Morgenson -- How Merrill Lynch Fell

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new_york_times:http://www.nytimes.com/2008/11/09/business/09magic.html

By GRETCHEN MORGENSON
Published: November 8, 2008
“We’ve got the right people in place as well as good risk management and controls.” — E. Stanley O’Neal, 2005
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Merrill Lynch, via Bloomberg News, left; David Karp/Bloomberg News, right
Ahmass Fakahany, left, and Osman Semerci, center, worked under E. Stanley O’Neal to expand Merrill’s investments related to mortgages. Such investments led to a $7.9 billion write-down a year ago, and Mr. O’Neal was forced out.
THERE were high-fives all around Merrill Lynch headquarters in Lower Manhattan as 2006 drew to a close. The firm’s performance was breathtaking; revenue and earnings had soared, and its shares were up 40 percent for the year.
And Merrill’s decision to invest heavily in the mortgage industry was paying off handsomely. So handsomely, in fact, that on Dec. 30 that year, 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.
“The mortgage business at Merrill Lynch was an afterthought — they didn’t really have a strategy,” said William Dallas, the founder of Ownit Mortgage Solutions, a lending business in which Merrill bought a stake a few years ago. “They had found this huge profit potential, and everybody wanted a piece of it. But they were pigs about it.”
Mr. Semerci and Mr. Fakahany did not return phone calls seeking comment. Bill Halldin, a Merrill Lynch spokesman, said, “We see no useful purpose in responding to unnamed, former Merrill Lynch employees about a risk management process that has not existed for a year.”
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.
Among the more complex derivatives, however, are the mortgage-related variety. They involve a cornucopia of exotic, jumbo-size contracts ultimately linked to real-world loans and debts. So as the housing market went sour, and borrowers defaulted on their mortgages, these contracts collapsed, too, amplifying the meltdown.
The synthetic C.D.O. grew out of a structure that an elite team of J. P. Morgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like I.B.M., General Electric and Procter & Gamble.
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