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THE CRASH -- What Went Wrong

The Wall Street machine cranked out CDOs full tilt from 2005 to 2007. It was a race against time as accelerating delinquencies ate away at the value of mortgage-backed securities that served as collateral for many of the deals. No one was trying to contain the erosion; rather, the players had every incentive to get the securities that backed the deals out of their inventories, so they created as many CDOs as possible.

In February and March 2007 alone, one of the world's biggest CDO dealers, Merrill Lynch, sold nearly $29 billion of the securities, 60 percent more than in any previous two-month period, according to data from Thomson Reuters. Goldman Sachs sold $10 billion that March, more than double any previous month. Citigroup sold $9 billion, one-third more than in February, itself a record month.

Deals were flying out so fast that the Wall Street firms sometimes could not tell investors what specific collateral was going into which CDO, making a mockery of anyone who tried to do a fundamental analysis of the assets backing the bonds before agreeing to buy.

"There was enough of a feeding frenzy that you didn't want to lose your place in line," Mann said, speaking as an investor who passed up many such deals. "A lot of people knew this was bogus, but the money was too good."

Creation: Manufacturing Money

Thursdays in 2006 were party nights for the structured-finance team that packaged CDOs at a top Wall Street investment bank. The evenings usually started with dinner at a trendy restaurant, perhaps Morimoto, run by one of Japan's original "Iron Chefs," or Babbo, Mario Batali's Italian gem in Greenwich Village. Then the brokers and bankers would take their clients to nightclubs such as Marquee and Pink Elephant, where they would run up $1,000 tabs and dance until 4 a.m. At 7 a.m., team members would arrive at their desks, haggard if not hung over.

Hangover or not, some traders couldn't explain how a CDO worked. The CDO alchemy involved extensive computer modeling, and those who wanted to wade into the details quickly found that they needed a PhD in mathematics.

But the team understood the goal, said one trader who spoke on condition of anonymity to protect her job: Sell as many as possible and get paid the most for every bond sold. She said her firm's salespeople littered their pitches to clients with technical terms. They didn't know whether their pitches made sense or whether the clients understood.

CDOs were first sold in the 1980s, part of a revolution in corporate finance called "securitization" that fueled the unprecedented boom in available credit. Lenders could package their mortgages, credit card loans, equipment leases, even corporate debt, and sell securities backed by the interest payments. This maneuver transferred the risk of not getting paid to the investors who bought the securities. The deals returned cash to lenders, which they could plow into new loans. This efficient machine pushed borrowing rates lower, creating a win-win-win for consumers, lenders and investors.

Wall Street saw any income stream as a candidate for securitizing. Mortgages went into pools that became the basis for mortgage-backed securities. Ditto credit cards and other forms of debt. The list was long. All those securities were scooped up and used as collateral for CDOs. Indeed, this diversity of loans was thought to be a plus for the CDOs' safety.

The entire chain depended on the concept of layered risk. Once the ratings firms evaluated the quality of the securities, a ladder would form: The securities on the top rung, or "tranche," were considered low risk and won a AAA rating. In return for their safety, these bonds paid the lowest interest rate. The reverse was true at the other end: The lower tranches absorbed the first losses from loan defaults, buffering the securities in the higher tranches. This extra risk earned them lower ratings, often AA, BBB or lower, but paid the highest interest rate.

The computer modelers gushed about the tranches. The layers spread out the risk. Only a catastrophic failure would bring the structure crashing down, and the models said that wouldn't happen.

CDO sales sputtered on and off until the surge in mortgage loans from the housing boom earlier this decade. Because mortgage-backed securities paid higher yields than other securities with the same ratings, they became wildly popular for use as CDO collateral. The CDO market took off. From $157 billion issued in 2004, it ballooned to $557 billion in 2006.

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