THE CRASH -- What Went Wrong

By Jill Drew
Washington Post Staff Writer
Tuesday, December 16, 2008

It was Wall Street's version of an inside joke: Take a motley collection of largely unwanted assets, repackage them into a new set of bonds, and name it after the pristine white-sand beaches of an exclusive New Jersey town where Katharine Hepburn once summered.

No one is laughing now.

The Merrill Lynch bond deal known as Mantoloking has ended up with a different punch line: proof of the frenzied, foolhardy drive for upfront fees that helped bring down the world's financial markets and trigger the largest federal bailout in history.

Wall Street firms thought they had a surefire way to profit from the booming real estate market without much risk to their companies. They engaged in a kind of financial alchemy, creating a trillion-dollar chain of securities on the back of subprime mortgages and other loans, which were sold to investors in private offerings that no government regulator scrutinized.

With these deals, known as collateralized debt obligations, the world glimpsed the raw power of unchecked financial markets operating full-throttle to the point of self-destruction. The cascading losses on CDO bonds have undermined the solvency of several large banks and obliterated the trust that is the bedrock of all functioning markets. The debacle also has called into question the competence of Wall Street, the independence of bond-rating firms, the prudence of insurers and the foresight of regulators.

Deals like Mantoloking were "the height of lunacy," says Joshua Rosner, a bond market expert who issued multiple warnings about lax lending standards during the past seven years, earning him status as an early prophet of the credit crisis.

So many of these bonds have become untouchable that they stand in the way of restoring the flow of credit that the global financial system needs to operate and that the economy needs to climb out of recession. Experts say that firm prices must be established for the bonds -- no matter how low they may go -- so the system can clear itself of these toxic assets.

Not only did no government agency or official try to stop the bond deals as they were selling, but Washington cheered this new market because it expanded homeownership -- at least until defaults started piling up.

"Wall Street and Washington acted in concert to provide an artificial sense of a safety net," said Julian Mann, a Los Angeles-based investment portfolio manager for First Pacific Advisors who looked over many CDO offerings.

Like many others, Mann faults Washington for failing to rein in the subprime market, with its many no-documentation, teaser-rate loans that extended credit to those who couldn't afford it and invited fraud. He also blames Wall Street for relying on elaborate models that predicted that default rates would be low when common sense screamed otherwise.

The incoming Obama administration has pledged to overhaul the regulatory structure, which could lead to an examination of the legal thinking that has embraced CDOs as "private placements." Sold from trusts often organized in the Cayman Islands, the bonds were listed only on the Irish Stock Exchange, of all places. An official there readily acknowledged that the exchange handled no trades in the bonds. No prices were made public, and documents on file at the exchange were available only to those who purchased the bonds.

The only public reporting of the deals were the gains or losses on the securities recorded by their owners. Under this system, regulators had no official window into the bigger picture -- that these private securities had grown so numerous and involved so many companies that they posed a collective risk to the entire financial system.

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