Bloomberg dropped a major investigation today on the AIG collapse, shedding much-needed light on the conflicted role of CDO managers in the crisis—something that’s gotten too little coverage.

Of course, Goldman Sachs (an Audit funder) is involved. But Bloomberg brings Societe Generale-owned TCW to the fore, and it looks very bad for them. Keep in mind as you read the piece that Goldman Sachs and Societe Generale, a French bank, were the two biggest beneficiaries of the backdoor bailouts taxpayers provided through AIG—more than $30 billion.

Bloomberg zeroes in on a CDO called Davis Square Funding III that Goldman created in 2004, TCW managed, and AIG insured. Bloomberg writes that TCW eventually swapped out one-third of the bonds, almost always with worse ones from later vintages, which is the year of origination.

What we have here is that Joe Cassano and AIG were even dumber than we thought. Usually when you insure something you know what you’re insuring. But AIG was insuring a CDO that by contract could swap its assets in and out, reconstituting itself. Not only that, it included collateral triggers in its insurance, which no other insurer did, and that ultimately led to its demise.

The triggers kicked in when the value of the CDOs declined or if a rating company downgraded AIG’s creditworthiness. By December 2008, the insurer had paid out more than $35 billion, according to a list of collateral provided by AIG to Congress.

AIG was essentially insuring hedge funds that were constantly rotating their investments.

The upside-down incentives are particularly interesting here:

Goldman Sachs did own an equity stake in Davis Square III, according to Michael DuVally, a spokesman for the firm, who declined to say how much it was. Even so, the bank didn’t try to influence TCW’s investment decisions, DuVally said.

It didn’t have to. TCW was promised 20 percent of what was left over after equity investors got 10 percent returns, according to a Goldman Sachs sales pitch to potential equity investors dated September 2004. That was on top of its fee of 0.10 percent of the CDO’s assets, according to the prospectus.

Such fees gave managers incentive to move riskier assets into CDOs because the higher returns they produced were likelier to trickle down to equity investors.

Basically, Goldman Sachs found the biggest, highest-rated mark in the world in AIG. Bloomberg further explains why the equity positions were such conflicts:

As existing collateral shrank because of mortgage prepayments, bond maturities and pay-downs, buying safer securities meant “equity investors would have gotten hammered because there wouldn’t have been enough cash flow for them,” Krakovsky said.

He said managers often owned equity pieces of CDOs and earned fees linked to their returns.

This is excellent context here, and I like the conversational style—quite the departure from normal Bloomberg prose:

That was the thing about CDOs, too. They were secretive. Prospectuses ran hundreds of pages yet often failed to detail a single purchase. What assets they held couldn’t be seen publicly. And they gave banks the chance to repackage risky securities and market them as safe investments, at the same time allowing firms to bet that mortgages would fail.

Those five sentences are worth chewing over for a few minutes. Sometimes we need to step back and think about what kind of enterprise was at the core of the crisis. There you go. This is tangential to this specific story, but I like that Bloomberg included it. It’s about the thinking at the core here:

By 2007, Goldman Sachs had moved so many securities into Abacus 2004-1 that much of the collateral didn’t exist when the CDO was created, according to data compiled by Moody’s. While AIG insured parts of Abacus deals, Goldman Sachs didn’t change the collateral in the pieces AIG insured, DuVally said.

And TCW kept shuffling junk into the CDO even as it became apparent that the whole subprime edifice was collapsing. This was apparent even to TCW, as Bloomberg makes clear:

While TCW was adding bonds made up of risky loans, its biggest mutual fund took a more ambivalent approach. TCW Total Return Bond Fund shrank its mortgage holdings not guaranteed by government-sponsored firms to 15.9 percent in July 2007 from 18.8 percent three months earlier, according to company filings.

Reporters Bob Ivry (a friend) and Jody Shenn also break some news here (UPDATE: I’m told the late Mark Pittman got a tagline that doesn’t show up on the Web. He was involved in starting the project):

The U.S. Securities and Exchange Commission is investigating how Wall Street banks bet against mortgage-linked securities to profit as their clients took losses, according to people familiar with the matter. As part of its examination of the market, the agency is looking at collateral replacement, said an SEC official with knowledge of the probe who asked not to be identified because he wasn’t authorized to comment.

Surely the bad guys are trembling now that the SEC is on the prowl!

Stories like this ought to stiffen what spine the SEC has left.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.