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Good and bad discussions of financial innovation
...This is usually how CDOs are portrayed these days: they're obviously voodoo finance, because—get this!—they claimed to take a bunch of risky bonds and transform them into a super safe bond. What a ridiculous idea, right? Now do you see how useless financial innovation is?

Of course, this isn't a remotely accurate description of CDOs. Notice how they conveniently leave out the explanation of how CDOs transform risky bonds into a safe bond. They do this through subordination and various other credit enhancements. Say we have a CDO with a $100 face value, backed by a pool of BBB-rated mortgage-backed securities. The CDO sells three classes of bonds: an equity tranche, a mezzanine tranche, and a senior tranche. Investors in the equity tranche will take the first 10% of the losses; investors in the mezzanine tranche will take the next 15% of the losses; and investors in the senior tranche will take the rest of the losses. Investors in the senior tranche wouldn't suffer any losses unless and until the total losses on the CDO exceeded 25%, so we'd say that the senior tranche has a subordination level of 25%. When Johnson and Kwak say that CDOs "manufacture 'safe' bonds out of risky ones," the "safe" bonds they're referring to are the senior tranches. But as you can see, the idea that the senior tranche would be "safe" isn't at all ridiculous—after all, there's almost always some level of subordination that will make the senior tranche a safe investment....