All the Devils Are Here [193]
Magnetar bought the equity portion, of course. At the same time, it shorted the triple-A tranches of Norma, just as John Paulson had done in his Abacus deal. Merrill Lynch prepared a seventy-eight-page pitch book to help convince investors to buy pieces of the CDO. The Journal would later note that the pitch book stressed that mortgage-backed securities “have historically exhibited lower default rates, higher recovery upon default and better rating stability than comparably rated corporate bonds.” Merrill’s fee was in the neighborhood of $20 million.
Ultimately, Merrill was able to sell $525 million worth of tranches, most of them lower-rated ones, which Merrill Lynch was promising at 5.5 percent interest above Libor, a very high yield. (Libor is the interest rate that banks charge when they lend to each other.) This was so even though, according to a lawsuit later filed against Merrill for its role in underwriting Norma, the securities had declined by 20 percent even before the deal closed. By December 2007—just nine months after Norma had been created—most of the deal had been downgraded to junk by the rating agencies.
“It was a tangled hairball of risk,” Janet Tavakoli, the CDO critic, told the Journal. “In March of 2007, any savvy investors would have thrown this... in the trash bin.”
But wait. If it was a $1.5 billion CDO, and Merrill could sell only $525 million of it, what happened to the other $975 million of Norma—all of which was triple-A? That’s what went onto Merrill’s books; it took the long position on the triple-As. This was the exposure that Semerci was claiming was nearly riskless.
A lawsuit would later claim that Merrill was actively seeking to move its worst securities off its books and into the hands of unsuspecting clients. Without question, Merrill Lynch was doing that, especially with the triple-Bs. In one of the seamier examples of Merrill’s efforts to unload some of the junk on its balance sheet, it actually securitized subprime loans from Ownit—Bill Dallas’s subprime originator, which it partially owned—after Ownit filed for bankruptcy. Then again, every other big CDO underwriter on Wall Street—Citibank, UBS, Morgan Stanley, you name it—was doing the exact same thing. “People on the outside thought the market was going gangbusters because of all the deals getting done,” CDO expert Gene Phillips told Bloomberg. “People on the inside knew it was a last-gasp effort to clear out the warehouses.”
In the aftermath of the crisis, Goldman Sachs would be the firm that was by far the most criticized for selling its clients down the river in its efforts to get risk off its own books. In truth, Goldman was just better at it than Merrill and the others. It was tougher and smarter in the way it went about it. And there was an even bigger difference between the way Merrill and Goldman went about attempting to reduce risk. Goldman as an institution never believed that the tiny bit of extra return offered by triple-A subprime-backed securities was worth the risk. As it began marking down its securities—and pushing them off its books—it treated triple-As just as ruthlessly as it treated all the other subprime securities it was marking.
On May 16, 2007, Dow Kim announced that he was leaving Merrill Lynch to start a hedge fund; finally O’Neal said he could go.18 During the previous