All the Devils Are Here [190]
“Bill, who ever thought CDOs would be WMD?” Advani wrote back. “Though have to say—every day more bad news—would be much too bad for the world to end—but that’s sure how it feels.”
20
The Dumb Guys
The collapse of the Bear Stearns hedge funds in June 2007 should have been a terrifying moment for Stan O’Neal. Merrill Lynch had been the first to make a grab for Bear’s triple-A subprime collateral, which began the run on the bank that brought down the two funds. Yet it had been unable to sell that collateral because nobody wanted it. Nobody could say anymore what it was worth.
Dale Lattanzio, who ran Merrill’s CDO business, and his boss, Osman Semerci, responded in exactly the way you would expect of two people whose multimillion-dollar bonuses were completely dependent on their ability to continue manufacturing CDOs. They told their superiors that the market was in the middle of a little rough patch, but there was nothing to worry about. Despite their obvious vested interest, O’Neal appeared to accept their analysis. According to The New Yorker magazine, the two men told O’Neal that “the CDO market would eventually stabilize, allowing Merrill to sell its holdings.” The magazine added, “O’Neal seemed reassured.” He did, however, ask them to try to hedge the position, which they insisted they were already doing. Indeed, in late 2006—around the same time Goldman Sachs concluded that it needed to get closer to home—Dow Kim was telling Semerci and Lattanzio the same thing. At a board meeting in July, the two men claimed the risk on the firm’s books amounted to no more than $83 million—a claim that other Merrill executives viewed as implausible. Yet O’Neal didn’t question them. When others tried to warn O’Neal that Semerci’s loss estimates were too low, they were met with a steely glare, according to several former Merrill executives.
Shortly after that board meeting, Merrill announced its second-quarter earnings. On the surface, the numbers were terrific: $2.1 billion in profits on $9.7 billon in revenues; the profit number was 31 percent higher than Merrill’s second-quarter profits in 2006. In the accompanying press release, Merrill specifically pointed to the success of its “credit products.” During the conference call with investors, CFO Jeff Edwards put it even more explicitly: the growth in fixed income was due in large part to “a substantial increase from structured finance and investment, which primarily reflects a better performance from our U.S. subprime mortgage activities.” Acknowledging that the market for CDOs “has yet to fully stabilize” after the collapse of the Bear Stearns hedge funds, Edwards added that “[r]isk management, hedging, and cost controls in this business are especially critical during such periods of difficulty, and ours have proven to be effective in mitigating the impact of our results.” Within three months, every one of these claims would prove to be delusional.
It seems inconceivable now that O’Neal himself had so little understanding of what lay ahead. He was a very smart man, a tough, seasoned Wall Street executive. One of the formative experiences of his career had been the Long-Term Capital Management disaster. He had been Merrill’s CFO during that crisis, and it remained seared in his memory. He knew how a series of events could spiral into catastrophe. He remembered that awful feeling of realizing that Merrill couldn’t put a value on the collateral it held. He saw how, in a crisis, “everything is correlated”—meaning that securities that were supposed to act as hedges suddenly started falling in tandem, exacerbating the losses. Panics have their own momentum, their own rhythms. It didn’t matter how much cash you said