All the Devils Are Here [4]
REMIC: Real Estate Mortgage Investment Conduit. The second of two laws passed in the 1980s to aid the new mortgage-backed securities market by enabling such securities to be created without the risk of dire tax consequences.
RMBS: Residential mortgage-backed securities. Securities backed by residential mortgages, rather than commercial mortgages.
RTC: Resolution Trust Corporation. Government agency created to clean up the S&L crisis.
SEC: Securities and Exchange Commission. Regulates securities firms, mutual funds, and other entities that trade stocks on behalf of investors.
SMMEA: Secondary Mortgage Market Enhancement Act. The first of two laws passed in the 1980s to aid the new mortgage-backed securities market
SIV: Structured investment vehicle. Thinly capitalized entities set up by banks and others to invest in securities. By the height of the boom, many ended up owning billions in CDOs and other mortgage-backed securities.
VaR: Value at Risk. Key measure of risk developed by J.P. Morgan in the early 1990s.
Prologue
Stan O’Neal wanted to see him. How strange. It was September 2007. The two men hadn’t talked in years, certainly not since O’Neal had become CEO of Merrill Lynch in 2002. Back then, John Breit had been one of the company’s most powerful risk managers. A former physicist, Breit had been the head of market risk. He reported directly to Merrill’s chief financial officer and had access to the board of directors. He specialized in evaluating complex derivatives trades. Everybody knew that John Breit was one of the best risk managers on Wall Street.
But slowly, over the years, Breit had been stripped of his authority—and, more important, his ability to manage Merrill Lynch’s risk. First O’Neal had tapped one of his closest allies to head up risk management, but the man didn’t seem to know anything about risk. Then many of the risk managers were removed from the trading floor. Within the span of one year, Breit had lost his access to the directors and was told to report to a newly promoted risk chief, who, alone, would deal with O’Neal’s ally. Breit quit in protest, but returned a few months later when Merrill’s head of trading pleaded with him to come back to manage risk for some of the trading desks.
In July 2006, however, a core group of Merrill traders had been abruptly fired. Most of the replacements refused to speak to Breit, or provide him the information he needed to do his job. They got abusive when he asked about risky trades. Eventually, he was exiled to a small office on a different floor, far away from the trading desks.
Did Stan O’Neal know any of this history? Breit had no way of knowing. What he did know, however, was that Merrill Lynch was in an awful lot of trouble—and that the company was still in denial about it. He had begun to hear rumblings that something wasn’t right on the mortgage desk, especially its trading of complex securities backed by subprime mortgages—that is, mortgages made to people wuth substandard credit. For years, Wall Street had been churning out these securities. Many of them had triple-A ratings, meaning they were considered almost as safe as Treasury bonds. No firm had done more of these deals than Merrill Lynch.
Calling in a favor from a friend in the finance department, Breit got ahold of a spreadsheet that listed the underlying collateral for one security on Merrill’s books, something called a synthetic collateralized debt obligation squared, or sythentic CDO squared. As soon as he looked at it, Breit realized that the collateral—bits and pieces of mortgage loans that had been made by subprime companies—was awful. Many of the mortgages either had already defaulted or would soon default, which meant the security itself was going to tumble in value. The triple-A rating was in jeopardy. Merrill was likely to lose tens of millions of dollars on just this one synthetic CDO squared.
Breit started calling in more favors. How much of this stuff did Merrill Lynch have on its books? How bad was