All The Devils Are Here: Unmasking the Men Who Bankrupted the World (59 page)

That was precisely the problem. The issue wasn’t actual cash losses. It was uncertainty. No one knew where the subprime problem would pop up next, no one could figure out what any of this stuff was worth, no one believed what anyone else said about what it was worth, and no one believed that anyone who was supposed to know something actually did. That included the nation’s top regulators. “I’d like to know what those damn things are worth,” Federal Reserve chairman Ben Bernanke said during an appearance at the Economic Club of New York in October 2007.

Bernanke’s comment infuriated an outspoken, deeply skeptical Georgia mutual fund manager named Michael Orkin. Not long after the Fed chairman’s speech, Orkin wrote in his monthly letter to investors, “Since the first shot was fired across the credit bow in February 2007, investors have been force-fed a constant diet of half-truths and whole lies regarding the nature and status of the mammoth mortgage-based derivative machine and the housing market bubble it inflated … The fact that the credit crisis has now
turned into a confidence crisis should serve as a wake-up call to Wall Street, the Treasury and the Fed.”

In late November 2007, a senior vice president in structured finance at Lehman Brothers, Deepali Advani, who had previously worked at Moody’s, forwarded an e-mail from one of the firm’s traders to a handful of his contacts. “The wheels on the bus are falling off, falling off, falling off … The wheels on the bus are falling off, all over Wall Street.” William May, a managing director at Moody’s, wrote back, “I think he’s too optimistic.”

“Bill, who ever thought CDOs would be WMD?” Advani wrote back. “Though have to say—every day more bad news—would be much too bad for the world to end—but that’s sure how it feels.”

T
he collapse of the Bear Stearns hedge funds in June 2007 should have been a terrifying moment for Stan O’Neal. Merrill Lynch had been the first to make a grab for Bear’s triple-A subprime collateral, which began the run on the bank that brought down the two funds. Yet it had been unable to sell that collateral because nobody wanted it. Nobody could say anymore what it was worth.

Dale Lattanzio, who ran Merrill’s CDO business, and his boss, Osman Semerci, responded in exactly the way you would expect of two people whose multimillion-dollar bonuses were completely dependent on their ability to continue manufacturing CDOs. They told their superiors that the market was in the middle of a little rough patch, but there was nothing to worry about. (Semerci denies ever saying or even implying that the market was going through a temporary rough patch. Given the unprecedented events, it was impossible for anyone to predict whether or when the market would recover. Because of this, Merrill Lynch was prudently taking steps to reduce its subprime risk. Indeed, according to Semerci, between the second and third quarters of 2007, Merrill Lynch reduced its subprime risk by 50 percent.”)

O’Neal appeared to accept their analysis. According to
The New Yorker
magazine, the two men told O’Neal that “the CDO market would eventually stabilize, allowing Merrill to sell its holdings.” The magazine added, “O’Neal seemed reassured.” He did, however, ask them to try to hedge the position, which they insisted they were already doing. Indeed, in late 2006—around the same time Goldman Sachs concluded that it needed to get closer to home—Dow Kim was telling Semerci and Lattanzio the same thing. At a board meeting in July, the two men claimed that Merrill Lynch was likely to lose no more than $83 million from its subprime exposure—a claim that other Merrill executives viewed as implausible. Yet O’Neal didn’t question
them. When others tried to warn O’Neal that Semerci’s loss estimates were too low, they were met with a steely glare, according to several former Merrill executives. (Semerci and Lattanzio vehemently deny that they ever made such a statement at the July board meeting. “It is absurd to suggest that the company’s exposure had been reduced to $83 million by mid-July 2007 when, as disclosed in the company’s third quarter earnings announcement, the exposure was $40.9 billion. In any event, I made no assessment at that meeting of the potential maximum exposure.”)

Shortly after that board meeting, Merrill announced its second-quarter earnings. On the surface, the numbers were terrific: $2.1 billion in profits on $9.7 billon in revenues; the profit number was 31 percent higher than Merrill’s second-quarter profits in 2006. In the accompanying press release, Merrill specifically pointed to the success of its “credit products.” During the conference call with investors, CFO Jeff Edwards put it even more explicitly: the growth in fixed income was due in large part to “a substantial increase from structured finance and investment, which primarily reflects a better performance from our U.S. subprime mortgage activities.” Acknowledging that the market for CDOs “has yet to fully stabilize” after the collapse of the Bear Stearns hedge funds, Edwards added that “[r]isk management, hedging, and cost controls in this business are especially critical during such periods of difficulty, and ours have proven to be effective in mitigating the impact of our results.” Within three months, every one of these claims would prove to be delusional.

