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THE CRASH -- What Went Wrong

Unfortunately, a toxic chain was also forming. Consumers jumped into houses they couldn't afford. Mortgage brokers closed deals swiftly, sometimes by inventing phony income data for borrowers. The loans were quickly sold into pools that issued securities, so the brokers were rarely on the hook for defaults. Wall Street traders swirled like piranhas, snapping up the securities for repackaging as CDOs. Everyone feeding on this chain earned money upfront, in the form of fees.

Volume and speed dominated the process. Michael Anderson, a former mortgage trader for a Wall Street firm, said he would receive an e-mail from a mortgage originator like Washington Mutual that offered, say, a $1 billion package that included thousands of loans. Anderson had as little as an hour to bid. Some Wall Street firms, including Merrill Lynch and Bear Stearns, bought mortgage origination companies so they could cut out the bidding process and pump collateral more quickly into their CDO machines.

So frenzied was the market that firms short on actual collateral kept their machines humming by creating "synthetic" CDOs. These bonds had no actual loans to secure their payments; rather, investors were promised payments from another kind of private contract designed to mimic the inflows and outflows from other CDOs.

Investors who asked questions were derided for not "getting it" and crossed off the preferred customer lists of Wall Street sales forces, thus losing an opportunity to buy this hot product. Skittish buyers could purchase an insurance contract that was supposed to protect the investors in the top tiers of the CDO in the event of a default.

Getting the bonds sold was the key objective. That's when the firms would collect their underwriting fee, estimated by Thomson Reuters at 1.1 percent, or $11 million for every $1 billion deal.

There was only one possible catch in the seamless CDO machine: the bond-rating firm. Without high marks from at least one independent rating company, it would be impossible to sell large swaths of bonds to the intended market of big institutional investors -- pension funds, insurance companies and many overseas buyers -- because their rules required them to purchase only highly-rated, lower-risk securities.

Ratings were the linchpin of the CDO sales frenzy. The Wall Street engine had considerable influence here, too: It paid fees to the ratings firms for every approved deal.

Scrutiny: Overwhelmed and Overrated

Richard Gugliada, who was managing director in charge of structured finance at Standard & Poor's ratings services before leaving in October 2005, huffs when asked how the firm maintained its independence when it was paid by securities underwriters.

"Never," he said. "We never changed a rating because we would be paid more."

Gugliada acknowledged that S&P was under pressure to increase its revenue and was seeking to take market share from its two main competitors, Moody's Investors Service and Fitch Ratings. To do that, he said, the firm needed to do three things: provide better service, cut its fees and loosen its criteria a smidge for what would earn a triple-A rating. "It's fair to say we did a little of all three," said Gugliada, who was criticized at a recent congressional hearing for sending an e-mail pressing one of his managers to make a credit estimate on a CDO deal without examining details of the underlying mortgage pools. Gugliada said the individual loans in those pools had been examined when they went into mortgage-backed securities, and it was S&P's policy to rely on those ratings in making a credit estimate.

A former S&P analyst in Gugliada's group, who spoke on condition of anonymity because he is out of work and fears being shunned by possible employers, recalls working flat-out by the end of 2005 to handle the huge flow of CDO deals pouring in from Wall Street. "I missed most of every holiday family gathering and worked on every vacation," the analyst said. He often left S&P's office in lower Manhattan near midnight and occasionally would get calls at 4 a.m. on European deals.

The Securities and Exchange Commission, charged with overseeing the private ratings companies, did little to scrutinize their procedures during this time. In the summer of 2007, after S&P, Moody's and Fitch began slashing their grades on CDO bonds they had once blessed, the SEC stepped in to investigate what had gone wrong. This summer, without naming names, an SEC staff report faulted the ratings firms for not doing enough to police their conflict-of-interest policies.

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