All The Devils Are Here: Unmasking the Men Who Bankrupted the World (33 page)

The man who had the ultimate authority over the mortgage desk for Merrill Lynch in those days was a veteran trader named Jeff Kronthal. He had spent his career around mortgage-backed securities; while still in his twenties, he had run the mortgage desk for Lew Ranieri at Salomon Brothers. Kronthal had joined Merrill in the late 1980s, just a few years after O’Neal, overseeing its trading desks until the mid-1990s, when he took over its derivatives business. Although he spent much of the 1990s pushing a reluctant Merrill to take more trading risk—he thought its tepid risk limits constrained its ability to make sizable profits—he also had a healthy fear of mortgage-backed securities. He had watched them get increasingly risky over the years. His essential view was that Merrill’s role should be to create structures that allowed investors to gain the exposure to risk they wanted to take. But Merrill itself should never assume those risks. “They are things you want to sell, not hold,” he used to tell the traders who worked for him.

In O’Neal’s push to have the firm take on more risk, Kronthal found himself in a tricky position. He had had a few run-ins with O’Neal over the years, but Patrick and Zakaria, both good friends of his, had persuaded him to stay. Once they were gone, Kronthal didn’t have any protectors in the executive suite.

More important, everyone around him was creating CDOs as fast as they could. Kronthal’s boss, Dow Kim, headed all of fixed income. “Stan was constantly pounding on him about why we weren’t making as much in fixed income as Lehman or Goldman,” says a former Merrill executive. As O’Neal pushed Kim, Kim pushed Kronthal.

From below, meanwhile, Kronthal was trying to keep the CDO team under control. That was no small task, either. The team was headed by Chris Ricciardi, an aggressive thirty-four-year-old trader. A decade before, while at Prudential Securities, Ricciardi had been part of a group that had first come up with the idea of bundling mortgages into a CDO. After successful stints at Prudential and then at Credit Suisse, Ricciardi and most of his team joined Merrill Lynch in July 2003, where he quickly ramped up the firm’s CDO business. Kronthal and his crew of veteran traders viewed Ricciardi warily. “He was dangerous,” says one former Merrill trader. “He didn’t care about rules. If one of his managers didn’t give him the answer he wanted, he sought out another manager. All he cared about was himself and his team. He was always threatening to leave and take his team with him.” Kronthal’s belief
was: let him go. But Dow Kim thought Merrill needed ten more salesmen just like him. He was exactly the kind of aggressive risk taker that O’Neal wanted at Merrill.

According to someone who did business with him, Ricciardi was surprisingly mild mannered for someone with such an outsized reputation. “He didn’t have a lot of flash,” this person says. But he was a natural leader, the kind of person who, as a college student, had put together groups that made money painting houses. And, this same person says, “he was very smart and he could articulate a case.” One investor recalls looking at an early Ricciardi deal that included credit card receivables as well as mortgage-backed securities. It had a very limited default history. The investor asked what would happen to the security if the credit card defaults started to rise. Ricciardi had no good answer, and the investor walked away from the deal. But Ricciardi still managed to maneuver the rating agencies into giving most of the deal a triple-A rating.

Ricciardi knew exactly what he’d been hired to do. “The strategy has been to be a high-volume underwriter, with a focus on areas that are very popular,” he told a trade publication in early 2005. What was popular, of course, was subprime mortgages. To ensure that it had a steady source of subprime mortgages to securitize and then bundle into CDOs, Merrill took a 20 percent stake in Ownit, a mortgage originator founded by Bill Dallas. A Merrill executive joined the Ownit board. By 2006, says Dallas, Merrill was pushing him to make loans that would generate more yield for Merrill’s CDOs.

“They never told us to make bad loans,” Dallas says now. “They would say, ‘You need to increase your coupon’ ”—meaning make loans with higher yields. “The only way to do that was to make crappier loans.” Between the fourth quarter of 2005 and the first quarter of 2006, Ownit went from being a company whose loans were virtually all fully documented to becoming a company that was, in his words, “no-doc-centric. We became more of a subprime lender.”

