All the Devils Are Here [105]
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