Even the most diligent readers of the business press can be forgiven for not understanding what a collateralized debt obligation is, how it differs from a mortgage-backed security, or how both were directly responsible for inflating the housing bubble and for causing tens of billions of dollars of losses on Wall Street. Following the money on this story isn’t simple when the “money” ends up as a credit derivative.

We are much smarter now thanks to an excellent page-one piece (link for non-subscribers) in The Wall Street Journal on December 27 headlined “Wall Street Wizardry Amplified Credit Crisis.” Reporters Carrick Mollenkamp and Serena Ng dive into how Merrill Lynch created a so-called mezzanine CDO (made up of middle-rated bonds) named “Norma,” recruited a Long Island penny-stock impresario to run it, and in its small way helped to undermine the global financial system. It’s one of the best explanatory pieces yet on how these financial instruments that were supposed to spread risk concentrated it instead.

So, sit back in that lounger, fill up your pipe, and let the Journal (with a little help from The Audit) explain what has the business press acting like it’s under attack with its deflector shields down.

We’ll start with the basics: there are mortgages. Millions of them. Banks don’t hold them any more—never mind why—instead they have Wall Street firms like Merrill Lynch put thousands of them together in a single vehicle and sell the rights to the principal and interest as bonds known as mortgage-backed securities. The advantages to this system are many, including the fact that the payment streams can be manipulated, in a good way, so that investors (e.g. Fidelity) can arrange to be paid first—if some borrowers default—from the money coming from borrowers in the pool who are still paying. The price for being first in line is accepting a lower interest rate. These securities are the ones rated AAA.

And CDOs? A CDO is another Wall Street-created vehicle that buys bonds or derivatives of bonds, manipulating the cashflows on those, so investors, again, can choose the risk. The difference, as the Journal explains, is that a CDO can buy a whole pool of risky securities, like those rated BBB- (not junk, but not great), for instance, and rearrange the payments so that a large percentage of the pool, 75 percent even, is rated AAA, as safe as a government savings bond.

As the Journal says:

But Norma and similar CDOs added potentially fatal new twists to the model. Rather than diversifying their investments, they bet heavily on securities that had one thing in common: They were among the most vulnerable to a rise in defaults on so-called subprime mortgage loans, typically made to borrowers with poor or patchy credit histories. While this boosted returns, it also increased the chances that losses would hit investors severely.

Why would anyone buy it? To get a higher rate for a bond with the same safety rating as corporate or Treasury bonds. Why would rating agencies (e.g. Standard & Poor’s, Moody’s) rate them so highly? Well, not to be too cynical, but the companies seeking the ratings pay the bills. We have a feeling that story has yet to be fully told, but here are a couple of good pieces from August.

But even casual readers can now see how Wall Street would have incentive to package and repackage securities backed by the same crappy mortgages that boiler-room operations like Ameriquest foisted on deceived and financially vulnerable borrowers.

While that’s bad enough, the Journal explains how the CDO shuffle got even more esoteric and dangerous.

Also, these CDOs invested in more than simply subprime-backed securities. The CDOs held chunks of each other, as well as derivative contracts that allowed them to bet on mortgage-backed bonds they didn’t own. This magnified risk. Wall Street banks took big pieces of Norma and similar CDOs on their own balance sheets, concentrating the losses rather than spreading them among far-flung investors.

“It is a tangled hairball of risk,” Janet Tavakoli, a Chicago consultant who specializes in CDOs, says of Norma. “In March of 2007, any savvy investor would have thrown this…in the trash bin.”

Tangled hairball. House of cards. Call it what you will, it was spit out or stacked up by the shamans on Wall Street, who used this financial voodoo to earn huge fees from underwriting these securities.

That’s how the $1.5 billion Norma CDO came about.

A key to the Journal story’s success is that it scored an interview with Corey Ribotsky, the Long Island-based penny-stock broker, whom Merrill set up as a “CDO manager” to recruit investors and administer Norma. Ribotsky hooked up with Merrill at a Long Island club after meeting a criminal defense lawyer who introduced him to a Merrill bond salesman.

Why was Merrill Lynch essentially setting up businesses for such outside CDO managers—and why Ribotsky, who’s being sued by three separate companies for manipulating their stocks? The Journal doesn’t answer this directly, and there may be another story there.
Still, his quotes are priceless:

“It sounded interesting and that’s how we ventured into it,” Mr. Ribotksy says.

Well, there you go.

The Journal reveals that Norma was comprised of derivatives and securities that Merrill itself had underwritten:

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

That circular cross-selling also multiplied the impact of housing defaults. The Journal cites a UBS study saying banks sold CDOs made up of derivatives worth three times more than the value of the underlying, asset-backed securities.

The banks are getting stuck with billion of dollars in losses in large part because they kept the “safest” parts of the CDOs on their books, since their low yields attracted few buyers. Since they concentrated CDOs in areas that have been slammed—like BBB-rated subprime securities—their values have taken huge hits. The Journal says mezzanine CDOs could account for up to three-quarters of the losses of the biggest banks like Citigroup and Merrill.

While the best mortgage-crisis stories may be yet to come, this one certainly helps untangle that hairball a bit.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.