Diablo

Diablo is the menacing slang term for a particularly notorious type of financial derivative: a Credit Default Swap (CDS) written on a Collateralized Debt Obligation (CDO). If that sounds like a mouthful, that's the point. A Diablo is, in essence, a bet on the performance of a package of other bets. These instruments gained infamy during the build-up to the 2008 Financial Crisis and are a perfect case study in financial engineering gone wild. They represent the polar opposite of the value investing philosophy, which champions simplicity, transparency, and a deep understanding of what you own. For a value investor, a Diablo isn't an investment; it's a black box filled with unknowable risk, a speculative gamble masquerading as a sophisticated financial product. Its complexity is not a feature but a fatal flaw, making it impossible to analyze or value with any certainty.

Imagine a tower of financial complexity built layer by layer. Understanding a Diablo means peeling back those layers.

• Layer 1: The Foundation. At the very bottom are thousands of individual debts. In the 2008 crisis, these were often subprime mortgages—loans made to borrowers with poor credit history.
• Layer 2: The First Structure (The CDO). Investment banks would buy up thousands of these individual mortgages and bundle them together into a new security, a Collateralized Debt Obligation. Think of it as creating a “fruitcake” of loans. They then sliced this CDO into different pieces, called tranches, from “safest” to “riskiest,” and sold them to investors.
• Layer 3: The Bet on the Structure (The Diablo). A Diablo is a bet on whether that CDO fruitcake will crumble. It's a Credit Default Swap, which is like an insurance policy. An investor could buy a Diablo to get paid if the underlying CDO defaulted (i.e., if the homeowners in the original bundle stopped paying their mortgages). Conversely, a speculator could sell a Diablo, collecting premium payments and betting that the CDO would perform just fine. This created a derivative of a derivative—a structure of risk built on another structure of risk.

The name “Diablo” is fitting because these instruments contained a devilish amount of hidden risk. Their danger stemmed from three core problems.

The creators of CDOs and Diablos argued they were safe through diversification. The logic was that out of thousands of mortgages, only a few would default at once. Credit rating agencies often stamped the “safest” tranches with a coveted AAA rating, the same rating given to U.S. government bonds. This was a catastrophic error. The models failed to account for the fact that a nationwide housing downturn would cause all the mortgages to go bad simultaneously. The diversification was an illusion, and the safety was a mirage.

The core tenet of value investing, popularized by Warren Buffett, is to stay within your “circle of competence.” A Diablo is the ultimate violation of this rule. The instruments were so opaque and mathematically convoluted that almost no one—not even the bankers trading them or the executives running the firms that guaranteed them (like insurance giant AIG)—truly understood the full extent of the risk they were taking on. How can you calculate the intrinsic value of something when you can't even untangle what it's made of? You can't.

Because Diablos and other complex derivatives were traded between all the major financial institutions, they created a hidden web of interdependency. When these instruments began to fail, the losses didn't stay contained. They cascaded through the entire global financial system, threatening to bring down the world's largest banks and triggering a full-blown crisis. This is the definition of systemic risk—where the failure of one part of the system endangers the entire system.

For a value investor, the story of the Diablo is a simple but powerful cautionary tale. Warren Buffett famously called complex derivatives “financial weapons of mass destruction,” and Diablos are a prime example. They violate every principle of sound, business-like investing:

• They lack transparency. You can't see the underlying assets or assess their quality.
• They have no margin of safety. Their value is purely speculative and impossible to calculate conservatively. A small error in assumptions could lead to a total loss.
• They encourage speculation, not ownership. You aren't buying a piece of a productive business; you are making a leveraged bet on a statistical formula.

The lesson for the ordinary investor is crystal clear: avoid complexity. True wealth is built by patiently owning pieces of wonderful, understandable businesses. Leave the devilishly complicated games to those who are willing to risk blowing up their own (and everyone else's) capital.