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THE CRASH -- What Went Wrong

Risky bet.

Nearly 60 percent of the underlying bonds were based on pools of corporate loans with below-investment-grade credit ratings, or junk. An additional 35 percent or so were based on asset-backed securities, including low-credit-quality subprime loans, according to the 178-page confidential offering prepared by its underwriter, Merrill Lynch. (The Washington Post obtained a copy from a firm representing one buyer.)

The offering document acknowledged several potential conflicts of interest. The most significant: The CDO pieces were plucked from an inventory held by Merrill's partner in the deal, Dillon Read Capital Management, a hedge fund owned by Swiss banking giant UBS that acted as the deal's servicing agent. Neither Dillon Read nor Merrill, which was the underwriter for several CDO pieces used as collateral, solicited independent bids to set the price for the bonds before hoisting them into Mantoloking.

The Dillon Read fund also purchased $45 million of preferred stock in the Mantoloking trust. The hedge fund's dual role as servicer and investor gave it the incentive to load the CDO with risky investments to enhance its potential return, according to the offering document.

The Mantoloking deal earned big fees for Merrill and others affiliated with the offering. Total fees aren't disclosed, but using the Thomson Reuters industry average, a rough estimate would be about $8.4 million.

Officials at Merrill and UBS declined public comment on the deal, which is now the subject of at least two legal actions by unhappy investors. The Dillon Read fund, despite the fancy footwork on this and other CDO deals, was later disbanded after big losses and its obligations were assumed by UBS. Merrill, too, swooned under losses from CDOs and other deals and sold itself to Bank of America in September.

IV
Disintegration: Caught in the Cataclysm

The beginning of the end, many CDO traders say, is easy to mark. It came in July 2007 when two Bear Stearns hedge funds loaded with CDOs collapsed. That sent CDO prices tumbling and created instability that fed on itself.

Merrill felt the tremors almost immediately. An early casualty was one $160 million tranche of the Mantoloking bonds, which was especially vulnerable to market conditions because it had an added twist of complexity: Its interest rate was reset monthly via auctions, which Merrill conducted for another tidy fee.

By re-auctioning the bonds every month, Merrill essentially was selling bonds with 40-year maturities as four-week notes. That made them attractive to corporate treasurers seeking short-term investments to park their working capital. The auctions injected another level of uncertainty into the bonds, but Merrill wasn't worried. The tranche had a AAA rating and a much higher interest rate than comparable short-term debt, so Merrill was confident that there would always be buyers.

At least, that was the theory.

Then in August, at the first auction after the Bear Stearns funds collapsed, the theory blew up. Almost no one showed up to place bids. Merrill did not step in as a buyer of last resort. The auction failed.

Investors who owned the securities were stuck. Mind CTI, a small Israeli telecom services company, was caught with $20.3 million of these AAA bonds, tying up two-thirds of its cash. The bonds have been downgraded to junk, and there are no buyers. The company has filed an arbitration case against its financial adviser, alleging that the bonds were bought without Mind's authorization.

MetroPCS Communications, a Dallas-based provider of Internet phone services, had another $20 million of Mantoloking bonds. Claiming that it never saw the offering document, the company has sued Merrill, which also served as its financial adviser. The lawsuit alleges that "Merrill deliberately failed to disclose the high-risk nature of the CDOs and its conflicts of interest to MetroPCS."

Merrill denies the allegation. "Metro PCS knew what it had purchased and authorized the purchases because they provided a higher yield than other investments," Merrill said in a statement, noting that MetroPCS officials approved each CDO purchase.

The failed Bear Stearns funds also owned Mantoloking bonds. Unfortunately, the damage didn't stop at Mantoloking's shores.

The catastrophe that the computer models had discounted now coursed through the global financial system. Banks around the world soon fessed up to the billions of dollars in CDOs held in off-balance-sheet vehicles. Their books were also packed with billions in contracts linked to synthetic CDOs bleeding red ink. Some banks and investment firms couldn't cover their losses. Their exposure caused the credit markets to seize up and led banks here and abroad to essentially refuse to transact business without a government guarantee.

