Colin Barr

Following the money in banking, economics, and Washington

How banks 'super-charged' the bubble

August 27, 2010: 1:18 PM ET

A new report shows how the too-big-to-fail banks gave the housing bubble a final breath of air, at great cost to everything but their bonuses.

They did it by manipulating the market for the yucky subprime-related debt called collateralized debt obligations, say ProPublica and NPR. The CDO boom started early in the last decade, as banks such as Goldman Sachs (GS), Citigroup (C) and the Merrill Lynch brokerage now owned by Bank of America (BAC) cooked up a way to turn risky asset-backed securities into safe-looking triple-A-rated bonds.

Peering into the subprime murk

But as the U.S. house-price boom topped out and big debt buyers such as pension funds started to back away from mortgage-related bonds, the banks turned increasingly to what ProPublica calls self-dealing – creating new CDOs to buy debt that would otherwise go unsold

By the time the bust came in 2007, $107 billion worth of new CDOs that were issued owned parts of other CDOs. That's almost a fifth of the market and up sharply from the 2007 level of just a few percent.

The surge in demand from CDOs filled in for a decline in purchases by other, less conflicted investors. The CDOs, though nominally independently managed, were -- like the rating agencies and others in this money grub -- dependent on the banks for fees.

Their purchases allowed Wall Street to sell even more mortgage debt, at a time when a slowdown in the housing market was making everyone nervous about the risks.

"The counterintuitive result was that even as investors began to vanish, the mortgage CDO market more than doubled from 2005 to 2006, reaching $226 billion, according to the trade publication Asset-Backed Alert," ProPublica reporters Jake Bernstein and Jesse Eisinger write.

Perhaps even more counterintuitive is that it seems likely no one will ever be punished. Merrill and Citi together took $60 billion in writedowns on their subprime blundering, and the Securities and Exchange Commission is probing the CDO business.

The SEC is looking at 50 CDO managers and has already brought a self-dealing case against one. Of course, the agency also wrung a $550 million settlement from Goldman Sachs in a CDO case brought this spring, along with a confession from Goldman that mistakes had been made.

But no one has gone to jail for CDO crookery and, maddeningly, there may not be grounds for criminal prosecutions.

"It remains unclear whether any of this violated laws," Bernstein and Eisinger write.

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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