In 2005, Merrill Lynch CEO Stanley O’Neal boasted that Merrill Lynch had “the right people in place as well as good risk management and controls.” In a devastating article in The New York Times Business Section on November 9th, Gretchen Morgenson demonstrated that O’Neal was wrong on all counts, especially when it came to Merrill’s decision in 2006 to invest heavily in the mortgage industry. Merrill had the wrong people overseeing a line of business that they did not understand and whose risks they did not appreciate.
Two indispensable members of O’Neal’s clique of trusted lieutenants ? Osman Semerci and Ahmass L. Fakahany ? helped orchestrate Merrill’s belated push into the mortgage industry. Semerci oversaw Merrill’s mortgage operation, and, according to former Merrill executives, often played the role of tough guy who silenced the critics warning about the risks the firm was taking. At the same time, Fakahany, who oversaw Merrill’s risk management, kept the machinery humming along by loosening internal controls, according to the same former executives. Their actions ultimately left Merrill vulnerable to the increasingly risky business of manufacturing and selling mortgage securities.
Merrill made matters worse by embracing and trafficking in complex and lightly regulated contracts tied to mortgages and other debt. When subprime lenders began toppling after record waves of homeowners defaulted on their mortgages, Merrill was left with $71 billion of eroding mortgage exotica on its books and billions in losses.
Merrill, like many other businesses on Wall Street who dealt with these opaque financial arrangements, got burned by inadequately assessing the risks it took with these new financial products, and it compounded by the error by holding on to the products too long.
The products that led to Merrill’s downfall were arcane instruments known as synthetic collateralized debt obligations (“CDOs”). The product was a combination of regular CDOs (the pools of loans bundled to investors) and credit default swaps (essentially insurance that bond holders buy to protect themselves against possible default). Synthetic CDOs are derivatives that can be used to limit risk, and their value is derived from underlying assets such as mortgages, stocks, bonds, or commodities.
Mortgage related derivatives are among the most complex of all derivatives. They involve a collection of exotic jumbo size contracts openly linked to real world loans and debts. As the housing market went over the cliff and borrowers defaulted on their mortgages, these contracts collapsed.
An elite team of JPMorgan bankers invented the synthetic CDO in 1997 to reduce the risk of loss on loans made to blue chip corporate borrowers. JPMorgan, however, kept only the highest quality and most bulletproof portions of their product in house, known as the super senior slice, and they quickly sold anything riskier to firms that were willing to take on the ownership dangers in exchange for heftier fees.
For years, this product remained a mechanism for offloading risks in high grade corporate lending. But soon a good idea ? like so many others ? started to be misused, and a product designed to insulate against risk soon became a device that actually concentrated the dangers. The shift began in 2002, as low interest rates pushed investors to seek investments with higher returns. Some of these biggest returns were being harvested in the riskier reaches of the mortgage market. Banks, investors, and rating agencies all claimed that the risk of owning such bundled mortgages was softened because of the broad diversity of loans in each pool. The risk still existed, but it lurked beneath the surface as synthetic CDOs became more leveraged and encompassed riskier asset classes.
In 2005, Merrill was racing to become the biggest mortgage player on Wall Street. Merrill went on a buying spree and made 12 major purchases of residential or commercial mortgage related companies or assets. The largest acquisition was First Franklin, a domestic subprime lender.
As the business grew, it was never clear how well Merrill’s management understood the risks in the mortgage business. John Kanas, the former CEO of North Fork Bancorp, spent many hours with senior Merrill executives, including Fakahany, discussing a possible merger. Kanas could not get comfortable with Merrill’s risk profile and believed that Merrill did not understand its own risk profile.
According to former Merrill executives, Fakahany weakened Merrill’s risk management unit by removing the long standing employees who “walked the floor” and talked with traders and other workers to figure out the risk the firm was taking on. The people chosen to replace those employees were loyal to O’Neal and his top lieutenants. As such, they were more concerned with achieving senior managements profit goals than about monitoring the firm’s risk.
Semerci was a pivotal figure in the mortgage push. He has been described as intimidating, and Semerci would chastise traders and other moneymakers who told risk management officials exactly what they were doing. “There was no dissent,” said a former Merrill executive. “So information never really traveled.” In addition to the mortgage business, Merrill also dove into the synthetic CDO market. Merrill also was unafraid to stockpile such CDOs to increase its fees. The risks in Merrill’s business model became viral after AIG stopped insuring the highest quality portions of Merrill’s CDOs against default. Merrill could not find an adequate replacement to insure itself. Instead of slowing down, however, Merrill continued to raise its unhinged mortgage bets.
Starting in 2007, the mortgage business began to fall apart. As mortgages started to fail, the debt ratings on the CDOs were cut. Anyone owning those products was locked in a downward spiral since no one wanted to buy a collapsed investment. Merrill was among the biggest victims.
Merrill suffered billions in losses, and O’Neal was forced out. His golden parachute of $161 million, however, was left intact. John Thain was brought in to stop the bleeding and started selling off Merrill assets to do so.
As multi-billion dollar losses kept piling up, Merrill was hard pressed to raise enough capital to replenish its coffers. As Wall Street learned of Merrill’s problems, its shares plummeted. Some banks were so concerned that they considered stopping trading with Merrill if Lehman went under. The day after Lehman filed for bankruptcy, Merrill was taken over by Bank of America.
One of the most well known brands in America and one of the nation’s leading brokerage firms — destroyed by the greed and blindness of its management.