My Experience with CDOs & The Real Estate Bubble

In early 2006 I was in the market for a new job. A friend from college worked for one of the largest banks and asked if I’d like to interview for a spot in his group.

He told me he was part of one of the fastest growing divisions in the bank. They were minting money and were busier than anyone at this huge, multi-national financial institution. It sounded intriguing so I took an interview. All I knew was that they worked with collateralized debt obligations (CDOs).

I was honest and told the guys that interviewed me that I had no experience with CDOs and didn’t really know that much about them, save for a few articles I had read in the Wall Street Journal. They told me that was fine. No one working in the division had any experience working with CDOs before because they were such a new and growing product for the bank. They assured me, “No one who interviews with us has any knowledge of this market, just Google it to show us you’re interested.”

When I showed up for the interview I noticed that every single partner and VP in this division was young, probably all in their late-20s. They were your stereotypical Wall Street bros – bragging about working 70-80 hours a week, how busy they were compared to the other divisions within the bank, talking about how much money they were making, etc.

Before the interview I studied up on CDOs and how they were structured (read The Big Short by Michael Lewis for more on CDOs). I had a few questions when I sat down with a couple of the higher-ups on the team:

Me: “How is it possible that these securities are able offer premium interest rates over Treasuries with the same AAA-ratings?”

Wall Street Bro: “The underlying loans are diversified across the country. It’s basically a free lunch.”

Me: “But how can these mortgage loans be considered as safe as government bonds? Don’t they have to be riskier?”

Wall Street Bro: “It doesn’t matter. The clients love the fact that they are AAA-rated. It’s the highest credit rating available.”

My only experience with bonds up to that point was with treasuries and high quality corporate debt. I didn’t understand how you could earn a higher interest rate while also taking on substantially more risk, considering these were mortgage loans taken out by individuals.

Other than my reservations about the structure of the bonds, the interview actually went fairly well. I had some back and forth phone interviews afterwards and eventually was offered the job. It was very tempting to accept it. The culture was fast-paced with tons of opportunities to move up and take on more responsibility. They were hiring plenty of other young people. The growth projections for the business were enormous. Plus, they were paying really good money, much more than I was making at the time.

In the end, something just didn’t feel right about taking the position. I wish I could say that I immediately realized that these types of collateralized bonds were only inflating the real estate bubble, but that would be a bit of a stretch. All I can say is that it didn’t feel like a stable environment for where I wanted to go with my career.

They say better to be lucky than good, so I’ll chalk it up to luck that I passed on the role.

I was told once the CDO market really started to break down by the end of 2006 and early 2007 that there was round after round of layoffs in the CDO division of this bank. By 2008, the remaining staff basically had nothing to do all day because the securitization market came to a standstill during the financial crisis. Eventually this group was sold to smaller bank.

Obviously, I dodged a bullet on that one. Had I taken the job I would have top ticked the real estate bubble as housing prices were just beginning to fall by the end of 2005-early 2006.

Here are a few lessons I took away from this experience:

Take the right risks with your career. I absolutely believe that you have to take some risks in your career to get to where you want to be. Your dream job doesn’t simply get handed to you. But that doesn’t mean you have to take every risk presented to you. It’s OK to say no when something seems off. Not every opportunity is the right one for each individual.

Pay attention to those in leadership positions. It’s perfectly acceptable to have young people in leadership positions. In fact, I would make the argument that having a solid mix of both young and old increases the diversity of opinion and style within management ranks. But make sure the young people know what they’re doing. This was probably my biggest tell for turning down this job. It just seemed like no one knew exactly what was going on.

Risk can change hands, but it never truly goes away. You can’t just make risk disappear by spreading out your bets. Yes, diversification helps lower risk but it can’t make it disappear for good. This is a fact that so many investors in CDOs, mortgage bonds and securitized products forgot when they were chasing yield during the real estate bubble.

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  1. Bruce Harpham commented on Sep 24

    Can you elaborate on career risks that you’ve taken?

    • Ben commented on Sep 24

      Good question. Things like moving to a new city for a good job. Taking less in pay early in my career to work for a place I’d get much more responsibility and learn a ton from a smaller team.

      I also think taking risks doesn’t always have to do with new jobs. It could be risky to speak up, push for change or give an unpopular, but well-thought out, opinion within an organization. Doing things differently can be seen as being risky if people are set in their ways.

  2. Hassan commented on Sep 24

    The thing with securitised credit is collateral quality is imperative; garbage in, garbage out. No-one should be ignoring that.

    • Ben commented on Sep 24

      Definitely, I have no problem with securitization. In fact, it has been great for expanding the mortgage industry in the past. The problem really was that not enough investors understood what they were buying during the real estate bubble. There was no credit analysis, only looking at faulty credit ratings that were accepted as being set in stone.