The Snowball: Warren Buffett and the Business of Life

by Alice Schroeder

In the case of mobile homes, the banks lent money to the manufacturers, who used it to lend money to the buyers. Historically, this process had worked, because if the mobile-home maker made bad loans, it faced the discipline of not getting paid back. But then the mobile-home makers began to sell their loans, handing off the risk of not getting paid back. That was now somebody else’s problem. The “somebody else” who had assumed the problem was an investor. In a process known as “securitization,” for some years, Wall Street had neatly packaged loans like these and sold them to investors through a “collateralized debt obligation,” or CDO—debt backed by the mortgages. They combined thousands of mortgage loans from all over the U.S. and sliced them into strips called “tranches.” The top-tier tranches got first dibs on all the cash flow from a pool of mortgages. The next tranches had second dibs, and so forth down the line. These tranches paid a rating agency to assign the top AAA rating to the first-dibs tranches, AA ratings to the second-dibs tranches, and so on. The banks sold off the tranches to investors. As lending standards declined, the quality of the CDOs—even AAA CDOs—got sludgier.5 Yet, investing in AAA CDOs now appeared to contain no risk. “When money is free,” wrote Charles Morris later, “and lending is costless and riskless, the rational lender will keep on lending until there is no one left to lend to.”6