How Merrill Lynch went from bullish to BS

NY Times:

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... Merrill’s decision to invest heavily in the mortgage industry was paying off handsomely. So handsomely, in fact, that on Dec. 30 that year (2006), it essentially doubled down by paying $1.3 billion for First Franklin, a lender specializing in risky mortgages.

The deal would provide Merrill with even more loans for one of its lucrative assembly lines, an operation that bundled and repackaged mortgages so they could be resold to other investors.

It was a moment to savor for E. Stanley O’Neal, Merrill’s autocratic leader, and a group of trusted lieutenants who had helped orchestrate the firm’s profitable but belated mortgage push. Two indispensable members of Mr. O’Neal’s clique were Osman Semerci, who, among other things, ran Merrill’s bond unit, and Ahmass L. Fakahany, the firm’s vice chairman and chief administrative officer.

A native of Turkey who began his career trading stocks in Istanbul, Mr. Semerci, 41, oversaw Merrill’s mortgage operation. He often played the role of tough guy, former executives say, silencing critics who warned about the risks the firm was taking.

At the same time, Mr. Fakahany, 50, an Egyptian-born former Exxon executive who oversaw risk management at Merrill, kept the machinery humming along by loosening internal controls, according to the former executives.

Mr. Semerci’s and Mr. Fakahany’s actions ultimately left their firm vulnerable to the increasingly risky business of manufacturing and selling mortgage securities, say former executives, who requested anonymity to avoid alienating colleagues at Merrill.

To make matters worse, Merrill sped up its hunt for mortgage riches by embracing and trafficking in complex and lightly regulated contracts tied to mortgages and other debt. And Merrill’s often inscrutable financial dance was emblematic of the outsize hazards that Wall Street courted.

While questionable mortgages made to risky borrowers prompted the credit crisis, regulators and investors who continue to pick through the wreckage are finding that exotic products known as derivatives — like those that Merrill used — transformed a financial brush fire into a conflagration.

As 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.

On Sept. 15 this year — less than two years after posting a record-breaking performance for 2006 and following a weekend that saw the collapse of a storied investment bank, Lehman Brothers, and a huge federal bailout of the insurance giant American International Group — Merrill was forced into a merger with Bank of America.

It was an ignominious end to America’s most famous brokerage house, whose ubiquitous corporate logo was a hard-charging bull.

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TYPICAL of those who dealt in Wall Street’s dizzying and opaque financial arrangements, Merrill ended up getting burned, former executives say, by inadequately assessing the risks it took with newfangled financial products — an error compounded when it held on to the products far too long.

The fire that Merrill was playing with was an arcane instrument known as a synthetic collateralized debt obligation. The product was an amalgam of collateralized debt obligations (the pools of loans that it bundled for investors) and credit-default swaps (which essentially are insurance that bondholders buy to protect themselves against possible defaults).

Synthetic C.D.O.’s, in other words, are exemplars of a type of modern financial engineering known as derivatives. Essentially, derivatives are financial instruments that can be used to limit risk; their value is “derived” from underlying assets like mortgages, stocks, bonds or commodities. Stock futures, for example, are a common and relatively simple derivative.

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For years, the product that Ms. Masters and her colleagues invented remained just a mechanism for offloading risk in high-grade corporate lending. But as often occurs with Wall Street alchemy, a good idea started to be misused — and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.

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There is much more in this apparently well researched piece. I have been saying for some time the problems in the mortgaged back securities business were related to inadequate risk management and this article seems to confirm that in spades.

In my experience in brokerage firms there are always creative people who can come up with ways to create business that puts the firms capital at risk and they are handsomely rewarded if they are right.

Those who try to protect the firms capital by asking the tough questions and saying no don't get the same rewards. You can save the firm billions in potential losses and at best get an atta boy. The big bucks go to those who create the cash flow. It is the nature of the business but it is an area that needs to be looked at.

It is really sad to see an institution like Merrill be humbled like this. They built their core business on retailing securities and they were very good at it. They made a huge mistake when they bet the company on exotic securities whose risk they did not understand.

My speculation is that the securities firms who concentrated in the retail business are, so far, the survivors and are helping to maintain the liquidity of our securities markets.

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