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Frenzy
When the housing market began to tank in 2005, Wall Street ran through the yellow light of caution and created even riskier investments -- and Washington had no mechanism for finding out what was going on.

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.

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."

I
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.

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.

II
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.

The firms all say they did not bend their rules. "We have rigorous policies and procedures in place to maintain our analytic independence and shield our analysts from encroachment of commercial interests," S&P said in a written statement. The company also said its criteria are "consistently applied."

In the trenches, the overworked former analyst said he never worked with investment bankers to structure any of these complex deals. Instead, as S&P's policy dictated, he engaged in back-and-forth discussions. The most contentious conversations, he said, involved bankers trying to copy some new twist in a competitor's CDO. Because CDO documents were private, the analyst could not tell the copycats how a competitor had won a top rating. He watched as bankers tried to reverse-engineer the new structure from scant public information, often leaving out important risk-mitigating elements.

The CDOs piled up at a staggering rate, and so did the complexity, along with the pressure to get them rated. "There was such a compressed time frame," the analyst said. "As soon as some new development emerged, everyone took advantage of it. There was such an explosion, so many deals with the same features, that when something went wrong, it wasn't just limited to a few hundred million, but to several billions."

The S&P statement said analysts were not compensated on the number of deals rated or on the percentage of high ratings granted. Although the firm acknowledges that its assumptions about defaults "did not serve us well on certain structured finance ratings," it also maintains that those assumptions "seemed reasonable given the projected market environment at the time they were made."

Gugliada, who praises structured finance for lowering borrowing costs and making credit more widely available, says the ratings firms misjudged the impact that a relatively few mortgage foreclosures would have on all the other mortgages in a pool. "In hindsight, we now know all mortgage-backed securities perform fine or they all default at the same time," he said.

The S&P statement called that view "overly simplistic and inaccurate," saying securities have different levels of credit enhancement, different mortgage types and different borrowers that can cause each to perform differently.

Gugliada used to believe that. But he now says that CDOs made up of BBB-rated pools of mortgage-backed securities should never have been rated any higher than BBB themselves. If the ratings agencies had understood that, "there wouldn't have been any CDOs" of mortgage-backed securities, he said.

But Wall Street didn't just create CDOs based on mortgages. As the frenzy went on, it cooked up CDOs based on CDOs.

III
Deluge: Morphing the CDO

The Mantoloking CDO, offered to investors in late 2006, owed its existence to an innovation that became typical of late-stage CDOs.

In Wall Street parlance, it was a "CDO squared" -- a CDO concocted from the unwanted parts of 126 other CDOs. In plain English, Mantoloking was a dumping ground.

BBB and BB bonds that had drawn few buyers in earlier incarnations were repackaged into a new set of tranches. At the top, $580 million of the bonds took on AAA designations. The remaining $185 million went into the lower, riskier tranches.

The CDO-squared carried an extra level of danger, however: If something went wrong, investors in Mantoloking's AAA tier had to stand behind the investors in the top layers of the original CDOs. The securities in the bottom tranches were a distant last in the lengthening queue.

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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