All the Devils Are Here [148]
Which also meant that, like virtually everyone else at Merrill Lynch, Breit had no idea what Semerci was doing with Merrill’s CDO business. Though he was one of the few people left at Merrill with the knowledge and background to sniff out problem trades, he was shut out entirely.
Toward the end of 2006, Merrill Lynch took a final step in its ongoing quest to be the dominant Wall Street player in subprime mortgages. It finally bought that mortgage originator O’Neal had been hankering for. The company was First Franklin, a unit of National City Corporation that had made $29 billion in mortgage loans the year before, virtually all of them subprime.12 The purchase price was $1.3 billion. Now Merrill would have its own source of mortgages that it could securitize to its heart’s content. Or so the company hoped.
The Merrill executive who had been handed the job of landing a mortgage company for Merrill was Michael Blum. In truth, Blum was not a big fan of the First Franklin purchase, though he had dutifully completed it. In 2005, he and his staff held a meeting with O’Neal to lay out Merrill’s possible options for getting into the mortgage origination business. O’Neal was eager to get going; Lehman Brothers already made four times what Merrill made in mortgages, in part because it owned BNC Mortgage, the eighth largest subprime company in the country. Blum thought the firm should start up its own originator rather than buy one. “Buying something will be painful because they are not well-managed companies and they are at the bottom of the food chain,” he told O’Neal, according to people who were in the meeting.
O’Neal asked him how long it would take to build a subprime company from the ground up. Three or four years, replied Blum. O’Neal gave Blum a steely look. “I’m fifty-four fucking years old,” he replied, “and I don’t have three or four years.”
Blum was also astounded by the price Merrill was willing to pay. (After the deal was announced, David Daberko, National City’s CEO, told Dow Jones News Service that the deal “is exactly what we were hoping for.”) But Merrill was so eager to get in the game that it would likely have paid even more; Blum could take comfort only in the fact that it wasn’t New Century. First Franklin was supposed to be one of the better-run subprime companies.
Almost immediately after the deal was completed, First Franklin began taking losses. Like all the subprime originators, it had kept the residuals and posted gains that reflected an optimistic estimate of their value. Now, as delinquencies rose, those gains were being reversed. In a meeting in January 2007, as Blum was going through the losses in the residuals book, Dow Kim suddenly looked up from his BlackBerry with some news. “Lehman Brothers just had a record quarter in mortgages,” he said, according to someone at the meeting. “I guess they’re just smarter than we are,” Blum replied.
And so it went. In a February meeting, Blum and his team argued that delinquencies were likely to get worse. He wanted Merrill to start hedging its exposure. Dale Lattanzio, whom Semerci had installed to run the CDO business after Ricciardi, brought out a series of charts, using the 1998 Long-Term Capital Management failure as his worst-case scenario. If something like that were to happen, he said, Merrill could lose as much as $70 million. Anything short of that scenario, the firm would be fine.
After the meeting, a risk manager told Kim that “there’s no way” Lattanzio’s estimate was right. Kim asked the risk manager to poke around and come up with a better estimate, according to a former Merrill executive. But the risk manager couldn’t get any information out of Lattanzio and Semerci, and had to drop the effort.
Blum couldn’t understand how the people running the CDO business could be so sanguine. They were using the same raw material