All The Devils Are Here: Unmasking the Men Who Bankrupted the World (60 page)

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 was supposed to reference. Norma included a handful of subprime mortgage-backed securities—about $90 million worth, or 6 percent of the overall holdings, according to the
Journal
. It also included pieces of other CDOs, primarily triple-B mezzanine tranches, some of which Merrill had warehoused in order to launder them into new triple-A tranches at a later date, and some of which were being managed by CDO managers Merrill had hired—including Ricciardi himself, who had joined Cohen & Company, a big CDO manager. The rest of Norma consisted of credit default swaps that referenced tranches of other CDOs that contained subprime securities. In early 2007, all three rating agencies gave 75 percent of Norma’s tranches a triple-A rating.

Magnetar bought the equity portion, of course. At the same time, it shorted the triple-A tranches of Norma, just as John Paulson had done in his Abacus deal. Merrill Lynch prepared a seventy-eight-page pitch book to help convince investors to buy pieces of the CDO. The
Journal
would later note that the pitch book stressed that mortgage-backed securities “have historically exhibited lower default rates, higher recovery upon default and better rating stability than comparably rated corporate bonds.” Merrill’s fee was in the neighborhood of $20 million.

Ultimately, Merrill was able to sell $525 million worth of tranches, most of them lower-rated ones, which Merrill Lynch was promising at 5.5 percent interest above Libor, a very high yield. (Libor is the interest rate that banks charge when they lend to each other.) This was so even though, according to a lawsuit later filed against Merrill for its role in underwriting Norma, the securities had declined by 20 percent even before the deal closed. By December 2007—just nine months after Norma had been created—most of the deal had been downgraded to junk by the rating agencies.

“It was a tangled hairball of risk,” Janet Tavakoli, the CDO critic, told the
Journal
. “In March of 2007, any savvy investors would have thrown this … in the trash bin.”

But wait. If it was a $1.5 billion CDO, and Merrill could sell only $525 million of it, what happened to the other $975 million of Norma—all of which was triple-A? That’s what went onto Merrill’s books; it took the long position on the triple-As. This was the exposure that Semerci was claiming was nearly riskless.

A lawsuit would later claim that Merrill was actively seeking to move its worst securities off its books and into the hands of unsuspecting clients. Without question, Merrill Lynch was doing that, especially with the triple-Bs. In one of the seamier examples of Merrill’s efforts to unload some of the junk on its balance sheet, it actually securitized subprime loans from Ownit—Bill Dallas’s subprime originator, which it partially owned—
after
Ownit filed for bankruptcy. Then again, every other big CDO underwriter on Wall Street—Citibank, UBS, Morgan Stanley, you name it—was doing the exact same thing. “People on the outside thought the market was going gangbusters because of all the deals getting done,” CDO expert Gene Phillips told Bloomberg. “People on the inside knew it was a last-gasp effort to clear out the warehouses.”

In the aftermath of the crisis, Goldman Sachs would be the firm that was by far the most criticized for selling its clients down the river in its efforts to get risk off its own books. In truth, Goldman was just better at it than Merrill and the others. It was tougher and smarter in the way it went about it. And there was an even bigger difference between the way Merrill and Goldman went about attempting to reduce risk. Goldman as an institution never believed that the tiny bit of extra return offered by triple-A subprime-backed securities was worth the risk. As it began marking down its securities—and pushing them off its books—it treated triple-As just as ruthlessly as it treated all the other subprime securities it was marking.

On May 16, 2007, Dow Kim announced that he was leaving Merrill Lynch to start a hedge fund; finally O’Neal said he could go.
^*
During the previous three years, the firm’s trading revenues had doubled; in 2006, his last full year with the firm, Kim was Merrill’s second highest-paid executive, after only O’Neal, taking home a paycheck of $37 million. Along with Fakahany, O’Neal had always viewed Kim as part of his inner circle and was gracious about his departure. It was only after the crisis that O’Neal would reflect back on Kim’s sudden departure, wondering why his head of fixed income hadn’t seen the problem coming. Or, worse, O’Neal would think in his darkest moments, maybe he
had
seen it coming. Maybe that’s why Kim had left.

This seems unlikely. Semerci would later insist that he had shown Kim his risk positions, according to several former executives. But people who have seen the e-mail traffic say that that doesn’t appear to be the case. One day, several months after he had left the firm, Kim returned to Merrill’s headquarters, trying to rustle up a Merrill Lynch investment for his hedge fund. He ran into John Breit in the hallway. “It’s a debacle,” Breit told him, relating the enormous subprime exposure. Kim was stunned. “We don’t have all that stuff!” he replied. Truly, he hadn’t known.

For that
New Yorker
article, O’Neal’s predecessor, David Komansky, told the writer John Cassidy that he simply didn’t believe O’Neal was unaware of the firm’s CDO exposure. Hard though it may be to believe, that does appear to be the case. “Stan was no longer dug in,” says a former executive. At the same time Goldman executives were canceling vacations to deal with the burgeoning subprime crisis, O’Neal was often on the golf course, playing round after round by himself. He had little or no direct contact with any of the firm’s operations—he had delegated that to Fleming, Fakahany, and others. Always a loner, he had become isolated from his own firm. He had no idea that key risk managers had been pushed aside, or that the people he had
put in important positions were out of their depths. Amazing as it sounds, out on the golf course the CEO of Merrill Lynch really didn’t have a clue.

