All the Devils Are Here [5]
A few months earlier, two Bear Stearns hedge funds—funds that contained the exact same kind of subprime securities as the ones on Merrill’s books—had collapsed. Inside Merrill, there was a growing nervousness, but the leaders of the mortgage desk kept insisting that its losses would be contained—they were going to be less than $100 million, they said. The top brass, including O’Neal, accepted their judgment. Breit knew better. The losses were going to be huge—there was no getting around it. He began to tell everybody he bumped into at Merrill Lynch that the company was going to have to write down billions upon billions of dollars in its subprime-backed securities. When the head of the fixed-income desk found out what Breit was saying, he called Breit and screamed at him.
Stan O’Neal had also heard that Breit had a higher estimate for Merrill Lynch’s potential losses. That is why he summoned Breit to his office.
“I hear you have a model,” O’Neal said.
“Not a model,” Breit replied. “Just a back-of-the-envelope calculation.” The third quarter would end in a few weeks, and Merrill would have to report the write-downs in its earnings release. How bad did he think it would be? O’Neal asked. “Six billion,” said Breit. But he added, “It could be a lot worse.” Breit had focused only on a small portion of Merrill’s exposure, he explained; he hadn’t been able to examine the entire portfolio.
Breit would never forget how O’Neal looked at that moment. He looked like he had just been kicked in the stomach and was about to throw up. Over and over again, he kept asking Breit how it could have happened. Hadn’t Merrill Lynch bought credit default swaps to protect itself against defaults? Why hadn’t the risk been reflected in the risk models? Why hadn’t the risk managers caught the problem and stopped the trades? Why hadn’t Breit done anything to stop it? Listening to him, Breit realized that O’Neal seemed to have no idea that Merrill’s risk management function had been sidelined.
The meeting finally came to an end; Breit shook O’Neal’s hand and wished him luck. “I hope we talk again,” he said.
“I don’t know,” replied O’Neal. “I’m not sure how much longer I’ll be around.”
O’Neal went back to his desk to contemplate the disaster he now knew was unavoidable—not just for Merrill Lynch but for all of Wall Street. John Breit walked back to his office with the strange realization that he—a midlevel employee utterly out of the loop—had just informed one of the most powerful men on Wall Street that the party was over.
1
The Three Amigos
The seeds of financial disaster were sown more than thirty years ago when three smart, ambitious men, working sometimes in concert—allies in a cause they all believed in—and sometimes in opposition—competitors trying to gain advantage over each other—created a shiny new financial vehicle called the mortgage-backed security. In the simplest of terms, it allowed Wall Street to scoop up loans made to people who were buying homes, bundle them together by the thousands, and then resell the bundle, in bits and pieces, to investors. Lewis Ranieri, the messianic bond trader who ran the Salomon Brothers mortgage desk and whose role in the creation of this new product would be immortalized in the best-selling book Liar’s Poker, was one. Larry Fink, his archrival at First Boston, who would later go on to found BlackRock, one of the world’s largest asset management firms, and who served as a key adviser to the government during the financial crisis,