Citigroup conference call, November 5, 2007:

Mike Mayo, Deutsche Bank analyst: "...I mean $43 billion of CDOs. And, excuse me, when were these structures established?..."

Gary Crittenden, Citigroup CFO: "...In terms of the -- so the positions, the warehouse positions have obviously been accumulated over -- the super senior portfolio positions have been accumulated over time. As I mentioned earlier on the call, the $25 billion that was effectively the liquidity puts really came on during the course of the summer. So this really happens in two different time periods..."

Merrill Lynch conference call, October 24, 2007:

Mike Mayo, Deutsche Bank analyst: "And how did you wind up with such a large concentration [of CDOs] in the place?..."

Stanley O'Neal, CEO [now retired]: "...Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves and there were some errors of judgment made within the risk management function and that is the primary reason why those exposures exist."

This kind of bobbing and weaving and ducking and speaking gibberish is why we need Wall Street under oath in a Senate hearing room.

The Citigroup translation goes like this: we've been buying the AAA-rated super senior tranches all along because we were told by the physics brainiacs that these securities were walled off from losses by over collateralization. Our pat answer for how we got $25 billion of CDOs back on our balance sheet this summer is going to be a "liquidity put." We are standing by the position that we gave our buyers the right to "put" the securities back to us without losses under certain conditions. (How that complies with securities laws banning guarantees against losses has yet to be addressed. How one can make an arms length sale of a security and still be contractually bound to take it back on the balance sheet has also not been addressed. Stockbrokers would lose their job, livelihood and licenses if they used this defense. This raises the additional question of regulatory passes for the privileged, another serious contributor to inefficient markets.)

Stan O'Neal's answer on behalf of Merrill Lynch is, on its face, very humble and simple: mistakes were made; errors of judgment. Recent articles, however, have raised suspicions that Merrill was not only holding the AAA tranches because they thought they were safe from losses because of over collateralization, but was also making hedging bets against the very subprime debt they were selling to customers; in other words, Enronomics: heads I win, tails you lose.

The danger with Alice in Wonderland securities concocted by the invisible hand of a rigged machine, is that all it takes to start a panic is for some sober looking types in scholarly garb to step into the public square and yell "the Emperor has no clothes!"

This is exactly what happened on February 15, 2007. Joseph R. Mason, associate professor of finance at Drexel University's LeBow College of Business and researcher Joshua Rosner, delivered a paper at Hudson Institute that laid bare the preposterous notion that one could indefinitely put lipstick on a pig (as they liked to say during the dot.com mania) and call it a AAA security. As the working paper found its way into the hands of Gretchen Morgenson at the New York Times and her article appeared three days later, the fireworks factory began to smolder in lower Manhattan, eventually igniting showy global displays throughout 2007. There was a run on a bank in London for the first time in 140 years, bankrupted hedge funds on Wall Street, insolvent mortgage lenders across the U.S., bailouts of money market funds by premier financial institutions and over a half trillion dollars of a liquidity infusion by the European Central Bank. There was also unprecedented help from the U.S. Federal Reserve in terms of cash infusions and back channel chats. But, by far, the most serious damage is the lingering distrust between the largest Wall Street trading firms which, unfortunately, also own banks. No one trusts each other's solvency so interbank lending has seized up.
Mason and Rosner made a prophetic pronouncement in their paper:

"The growing investor acceptance of CDO structures has been supported by rating agencies' willingness to rate these assets. Unlike other assets that rating agencies rate, these assets are subject to considerable market risk, a risk which rating agencies do not claim to be able to effectively rate...Because many buyers of senior CDOs can only hold investment grade assets they may continue to hold deteriorating and increasingly illiquid assets as long as their ratings have not been downgraded. Because the market is OTC [over the counter], investors may incorrectly value these assets in their portfolio and be forced to recognize large mark to market losses in a fast moving, liquidating market...."

J. Kyle Bass, managing partner at Hayman Advisors, framed more of the problem to the House subcommittee on Capital Markets in testimony on September 27, 2007:

I will tell you why and how regulators completely missed the epic size and depth of the problem in the credit markets today. An important concept to appreciate is that each securitization is essentially an off balance sheet bank...However, the securitization market has no Federal and State banking regulators to monitor its behavior. The only bodies that provide oversight or implicit regulation are the NRSROs [rating agencies] -- bodies that are inherently biased towards their paymasters, the securitization [Wall Street] firms.

Without sufficient oversight, this highly levered, unregulated, off balance sheet securitization market and its problems will continue to have severe ramifications on global financial markets.

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