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A Crib Sheet on Wall Street's Self-Dealing Money Machine

Here's a primer on our story on how banks ginned up the CDO business, taking riskier assets and, to hide how risky they were, putting them into new, riskier assets, and then buying those themselves.

Last night, we published a story about self-dealing by the big Wall Street banks, cashing in on the world of structured finance. We know the subject matter is heady stuff, so together with our partners at NPR’s Planet Money, we’ve tried to make it as digestible as possible — with our first-ever cartoon, colorful charts (or “lovely chart porn,” as described by Barry Ritholtz), and an Auto-Tune song about the banks.

Felix Salmon at Reuters, Ritholtz at The Big Picture and The New York Times’ Dealbook also have smart takes that you should be sure to catch.

But for those of you who, unlike Felix Salmon, don’t care to read all the “juicy details” about the specific CDO names and narratives in the full story, we’ve pulled out some of the basic questions and answers right here.

The setup:

As the housing boom slowed in mid-2006, the big banks on Wall Street had a problem. They’d created a lucrative money machine by buying and selling bundles of mortgage bonds known as collateralized debt obligations, or CDOs, but investors were getting more and more nervous about the product as they noticed high default rates on mortgages and worried about the quality of the assets stuffed into the CDOs.

Why was this a problem?

This was a problem for the banks for a few reasons. Banks still had pieces of un-bundled assets on their books — likely to lose value because of flagging demand, which would incur losses to the bank.

And then bankers in particular were making some pretty sweet bonuses for every CDO deal they struck. From our story:

A typical CDO could net the bank that created it between $5 million and $10 million -- about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.

In other words, there was still a lot of money to be made if they kept the CDO market going. So they found a way to do so — artificially. They created fake demand.


The banks kept creating CDOs. The nature of CDOs, however, is such that they’re tiered, based on risk as assessed by the rating agencies (which, as we now know, often caved to pressure from the banks).

The banks didn’t have a problem holding on to the top-tier assets (the top 80 percent of a CDO, considered “super senior”) because they figured they were safe. But with each CDO, there were still the riskier, bottom-tier assets — assets that they wanted others to take.

So they began using those risky parts of CDOs in other CDOs. As my colleagues describe it, it became “a daisy chain that solved one problem but created another.” From the story again:

An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds.

CDOs often bought pieces of each other — a sort of you-buy-my-stuff, I’ll-buy-yours:

A CDO would buy a piece of another CDO, which then returned the favor. The transactions moved both CDOs closer to completion, when bankers and managers would receive their fees.

Which banks did this self-dealing?

Merrill Lynch did it the most, but many others did as well, including Citigroup, UBS and Goldman Sachs.

Really, this chart just about says it all.

Were there protections against this happening?

You may recall that when the SEC sued Goldman Sachs for civil fraud in April, one of the regulator’s biggest issues with the bank was that it represented to investors that a third-party CDO manager called ACA was choosing the assets that went into the CDO, and that ACA’s interests were aligned with that of investors.

The SEC alleged that in fact, both Goldman and the hedge fund Paulson & Co. — which had interests different from those of investors — had undue influence in choosing what went into the CDO, and that this fact was never disclosed to investors.

CDO managers, like ACA, were meant to act in the interests of investors, protect against abuse and pick assets that would help the CDO perform well. But as Goldman’s Abacus deal and many of the deals in our story illustrate, that’s seldom how it worked:

The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

As we’ve said, Merrill Lynch was particularly notorious among CDO managers for vetoing their choices when non-Merrill assets were suggested:

"All the managers complained about it," recalls [Fiachra] O'Driscoll, the former Credit Suisse banker who competed with other investment banks to put deals together and market them. But "they were indentured slaves." O'Driscoll recalls managers grumbling that Merrill in particular told them "what to buy and when to buy it."

They obviously weren’t the only ones:

A little-noticed document released this year during a congressional investigation into Goldman Sachs' CDO business reveals that bank's thinking. The firm wrote a November 2006 internal memorandum about a CDO called Timberwolf, managed by Greywolf, a small manager headed by ex-Goldman bankers. In a section headed "Reasons To Pursue," the authors touted that "Goldman is approving every asset" that will end up in the CDO. What the bank intended to do with that approval power is clear from the memo: "We expect that a significant portion of the portfolio by closing will come from Goldman's offerings."

What were the ramifications of this self-dealing on the larger financial system?

Ultimately, the fact that so many CDOs contained pieces of each other and that so many were created for the purpose of sweeping risky assets off the books of investment banks meant that the market was impossibly intertwined and fragile.

“Partly because CDOs had bought so many pieces of each other, they collapsed in unison,” we noted in our story.

And while bankers and CDO managers took home their bonuses from the deals they spurred with artificial demand, the banks themselves, as we mentioned, had either incorrectly assumed that the “super senior,” or top, tier of the CDO was safe to hold on to or had been unable to get rid of those assets fast enough. That meant some of the biggest self-dealers — Merrill and Citigroup — both lost billions:

Nearly half of the nearly trillion dollars in losses to the global banking system came from CDOs, losses ultimately absorbed by taxpayers and investors around the world. The banks' troubles sent the world's economies into a tailspin from which they have yet to recover.

What are the banks’ responses to this?

When asked, the banks answered in broad strokes, never directly addressing our questions:

Asked about its relationship with managers and the cross-ownership among its CDOs, Citibank responded with a one-sentence statement:

"It has been widely reported that there are ongoing industry-wide investigations into CDO-related matters and we do not comment on pending investigations."

None of ProPublica's questions had mentioned the SEC or pending investigations.

Posed a similar list of questions, Bank of America, which now owns Merrill Lynch, said:

"These are very specific questions regarding individuals who left Merrill Lynch several years ago and a CDO origination business that, due to market conditions, was discontinued by Merrill before Bank of America acquired the company."

Will anyone be held accountable?

It’s not clear whether any of this was illegal, but regulators are looking closely at the CDO business and scrutinizing what kind of pressure the banks may have exerted on CDO managers.

The SEC has said it’s looking “at as many as 50 CDO managers as part of its broad examination of the CDO business' role in the financial crisis.”

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