset. Abstraction isn’t the problem, it’s the ratings of these abstractions that were entrusted with agencies that had never gotten the chance to play in the “exotics sandbox”. All the sudden, the popular kids in the playground were asking them to play, and they got drunk with their power, hilarity ensued.

  7. Alcohol, is there anything you cannot help explain?

    • u1itn0w2day says:


      Actually… this is the before AND after picture.You drink before to celebrate BEFORE you realize what you have done and you drink AFTER when you finally realize what you have done.

  8. sleze69 says:

    Sounds like the people who rated the top tier of the second tower of glasses were incompetant or committing fraud.

  9. SasmitaScuderi says:

    Zippy, fun explanation. There is a whopper of a gloss, though… he casually mentions these CDOs were rated AAA, etc, by companies who did not understand what they were evaluating. Collapse of believability in bond ratings is undermining the credit markets like a cancer. What sensible manager will go for a Moody’s ‘AAA’ offering when in truth, who knows wtf ‘AAA’ really means anymore.

    • B says:

      @SasmitaScuderi: This is the key to the whole thing. However, I don’t think they were rated AAA simply because the CDOs were misunderstood, i think it was active fraud by the investment bankers and rating companies to give them a high rating. And this is why the market failed, because the misrepresented securities meant the market was no longer free.

      • ojzitro says:

        @B: Blaming only the rating agencies for this is a bit naive.

        • B says:

          @ojzitro: That’s why I’m also blaming the investment bankers. But you’re right. Its also the fault of the mortgage lenders for giving out loans to people who couldn’t pay them back and of course the borrowers for taking out loans they couldn’t afford. But those actions were merely stupid, not criminal, except in the case when the lenders or borrowers were forging loan documents or otherwise committing fraud.

  10. Looks oddly like a pyramid

  11. ShreddieMan says:

    Actually, it’s an Irish accent. Admittedly a pretty subtle one but definitely not British. I do know a thing or two being an Americanised (yes, I’m using an ‘s’) Irish national who grew up in Scotland. Still, a British or Irish accent has a rather soothing effect even when describing loathesome, greedy economic behaviour.

  12. Sounds like one Ponzi scheme was selling shares into another Ponzi scheme who sold shares of the second Ponzi scheme back to the first Ponzi scheme. Then one day the scammers found out they were scamming each other.

    And the Stock Market plunges 40% in one year.

  13. johnva says:

    Outlaw hedge funds. Seriously.

  14. parrotuya says:

    Let them eat CDO’s!

  15. papahoth says:

    Still too complicated for simple folks like us McCain supporters. Has to be lending to minorities is the cause of it all. Go ahead and vote for that terrorist.

  16. dweebster says:

    Old news, we’ve seen this stuff for years: [skepdic.com]

    Amway, anyone?

  17. cascascas says:

    Just for the record, that’s a sexy Irish accent. (He’s even called Paddy for goodness sake!)

  18. u1itn0w2day says:

    I guess the glass at the top got the teaser rate or more realistic and affordable payments while the glasses at the bottom got the 1000 dollar a month increase in payment part of the mortgage.

  19. Red_Eye says:

    Ok but seriously is the best ‘Fix’ to fill that second stack of glasses? That Still leaves the people losing their shirts as individuals in the glasses in the bottom of the first stack and also doesn’t bail out the mortgage holders in the first bottle.

    So instead of fixing the economic condition that caused the first bottle to not fill as well as it had been we are just gonna fix the outcome for the investors. So really we have just slowed the collapse by artificially filling the glasses from a 3rd bottle that is fed from the taxpayers pocket. Again where is the fix for the mortgage crisis?

    • B says:

      @Red_Eye: Actually, the Paulson plan for the bailout is to buy the second set of glasses (and third and fourth, if necessary). Well, not buy them, exactly, more like trade them for US Treasury bonds.

      • quail says:

        @B: Thankfully, written into that bill was stock injection language. Most economists agree that a stock injection in most cases would be safer for the taxpayer, would punish the board of directors, and is the best way to see a return on investment for the taxpayer.

        Instead of buying only the toxic debt, that nobody wants, the government would buy controlling stock interest in the company itself. Yes. It sounds a little socialistic but unchecked capitalism led us to this mess.

        A stock injection plan, loved by most economists and hated by the companies, was lobbied heavily against. The Paulson plan that made it through had late night language that gave the treasury department the option to choose what would work best for each situation.

        Personally, for the big offenders I hope that the government does buy controlling stock interests and not just their bad debts.

  20. quail says:

    Did anyone else listen to “This American Life” last weekend where they discussed all of this? Truly, the most terrifying part of all of this is the CDS, Credit Default Swap. Unregulated and without transparency they started off as insurance for stocks and bonds. Then the pinstripe guys began to bastardize them into hedge tools and leveraged instruments.

    In essence there’s 5 trillion dollars worth of bonds in the world. But there’s 60 TRILLION that’s insured by these CDS instruments that are held by big companies and banks all over the world. Being unregulated means that they don’t have to have the funds to cover their obligations. And you didn’t have to own the bond either to get a CDS.

    If all we had to worry about was a subprime mortgage problem, then no big deal. The world’s economy could handle that loss. But these companies have networked that toxic debt throughout the world with these crazy CDS instruments. If too many big players go down, then the house of cards collapses.

    CDO’s are a smaller part of this bigger problem.

    • Trai_Dep says:

      @quail: Yup.
      It sounds like the first iteration of these CDOs were reasonable. Instruments targeting very sophisticated buyers to mitigate relatively staid risks. Say, CALPERS insuring a Ford bond, which was already AAA, made even more so once a well-funded insurer (that’s basically what it was) backed up the miniscule chance that Ford might default.

      That incidentally, was what Washington pols were defending in the early 2000s.

      It’s only once these were gathered together then sectioned off, then derivatives of these groups of CDOs were gathered and sectioned off. Then allowing third parties to bet on bonds they weren’t party to that everything got crazy. With the rating agencies giving their bribed approval for the whole, sickening mess.

      That is what Gramm and the Free Market Uber Alles types gave us.

      It puts a face to the lie that the ideal role for gov’t is to not regulate business. Without intervention, business will almost always go for the short con to goose this quarter’s numbers, rather than making longer-term investments that provide true value and wealth.

  21. B1663R says:

    my dad always said watch out for banks, they are the biggest pyramid scheme going.

    a bank doesn’t give you money (interest) for nothing unless it benefits them somehow.

    i guess it’s a little more complicated than that.

  22. ArildaFlan says:

    Just a small correction on the initial post . . . Paddy’s “sexy” accent is actually Irish.

    And Paddy has done another video explainer on the Marketplace website, on credit default swaps: http://www.publicradio.org/columns/marketplace/offair/2008/10/untangling_credit_default_swap.html

  23. banmojo says:

    damn, I actually understood everything he said. Does he give any other lectures on economy/money issues??