In short order, Merrill would then create mortgage-backed securities out of the mortgages it bought, warehouse the new securities until they could be bundled into a CDO, and negotiate hard with the rating agencies—and tinker with the CDO’s structure—to get most of the security labeled triple-A. (E-mails would later reveal at least one instance in which Merrill specifically linked its fee to a high rating.)

Ricciardi and his team picked the firms that would manage the assets in the CDOs once they’d been created, and the investors who bought the
tranches. They had big, sophisticated investors all over the globe lined up to buy Merrill’s CDO tranches. But Ricciardi was also not above pitching smaller-fry. According to the
Wall Street Journal
, “Merrill distributed some of its riskiest CDO slices through its global network of wealthy private clients.” In 2004, at New York’s Harvard Club, the
Journal
added, “salesmen described the merits of CDO investing to doctors, hedge-fund managers and businessmen.” Merrill’s risk managers, meanwhile, would hold regular meetings to try to figure out who Ricciardi was selling his CDOs to and whether the buyer was truly an appropriate investor.

Finally, Ricciardi was in the vanguard of the practice of rebundling the triple-B mezzanine portion of the CDO into new CDOs. Thus would triple-Bs be turned into triple-A tranches, which were much easier to sell. “Ricciardi could find someone to buy any piece of shit,” says a former Merrill executive.

Kronthal didn’t have any moral objection to the CDO business. Nobody on Wall Street did. But as an old hand at the business, he was keen to make sure that Merrill itself wasn’t warehousing too many CDO tranches. For instance, he imposed a $1 billion limit on triple-A tranches that could be held as an investment on Merrill’s own books. Largely because of Kronthal’s caution, by the spring of 2006, Merrill had around $5 billion or $6 billion in its total exposure to CDOs with mortgage-backed tranches. Most of the exposure consisted of securities Merrill was warehousing until they could be bundled into new CDOs. It was hardly a small number, but it was a manageable one. It didn’t put the firm at risk.

In early 2006, Ricciardi suddenly left Merrill. He jumped to Cohen & Co., a firm that managed many of the CDOs that Ricciardi had sold at Merrill. He became the firm’s president. For Dow Kim, his departure was a blow. Kim quickly assured the rest of the CDO staff that the firm would do “whatever it takes” to stay number one. He said the same to Stan O’Neal.

A few months later, in April, Merrill’s directors and top executives went to Pebble Beach for an off-site. During one of the working sessions, the discussion centered on Merrill’s fixed-income department. “The world has changed,” O’Neal told the assembled executives, according to several people who were there. Fixed income and credit, he added, were no longer cyclical in nature. There was going to be an ongoing demand for fixed-income products. “We need to continue our ability to take risk and manufacture products,” he said.

By then, Kronthal was beginning to fear the mortgage market was becoming overheated. His bosses, starting with O’Neal, felt otherwise. They wanted more people like Ricciardi, not fewer. They wanted to buy a mortgage originator, just like Lehman and some of the other firms had. They wanted to raid other firms to bring in aggressive young talent. Kronthal thought the hour was getting late, and Merrill would be better served pulling back.

At the off-site, Kronthal and his team gave a series of presentations outlining the risks—and the possibilities—in Merrill’s various fixed-income desks. In 2005, Kronthal had been Merrill’s highest-paid nonexecutive employee, with a bonus of more than $20 million. That sum was a testament to the profits his desks were making at Merrill. To the board that day, Kronthal and his team were portrayed as the graybeards, the seasoned hands who knew how to take smart risks.

Six weeks later, they were all fired.

G
eorge W. Bush believed in homeownership, too.

