While the US markets leapt overnight on news that the Fed will once again lower interest rates, the stench from the sub-prime fiasco doesn’t seem to be dissipating. Fortune’s Shawn Tully produced a fascinating cover story last week, focusing on the woes at Citigroup and Merrill Lynch who between them have managed to lose US$17.7 billion. And worst of all, most experts predict that we haven’t seen the last CDO-related write down.

Tully provided a concise explanation as to what went awry – and how the world’s largest banks, the professors of risk, managed to get it so wrong. Fortune noted that:

At first, Merrill treated the CDO trade as a client business. The idea was to get in and out quickly – help structure the CDO, hand it to the manager, and pocket the fees. But as the fees rose, so did Merrill’s hunger for market share.

[However] the market for CDO debt, however, changed radically starting in 2006. Anyone who picked up a newspaper read constantly about the woes in housing. Foreclosures were rising, home prices were falling in dozens of major markets, and the Fed was closing the era of supercheap money.

… Under normal circumstances, such worries would have led to higher interest rates on subprime mortgage bonds. But these were not normal times. Instead of rising, rates on subprime mortgage bonds remained abnormally low until the summer of 2007, and in some months even dropped below 2006 levels.

And the kicker:

To keep the merry-go-round spinning, Merrill apparently made a pivotal – and reckless – decision. It bought big swaths of the AAA paper itself, loading the debt onto its own books. “Merrill took the top tranches onto its own balance sheet,” says Scott Sprinzen, an analyst with S&P. “The amounts were staggering.”

Ultimately, what Tully suggested is that the reason Merrill dropped billions on CDOs was because it stopped acting as an intermediary (in which it set up vehicles, and transferred the risk to investor clients such as hedge or pension funds) but instead started playing the market itself (much like the Goldman Sachs does).

The problem was, Merrill’s decision to take such a large a proprietary position was based not on investment fundamentals (which were looking very weak due to the property market collapse), but on its desire to keep its fee machine rolling (the bank reaped US$700 million in fees from financing CDOs in 2006). While Merrill was buying CDOs, Goldman Sachs was shrewdly hedging its exposure. As a result Goldman shares are up this year, while the remainder of the industry has been sold down by almost 14 percent.

Merrill, guided by disgraced former CEO Stan O’Neal (who led the destruction of billions of dollars of shareholders equity but walked away with a severance package in excess of US$150 million), blithely ignored the obvious risks attached to the securitised assets.

The concern remains that while Merrill has already written off US$7.9 billion, it “still has $21 billion of unhedged exposure to subprime bonds”. Further, while the bank has hedged US$11 billion of further exposure, “analysts are worried about how effective those hedges will be as prices plunge”.

Despite the gloomy predictions, investors have shown they are willing to look on the bright side. Last night, Merrill shares rose 8.89 per cent on the news of the rate drop.

Have we seen the end of the carnage? Wouldn’t bet on it.