Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [52]
By the spring of 2008, it was painfully clear that mortgage loan losses would be much higher than the Fed’s earlier highest projections, and my numbers were closer to reality. The overall size of the U.S. residential mortgage loan market is around $11.5 trillion, of which a little more than 11 percent is subprime and more than 10.4 percent is Alt-A (with credit scores in between subprime and the higher prime borrowers). John Paulson of Paulson & Co. compiled data from LoanPerformance and the Mortgage Bankers Association in a public presentation showing that between March 2007 and March 2008, subprime delinquencies had soared to 27.2 percent in the $1.3 trillion subprime market, an increase of around 163 percent, and in the $1.2 trillion Alt-A market, delinquencies soared to 9.1 percent, a year over year change of around 380 percent. Prime mortgage delinquencies were up to 3.2 percent, a 2.1 percent increase from fourth quarter of 2006 to 2007.
Given the gravity of the loan problems, investment banks should have been reporting large losses much earlier. For example, on October 8, 2007, I told clients that Merrill’s mal de MER was just beginning. At the time a friend asked me where Merrill stock would be in six months. I responded: “In someone else’s portfolio.” Not mine and not Warren Buffett’s. Jeff Edwards, Merrill’s CFO had made rosy statements in July 2007. Astute shareholders, not to mention the SEC and Merrill’s board, might have wondered why the massive losses reported in third quarter had not shown up much earlier. Stan O’Neal, the CEO, appeared to have a big problem.
On October 10, 2007, I reminded David Wighton of the Financial Times that Merrill was one of the lenders to the mortgage-backed securities hedge funds managed by Bear Stearns Asset Management that collapsed in August 2007. Creditors had challenged BSAM’s mark-to-market valuations in April, and that is what got the ball rolling for the downfall of the funds: “Merrill was not so finicky when it came to marking its own books.”33
Merrill began reporting massive losses, but in my view, they were quarters late. I was amazed O’Neal was still in his CEO chair. On October 24, CNBC’s Joe Kernen, with GE’s former CEO, Jack Welch, covered Merrill’s earnings report. I appeared on a segment with Charlie Gasparino, CNBC’s online editor.
I led off: “Way back in first quarter” I had called this and said Merrill’s risk managers should “get out and short. Short Merrill’s positions.”34
Gasparino asserted: “When we were reporting this about three weeks ago, ahead of everybody . . . we reported there was going to be a larger third quarter loss.”
I countered that O’Neal has a big problem: “They were not hedging properly in first quarter.” I added: “I laughed in disbelief” when I saw second quarter earnings. “It is an Enronesque kind of problem, it is a business management problem, not a risk management problem.”
Gasparino said he wouldn’t go that far and focused on the CFO (Jeff Edwards) and the potential ouster of a risk manager instead of picking up on my assertion about O’Neal. He said the problem with getting rid of Ahmass Fakahany: “Fakahany (the risk manager) and Stan O’Neal are very close.”
“I don’t think O’Neal survives this,” I responded.There is no problem getting rid of O’Neal’s friends if he is gone, and O’Neal will have to answer to shareholders and the board about failure to report losses in second quarter. Within a few days, O’Nal resigned. I added that the rest of Wall Street had underestimated how horrific the losses due to low recovery rates would be in subprime.35
After the collapse of the stock market technology bubble and the outing of Enron’s and Worldcom’s problems, Stan O’Neal wrote an opinion piece for the Wall Street Journal saying,“In any system predicated on risk-taking, there are failures, sometimes