It seems inconceivable now that O’Neal himself had so little understanding of what lay ahead. He was a very smart man, a tough, seasoned Wall Street executive. One of the formative experiences of his career had been the Long-Term Capital Management disaster. He had been Merrill’s CFO during that crisis, and it remained seared in his memory. He knew how a series of events could spiral into catastrophe. He remembered that awful feeling of realizing that Merrill couldn’t put a value on the collateral it held. He saw how, in a crisis, “everything is correlated”—meaning that securities that were supposed to act as hedges suddenly started falling in tandem, exacerbating the losses. Panics have their own momentum, their own rhythms. It didn’t matter how much cash you said you had; if your counterparties lost faith in you, you were finished. “You couldn’t rely on anything,” he liked to say.

O’Neal had worked fifteen hours a day for months during the LTCM crisis. He had gone home, night after night, worried about whether the firm would have enough liquidity to fund itself the next day. And, he liked to say,
he never forgot those lessons. Yet now it appeared as if he
had
forgotten those lessons.

O’Neal had discovered another fact as a result of the Bear fiasco that should have shaken him to his core. He had learned the size of Merrill Lynch’s subprime exposure. It was enormous. When Kronthal had left in July 2006, the firm had somewhere between $5 billion and $8 billion in subprime risk on its books. Most of it was either subprime mortgages waiting to be securitized, tranches of mortgage-backed securities waiting to be put into CDOs, or triple-B CDO tranches waiting to be repackaged into new CDOs as triple-As. This was hardly an insignificant exposure; if those subprime securities had to be written down in large numbers, Merrill was going to feel a good deal of pain. People would undoubtedly get fired. But it was not an amount that could bring the firm down.

A year later, Merrill Lynch held an astonishing $55 billion in subprime exposure on its balance sheet. In the space of one year, Semerci and Lattanzio had added somewhere between $45 billion and $50 billion in additional exposure. Some of it was the same kind of collateral that had been on the books when Kronthal had been running the show: mortgage-backed securities of one sort or another waiting to be resecuritized. But the vast majority of it was triple-A tranches of subprime CDOs.

(In a phone conversation, Lattanzio said that the way he is characterized in this chapter is misleading and unfair. His view is that he and Semerci have been singled out by other former Merrill Lynch executives who needed a convenient scapegoat to avoid their own blame for the Merrill Lynch debacle. According to Lattanzio, by the time he took the reins of the CDO business, the machinery that would drive the firm’s exposure into the stratosphere was already well in place, and there was little he or Semerci could do to stop it. Further, he said the purchase of First Franklin, which generated subprime mortgages that his division had to then bundle into CDOs, had been made at the executive-suite level—and that is where the blame belongs.)

Anyone who looked closely at this triple-A exposure would realize in an instant what Lattanzio and Semerci had done. With AIG no longer around to write protection—leading to a lack of buyers for the super-senior tranches—the only way Merrill could continue churning out new CDOs was to keep the triple-A risk itself. So that’s what Semerci and Lattanzio had done. In the case of CDOs with subprime mortgage-backed securities, Merrill simply bought the triple-A tranches and put them on its books. In the case of synthetic CDOs—a business Merrill was also deep into—the firm
would find a hedge fund to take the short position and take the long position itself. In most cases, Merrill bought protection from a monoline insurer like MBIA (which, under the rules, also enabled the firm to book the income on the triple-A tranches up front), but in the event of disaster, that wasn’t likely to help much. The monolines had insured so much triple-A risk that any market event that hurt Merrill Lynch would destroy them.

The result of Semerci and Lattanzio’s strategy was that Merrill Lynch would remain the number one underwriter of CDOs and the two men would get their big bonuses. But in the process, they had put Merrill Lynch itself at grave risk.

Did the two men understand that? At a certain point, late in the game, Semerci in particular seems to have understood the gravity of the situation. According to several former top Merrill executives, he appears to have managed his risk assumptions in such a way as to keep the estimated losses that he presented to management and the board artificially low. They also believed his marks were too high. These same executives are convinced, for instance, that Semerci knew full well when he made that board presentation in July 2007 that Merrill losses were going to be far higher than $83 million.

But until it was far too late, it appears that Semerci and Lattanzio did not fully understand the import of their strategy. Why? Because just like Ralph Cioffi and Mike Tannin at Bear Stearns, Semerci and Lattanzio still believed that a triple-A rating meant something. As the market had gotten shaky, they had begun shorting the ABX triple-Bs, but it never occurred to them that they were on the wrong side of the triple-A bets. Their belief in the value of the triple-A was why Semerci could tell Kim, with a straight face, that Merrill had very little 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.

(Semerci and Lattanzio both take issue with this characterization. “Between August 2006 and September 2007,” Semerci wrote in a letter, “the firm’s overall subprime exposure including, but not limited to, CDOs, subprime loans, subprime warehouse facilities, CDO warehouse facilities etc., was substantially reduced, notwithstanding the decision taken by the company before my tenure to purchase First Franklin with existing inventory.” As for the charge that he viewed Triple A securities as riskless, Semerci says that was not the case: “There is no such thing as a riskless position in the markets,” he wrote.)

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.