Larry A. Goldstone, president and chief executive of Thornburg Mortgage in Santa Fe, N.M., a boutique provider of prime loans to wealthy homeowners, remembers his reaction when UBS announced on Feb. 14 this year that it had nearly $70 billion in risky mortgage assets to unload.

"I realized the market in general was far worse than I had imagined," he said. "If UBS had that much, what about Goldman? What about Citi? What about everyone else?"

V
Desperation: The Grab for Cash

To limit the carnage, banks scrambled to offload their money-losing positions and find new sources of cash.

In April 2007, Bear Stearns came up with a plan to sell stock in a new company that would essentially take over many of the imploding CDOs that its two hedge funds had invested in. The plan was called off before any public shares were sold, and the hedge funds collapsed.

Wachovia, the North Carolina-based financial powerhouse, had a different idea for how to protect itself. It came up with people like Donald S. Uderitz.

Uderitz had spent years on Wall Street, but in January 2007 he struck out on his own. He raised $50 million from investors and started a firm near his home in Delray Beach, Fla. He wanted to get in on the CDO business.

Uderitz had once worked for Wachovia. In spring 2007, a Wachovia affiliate approached Uderitz with an attractive offer. The affiliate wanted to buy a kind of insurance from Uderitz's fledging company that would protect the bank against losses on $10 million worth of bonds from a deal called Forge CDO, which Merrill had sold in April 2007. Wachovia would pay Uderitz $275,000 a year for the protection, under a contract that would last until 2053, a healthy stream of income for what was presented as a low-risk transaction. The Forge bonds were rated AA, one step below the highest grade, but still considered unlikely to default.

Wachovia requested that Uderitz post $750,000 to secure his pledge to pay if the bonds defaulted. Wachovia promised to hold it in a separate account and return it once the contract expired. On May 30, Uderitz wired the cash and thought he could sit back and collect more than 40 years of monthly payments.

He thought wrong. On June 18, less than three weeks after signing the documents, Wachovia sent the first of repeated requests for millions in additional collateral, several just a few days apart. One arrived by e-mail on Thanksgiving eve.

Uderitz had already posted nearly $9 million. Now the bank wanted another $550,000. On Thanksgiving morning, Uderitz got up early, put a turkey in the oven and headed to his office to deal with the nightmare. Nearly one-fifth of his investors' money was now frozen in this supposedly low-risk deal.

When Uderitz refused to pony up more cash, Wachovia declared him in default and seized the collateral. Uderitz has since sued Wachovia, alleging that the contract was a sham to "squeeze us out of the trade and steal our money." Wachovia has countersued, seeking the rest of the money that it says is due.

Wachovia, saddled with other losses, is in the midst of merging with Wells Fargo. It has denied Uderitz's allegations, saying in court filings that the freefall in prices of mortgage-related securities had triggered provisions in the contract that authorized the bank to collect the additional collateral.

Uderitz has a less legalistic view. "They were obviously having some major, major problems," he said. "I think there had to be a conscious shift in their thinking: Go get collateral from whomever we can. We have to save our ass."

VI
Wreckage: Scavengers in the Ashes

CDOs have become a knot of toxic debt choking off the flow of credit to consumers and businesses around the world. The Treasury Department's evolving bailout plan essentially acknowledged the need to set some sort of price for these bonds when it recently agreed to cover most of Citigroup's $306 billion in portfolio losses.

Brendan O'Connor knows that is easier said than done. He's a vice president of SecondMarket, a New York company that specializes in bringing together buyers and sellers for hard-to-value assets.

The CDO mess has given SecondMarket a new line of business. It has expanded to 60 employees and moved from its nondescript office near the Staten Island Ferry terminal in Manhattan to the former Standard Oil building on Broadway. Wall Street's big bronze bull sculpture sits on the median outside.

