All the Devils Are Here [191]
O’Neal had worked fifteen hours a day for months during the LTCM crisis. He had gone home, night after night, worried about whether the firm would have enough liquidity to fund itself the next day. And, he liked to say, he never forgot those lessons. Yet now it appeared as if he had forgotten those lessons.
O’Neal had discovered another fact as a result of the Bear fiasco that should have shaken him to his core. He had learned the size of Merrill Lynch’s subprime exposure. It was enormous. When Kronthal had left in July 2006, the firm had somewhere between $5 billion and $8 billion in subprime risk on its books. Most of it was either subprime mortgages waiting to be securitized, tranches of mortgage-backed securities waiting to be put into CDOs, or triple-B CDO tranches waiting to be repackaged into new CDOs as triple-As. This was hardly an insignificant exposure; if those subprime securities had to be written down in large numbers, Merrill was going to feel a good deal of pain. People would undoubtedly get fired. But it was not an amount that could bring the firm down.
A year later, Merrill Lynch held an astonishing $55 billion in subprime exposure on its balance sheet. In the space of one year, Semerci and Lattanzio had added somewhere between $45 billion and $50 billion in additional exposure. Some of it was the same kind of collateral that had been on the books when Kronthal had been running the show: mortgage-backed securities of one sort or another waiting to be resecuritized. But the vast majority of it was triple-A tranches of subprime CDOs.
Anyone who looked closely at this triple-A exposure would realize in an instant what Lattanzio and Semerci had done. With AIG no longer around to write protection—leading to a lack of buyers for the super-senior tranches—the only way Merrill could continue churning out new CDOs was to keep the triple-A risk itself. So that’s what Semerci and Lattanzio had done. In the case of CDOs with subprime mortgage-backed securities, Merrill simply bought the triple-A tranches and put them on its books. In the case of synthetic CDOs—a business Merrill was also deep into—the firm would find a hedge fund to take the short position and take the long position itself. In most cases, Merrill bought protection from a monoline insurer like MBIA (which, under the rules, also enabled the firm to book the income on the triple-A tranches up front), but in the event of disaster, that wasn’t likely to help much. The monolines had insured so much triple-A risk that any market event that hurt Merrill Lynch would destroy them.
The result of Semerci and Lattanzio’s strategy was that Merrill Lynch would remain the number one underwriter of CDOs and the two men would get their big bonuses. But in the process, they had put Merrill Lynch itself at grave risk.
Did the two men understand that? At a certain point, late in the game, Semerci in particular seems to have understood the gravity of the situation. According to several former top Merrill executives, he appears to have managed his risk assumptions in such a way as to keep the estimated losses that he presented to management and the board artificially low. They also believed his marks were too high. These same executives are convinced, for instance, that Semerci knew full well when he made that board presentation in July 2007 that Merrill losses were going to be far higher than $83 million.
But until it was far too late, it appears that Semerci and Lattanzio did not fully understand the import of their strategy. Why? Because just like Ralph Cioffi and Mike Tannin at Bear Stearns, Semerci and Lattanzio still believed that a triple-A rating meant something. As the market had gotten shaky, they had begun shorting the ABX triple-Bs, but it never occurred to them that they were on the wrong side of the triple-A bets. Their belief in the value of the triple-A was why Semerci could tell Kim, with a straight face, that Merrill had very little