Complexity of the CDOs Demystified

In early April the megabillionaire Warren Buffett hosted 150 students from the University of Pennsylvania's Wharton School and offered to have a Q&A session with him. One of the students asked the following question related to CDOs and the answer to it by Mr. Buffett really clarified the complexity and the blunder of the CDOs.
here is one of the excerpts from his question-and-answer session with the students.

Do you find it striking that banks keep looking into their investments and not knowing what they have?

I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them, and then those all tranched into maybe 30 slices. You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO, you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing. It's ridiculous. And of course, you took a lower tranche of a mortgage-backed security and did 100 of those and thought you were diversifying risk. Hell, they're all subject to the same thing. I mean, it may be a little different whether they're in California or Nebraska, but the idea that this is uncorrelated risk and therefore you can take the CDO and call the top 50% of it super-senior - it isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate.



Direct Link to the Q&A session

Charlie Munger's Wesco Financial Corp. (WSC) Annual Shareholders meeting on Wed, May 07, 2008 in Pasadena, California

Charles Munger, Vice Chairman of Berkshire Hathaway will host Wesco Financial Corp. (WSC) Annual Shareholders meeting on Wed, May 07, 2008 in Pasadena, California. Charlie is the Chairman, Chief Exec. Officer and President of Wesco, which is 80% owned by Berkshire Hathaway.

Charlie himself is very intelligent businessman and investor just as smart as Warren Buffett.

Link to some of the quotes by Charlie Munger

Notes from Berkshire Hathaway Annual Meeting 2008

Berkshire Hathaway Annual Meeting, Omaha NE 2008
May 3, 2008
Typewritten notes courtesy of Peter Boodell(As is standard, no recording equipment was used to reproduce these notes. As a result, these notes are recollections only – not quotes, and should not be relied upon. –PB)

Link to the Annual Meeting notes