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exposure to subprime risk: he still thought the triple-As were close to riskless. That’s why he could tell O’Neal he was reducing the risk in the portfolio. And that’s why Semerci and Lattanzio could estimate Merrill’s worst-case scenario losses in the tens of millions, rather than the billions. The two men were no different than the “real-money” investors who had been lured into the game by Wall Street, convinced they were getting the high-finance equivalent of a free lunch: an ultrasafe security that also generated higher yields than Treasury bonds. Even many of these investors, though, had become leery of a triple-A rating by the summer of 2007, especially as the spread between Treasuries and super-senior tranches narrowed to a smidgen. As Merrill Lynch had loaded up on triple-A mortgage-backed securities, the firm had become, without knowing it, one of the dumb guys. That was the real difference between Goldman Sachs and Merrill Lynch. “We fell for our own scam,” John Breit, the Merrill risk manager, would later say.

For some time now, the synthetic CDO business resembled nothing so much as a daisy chain. It was just the way Lew Ranieri had described it in that speech he gave at the OTS. The buyers of the lowest-rated equity tranches weren’t investors who were eager to take that risk in return for the promise of a high yield. Many of those investors were gone. Mostly, the buyers were hedge funds interested in doing that correlation trade, the one where they bought the equity and then shorted the triple-A, so they won no matter what the housing market did. The riskiness of the equity slice was meaningless to them. The buyers of the mezzanine, or triple-B, slices were other CDOs, which would then launder them into new triple-A slices. And the buyers of the triple-A were quite often the underwriters themselves, taking the long side against the same hedge fund that had also taken the short side of the triple-As. With no need for actual collateral—since everything was referenced—such deals could be done ad infinitum. If you were working feverishly to churn out CDOs and keep your number one ranking, this was an important component of your strategy—because these were the easiest deals to do. So in addition to underwriting cash CDOs, using mortgage-backed securities, Semerci and Lattanzio also dove into the synthetic game.

It was not a pretty thing to watch. Chicago-based hedge fund Magnetar would come to be the face of the correlation trade. According to the nonprofit investigative news service ProPublica, which conducted a six-month investigation into Magnetar’s trades, some $30 billion worth of CDOs in which Magnetar owned the equity were issued between mid-2006 and mid-2007; by J.P. Morgan’s estimate, Magnetar’s CDOs accounted for between 35 and 60 percent of the mezzanine CDOs that were issued in that period. Merrill did a number of these deals with Magnetar. The performance of these CDOs can be summed up in one word: horrible.

The essence of the ProPublica allegation is that Magnetar, like Paulson, was betting that “its” CDOs would implode. Magnetar denies that this was its intent and claims that its strategy was based on a “mathematical statistical model.” The firm says it would have done well regardless of the direction of the market. It almost doesn’t matter. The triple-As did blow up. You didn’t have to be John Paulson, picking out the securities you were then going to short, to make a fortune in this trade. Given that the CDOs referenced poorly underwritten subprime mortgages, they had to blow up, almost by definition. That’s what subprime mortgages were poised to do in 2007.

Take a deal called Norma, a $1.5 billion synthetic CDO that Merrill Lynch put together in March of 2007, and which would later be dissected by the Wall Street Journal. The CDO manager Merrill chose to manage the deal was NIR. It was a former penny stock operator that Merrill had found and put into the CDO management business. Merrill had a number of similar captive CDO managers who knew without being told what kind of collateral the CDO