One new hire: L. William Seidman, the former chairman of the Federal Deposit Insurance Corp. who once ran the Resolution Trust Corp., the federal agency that disposed of tattered real estate assets during the savings and loan crisis. Seidman is serving as a senior adviser.

"We're creating a transparent marketplace to try to provide liquidity for these investments," said Barry E. Silbert, its chief executive. Original buyers, he said, didn't do a "deep dive" into the details of the blizzard of securities that underlie CDO bonds. Silbert's staff is developing analytical tools to take apart CDOs, research that he says will be available to the public. Only qualified buyers and sellers will have access to bond prices, however.

Price has turned out to be the sticking point in selling the distressed CDO bonds. O'Connor has been trying to find buyers for one portfolio of CDOs, purchased for $40 million by a company he declined to name. The company fired the executive who had authorized the CDO purchases, and his replacement told O'Connor he wanted to get them off the company's books by year's end. He was willing to take just about any price.

O'Connor canvassed possible buyers and came back with a bid of 2 to 3 cents on the dollar. "Not that low," the executive said. A second bid of 8 cents was also rejected.

O'Connor found a new buying group willing to up the ante: 10 to 15 cents on the dollar. O'Connor thought he had a winner.

"I told the company that we had what I considered a very realistic buyer for the entire $40 million of assets," he said. "But after a couple of days, the corporation still rejected it. It's a very tricky thing. They want to sell, but they are clinging to a sense of hope. It's no longer a mathematical discussion, it's a psychological discussion. It's not a badge of honor to walk around the office being the one who decided to sell assets at a distressed level."

VII
Epilogue: Regulation Rising

Joshua Rosner recalls standing before a group of bankers, economists, regulators, Capitol Hill staffers and housing advocacy groups assembled at the District-based Hudson Institute on Feb. 15, 2007, looking out at blank stares. He had just presented a scholarly paper, which he had co-authored, predicting the crisis that would result from the CDO frenzy.

No one wanted to hear what Rosner was saying: The massive CDO market was about to collapse. The rise in subprime mortgage delinquencies, the reality of which had been masked for months by the CDOs' opaque structures and lack of public pricing, was choking off cash needed to pay investors.

"There was a lot of skepticism," said Rosner, managing director of Graham Fisher & Co., a New York-based independent consultant that advises institutions on mortgage investments. Wall Street, he said, still had everyone mesmerized by its creation. He remembers strains of the popular song by the 1960s pop band the Monkees, running through his head: "Then I saw her face. Now I'm a believer . . ."

Plummeting CDO prices, he told the group, would cause a crisis on at least the same scale as the 1980s thrift crisis, when hundreds of financial institutions failed under the weight of bad real estate investments. The federal government shelled out hundreds of billions of dollars to rescue the economy.

Rosner's analysis was dead-on, although the mess may end up being even larger than he envisioned. Desmond Lachman, a resident fellow at the American Enterprise Institute and a former top Wall Street economist, says the U.S. economy has entered its deepest recession since World War II, one that could result in losses to the U.S. financial system of about $1.6 trillion, or 12 percent of gross domestic product. The thrift crisis, by contrast, cost the U.S. financial system about 2.5 percent of GDP.

Rosner says he could become a believer in CDOs if they were reworked and traded in a public market. He has urged regulators to build a new framework that stresses transparency and oversight of the structuring, sales, ratings and valuations of CDOs. Without that, the bonds are too reliant on ratings as a measure of the safety, ratings now known to be flawed.

Former SEC commissioner Paul S. Atkins, a strong advocate of deregulation during his six-year tenure that ended earlier this year, agreed that the trading of CDOs and other private investments must be done more openly to prevent systemic risk. But he cautioned that there needs to be smarter regulation, not just more rules.

"Remember this crisis began in regulated entities," Atkins said, referring to investment and commercial banks overseen by the SEC and other federal agencies. "This happened right under our noses."

Staff writer Zachary A. Goldfarb and staff researcher Robert E. Thomason contributed to this report.


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