In August, O’Neal went to Martha’s Vineyard for vacation. By then, the market was signaling that the end was near; on the ABX, even the triple As were starting to drop in value. In late July, the Dow had its worst week in more than four years. The CDO market continued to contract. Day after day, the decline continued. Somehow, the combination of the ongoing turmoil in the market and his ability to step back and see things more clearly while he was far away from Wall Street had the effect of finally rousing O’Neal. By the time he returned to work at the beginning of September, he was no longer in denial. O’Neal finally understood that the triple-A securities on Merrill’s book posed a huge threat to the firm. At a minimum, the securities were going to have to be marked down, and there would have to be write-downs that would damage Merrill’s earnings. The firm’s third-quarter earnings report was due in October; he had a month to come to terms with the problem. As he thought about it, O’Neal wasn’t just worried. The memory of the LTCM disaster was flooding back. He was scared.

John Breit understood the problem by then as well. In July, Lattanzio had commandeered two junior quants and told them to sign off on a new valuation method the mortgage desk wanted to use for CDOs squared. The quants, feeling they were being asked to ratify something that had not been vetted through proper channels, complained to their manager. The manager happened to tell Breit the story. Breit’s curiosity was sparked. Calling in a favor from someone in the finance department, he got ahold of a spreadsheet with the collateral in the CDOs squared. He quickly saw how bad it was. He keep digging, quietly; before long he had discovered the $55 billion exposure.

But Breit was still persona non grata on the trading floor. He had no access to top management. He had long since been tossed off the risk management committee. Thus he resorted to the only action he could think to take: he began buttonholing people he bumped into at Merrill, telling them the losses on the mortgage desk were going to be in the billions, not the millions. In early August, Breit went on vacation in the Hamptons. One day he received a phone call from Semerci, who had heard through the grapevine what Breit was saying. Semerci was enraged, and insisted that the losses were only going to amount to a couple of hundred million dollars. By the end of August, the mortgage desk had upped its loss esimate to $600 million—a number Breit still thought was absurdly low. (Semerci says he was in “daily contact” with Keishi Hotsuki, the firm’s head of risk management.)

By mid-September, Merrill Lynch was conceeding $1.2 billion in triple-A losses. Seeing the problems grow, Greg Fleming reached out to his old friend Jeff Kronthal. O’Neal had named Fleming co-president of Merrill Lynch—along with Fakahany—shortly after Dow Kim left. Although he was still under strict orders to stay away from fixed income, the problems on the mortgage desk seemed too deep to just look the other way. Kronthal explained to Fleming how CDOs work and began tapping into his own sources at Merrill Lynch to see if he could find out what was going on. One of those sources was Breit. Breit told Kronthal that he thought the write-downs were going to be much bigger than anyone on the mortgage desk was admitting, which by then was around $3 billion. Kronthal conveyed this to Fleming, who conveyed it to O’Neal. O’Neal asked to see Breit.

The two men had known each other for more than a dozen years; they had even worked together on occasion. O’Neal knew that Breit understood risk as well as anyone at Merrill. “I hear you have a model of the CDOs that disagrees with the valuations being put out there by Semerci,” O’Neal began. No, Breit replied, he didn’t have a model; just a back-of-the-envelope calculation. Then he gave O’Neal his number: $6 billion in losses. And he added, “It could be a lot worse. I haven’t even looked at the high-grade CDOs, just the CDOs squared and the mezzanines.”

O’Neal looked like he was going to throw up. “What about all the protection we bought?” he asked. Breit explained that with AIG no longer in the business, Merrill had been buying protection from the monolines, which had taken on so much risk they would be insolvent long before they could pay off Merrill. O’Neal kept probing. What about the risk models? he asked. Worthless, replied Breit matter-of-factly. The risk wasn’t captured by VaR, and the VaR analysis of the underlying credit quality was wrong. Other risk models didn’t do any better. As O’Neal listened in silence, Breit explained how an important Merrill risk measure had been changed in such a way as to disguise the increasing amount of triple-A risk on the firm’s books. Breit today says he does not believe this was purposely changed to hide the ball—he thinks it might have even been a regulatory change—but it had that effect. “It distorted the true nature of the risk,” he told O’Neal. After talking for a few more minutes, Breit shook O’Neal’s hand and wished him luck. “I hope we talk again,” he said.

That’s when O’Neal told him he wasn’t sure how much longer he would be Merrill’s CEO.

For Breit, it was a sobering conversation; he could see how shattered O’Neal was at the news. For O’Neal, it was an infuriating conversation. How could Breit convey this information so calmly? Wasn’t he supposed to be managing risk? Didn’t he bear at least some responsibility for what the mortgage desk had done? O’Neal still had no idea that Breit had been pushed aside. He thought Breit was still a risk manager on the front lines of the mortgage desk. The fact that he himself had put in place the dynamic that allowed good risk managers like Breit to be cast aside eluded him entirely.