In June 2002, nine months after 9/11, the president traveled to Atlanta, where, in an African-American church on the city’s south side, he unveiled his homeownership agenda. Entitled “Blueprint for the American Dream,” it promoted homeownership among minorities. The administration’s goal, Bush said, was to raise the number of minority homeowners by 5.5 million by 2010. “Part of being a secure America is to encourage homeownership,” he said, thus making homeownership seem somehow a part of the battle against terrorism.

Sitting in the audience that day was a man named Franklin Delano Raines, the chief executive of Fannie Mae. It was a triumphant moment for Raines, and not only because he was a minority himself—the first African-American CEO of a Fortune 500 company. Along with Leland Brendsel, the chief executive of Freddie Mac, Raines had gone to Atlanta that day at the behest of the White House, which wanted him to be part of the administration’s orchestration of the events of that day. (The two men flew back on Air Force One.) For all the controversies that had dogged the GSEs, the new administration seemed to be signaling that it could live with Fannie and Freddie just the way they were. A few months later, at a White House conference on minority homeownership, the president went out of his way to praise Raines’s stewardship of Fannie Mae.

And yet, if Raines thought he could rest easily, he was dead wrong. Within a year, the Bush White House would be engaged in a bitter war with Fannie and Freddie. By the end of 2004, the war would cost Raines his job, while Fannie Mae would be forced to restate billions of dollars in earnings in one of the largest accounting scandals in American history.

These events created an envious amount of
Sturm und Drang
in Washington. But ultimately, very little changed. The administration had started the war because it feared that Fannie and Freddie had become so big they posed a systemic risk to the financial system. The White House wanted to force the GSEs to pare back the risks on its books. Yet the “intifada,” as Raines would later call it, arguably wound up making matters worse, because it helped push the GSEs into buying riskier mortgages at exactly the wrong time. Just as important, this intense focus on the dangers Fannie and Freddie posed to the system allowed Congress and regulators to turn a blind eye to the systemic risks that were building up, inexorably, in the private market. After all, if clipping the wings of the GSEs was your primary objective, then you wouldn’t be inclined to look skeptically at their private competitors, would you?

Frank Raines, as everyone called him, was the quintessential postmodern Horatio Alger; born poor, he attached himself to the meritocracy and rode it for all it was worth. He grew up in Seattle, his father a custodian for the city parks department, his mother a cleaning woman for Boeing, a company whose board Raines would later serve on. After he became Fannie Mae’s CEO, Raines liked to recall that his father didn’t make enough money to get a thirty-year fixed-rate mortgage. The only way he could buy a home was to pay an exorbitant rate of interest to a hard-money lender.

Raines earned a scholarship to Harvard, where he joined both the Young Democrats
and
the Young Republicans and was named a Rhodes Scholar. After graduating from Harvard Law School, he interned in the Nixon White House and then served in the Carter administration before leaving to become a partner at Lazard Frères, where he spent the next eleven years. Deciding that he had had enough of the nonstop travel that was the life of an investment banker, he quit without knowing what he was going to do next. In 1991, Jim Johnson offered him the vice chairmanship of Fannie Mae, the same job Johnson had held when he was Maxwell’s protégé. Raines said yes; Fannie’s offices were just a mile and a half from Raines’s home in Washington.

Five years later, he jumped back into government, becoming the head of the Office of Management and Budget at the beginning of Bill Clinton’s second term. When Raines asked the president how long the job would last, Clinton replied, “Until you balance the budget.” Within two years, the Clinton
administration had indeed produced a balanced budget, the first in a generation, for which Raines reaped enormous credit. When he returned to Fannie Mae in 1998—with a promise from Johnson that he could soon take it over—his political stock could not have been higher. Charismatic, smart, and tough, he had “extraordinary presence,” recalls Andrew Lowenthal, a lobbyist whose clients once included Freddie Mac. “You see him, you meet him, you want to believe him.” There were people in Democratic circles who speculated that he might someday become the first black president of the United States.