All the Devils Are Here [195]
By mid-September, Semerci and Lattanzio were conceded $1.3 billion in triple-A losses. Seeing the problems grow, Greg Fleming reached out to his old friend Jeff Kronthal. O’Neal had named Fleming co-president of Merrill Lynch—along with Fakahany—shortly after Dow Kim left. Although he was still under strict orders to stay away from fixed income, the problems on the mortgage desk seemed too deep to just look the other way. Kronthal explained to Fleming how CDOs work and began tapping into his own sources at Merrill Lynch to see if he could find out what was going on. One of those sources was Breit. Breit told Kronthal that he thought the write-downs were going to be much bigger than anyone on the mortgage desk was admitting, which by then was around $3 billion. Kronthal conveyed this to Fleming, who conveyed it to O’Neal. O’Neal asked to see Breit.
The two men had known each other for more than a dozen years; they had even worked together on occasion. O’Neal knew that Breit understood risk as well as anyone at Merrill. “I hear you have a model of the CDOs that disagrees with the valuations being put out there by Semerci,” O’Neal began. No, Breit replied, he didn’t have a model; just a back-of-the-envelope calculation. Then he gave O’Neal his number: $6 billion in losses. And he added, “It could be a lot worse. I haven’t even looked at the high-grade CDOs, just the CDOs squared and the mezzanines.”
O’Neal looked like he was going to throw up. “What about all the protection we bought?” he asked. Breit explained that with AIG no longer in the business, Merrill had been buying protection from the monolines, which had taken on so much risk they would be insolvent long before they could pay off Merrill. O’Neal kept probing. What about the risk models? he asked. Worthless, replied Breit matter-of-factly. The risk wasn’t captured by VaR, and the VaR analysis of the underlying credit quality was wrong. Other risk models didn’t do any better. As O’Neal listened in silence, Breit explained how an important Merrill risk measure had been changed in such a way as to disguise the increasing amount of triple-A risk on the firm’s books. Breit today says he does not believe this was purposely changed to hide the ball—he thinks it might have even been a regulatory change—but it had that effect. “It distorted the true nature of the risk,” he told O’Neal. After talking for a few more minutes, Breit shook O’Neal’s hand and wished him luck. “I hope we talk again,” he said.
That’s when O’Neal told him he wasn’t sure how much longer he would be Merrill’s CEO.
For Breit, it was a sobering conversation; he could see how shattered O’Neal was at the news. For O’Neal, it was an infuriating conversation. How could Breit convey this information so calmly? Wasn’t he supposed to be managing risk? Didn’t he bear at least some responsibility for what the mortgage desk had done? O’Neal still had no idea that Breit had been pushed aside. He thought Breit was still a risk manager on the front lines of the mortgage desk. The fact that he himself had put in place the dynamic that allowed good risk managers like Breit to be cast aside eluded him entirely.
And yet, having belatedly woken up to the magnitude of the problem, O’Neal absolutely understood what had to be done. Very simply, the firm needed to be sold—as quickly as possible. One thing he understood clearly is that when you face a black hole of write-downs, there is no way to know how deep the hole really is. The knee-jerk solution would be to raise capital—which, in fact, firms all over Wall Street were scrambling to do.