There has been a lot of ink spilled on the issue of all those poorly performing CDOs (CDO news) insured by AIG (NYSE: AIG), which resulted in a massive, hugely controversial bailout effort that flowed through to Goldman Sachs (NYSE: GS) and other firms.

Bloomberg weighs in with an interesting look at how some of these CDOs ended up with such trashy assets. The CDOs were underwritten by Goldman Sachs but managed by a firm called TCW, which over time replaced the assets, as required by the underwriter, with junkier bonds, effectively increasing the chances that the CDO would eventually have huge problems. TCW was able to do this without the permission of AIG, even though AIG was obligated to insure the bonds. As the value of the CDOs tanked, certain collateral triggers activated, which called for AIG to make cash payments. It famously fell behind on these payments.

The article takes a close look at one CDO, Davis Square III, to show how this collateral replacement all but doomed AIG. TCW, it turns out, owned a portion of the equity tranche. Thus, they had an incentive to load up with higher-risk, higher-reward securities in the CDOs because the higher the return, the more they were entitled to. One interesting fact: AIG apparently had agreed to collateral triggers, while other bond insurers did not. 

For more:
- here's the really good Bloomberg article

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