Too Big to Fail [83]
But Jeffrey Kronthal, a Merrill executive who had helped recruit Ricciardi to Merrill, had been growing increasingly concerned that a storm was threatening not just extravagant projects like Costa Bella, but the entire CDO market, and he began to urge caution. He insisted the firm maintain a $3 billion ceiling on CDOs with subprime tranches. Kronthal’s wariness put him directly in the path of O’Neal’s ambition to be the mortgage leader on Wall Street—a situation that was clearly untenable. In July 2006, Kronthal, one of its most able managers of risk, was out, replaced by thirty-nine-year-old executive Osman Semerci, who worked in Merrill’s London office. Semerci was a derivatives salesman, not a trader, and had had no experience in the American mortgage market.
Despite its ongoing management turmoil, Merrill Lynch kept ratcheting up the volume of its mortgage securitization and CDO business. By the end of 2006, however, the market for subprime mortgages was perceptibly unraveling—prices were falling, and delinquencies were rising. Even after it should have recognized an obvious danger signal when it was no longer able to hedge its bets with insurance from AIG, Merrill churned out nearly $44 billion worth of CDOs that year, three times the total of the previous year.
If they were worried, however, Merrill’s top executives didn’t show it, for they had powerful incentive to stay the course. Huge bonuses were triggered by the $700 million in fees generated by creating and trading the CDOs, despite the fact that not all of them were sold. (Accounting rules allowed banks to treat a securitization as a sale under certain conditions.) In 2006, Kim took home $37 million; Semerci, more than $20 million; O’Neal, $46 million.
In 2007, Merrill kept its foot firmly on the gas pedal, underwriting more than $30 billion worth of CDOs in the first seven months of the year alone. With his bets paying off so incredibly well, though, O’Neal had overlooked one critical factor—he hadn’t made any preparations for an inevitable downturn, having never paid much attention to risk management until it was too late. Merrill did have a department for market risk and another for credit risk, though neither reported directly to O’Neal; they were the responsibility of Jeffrey N. Edwards, the chief financial officer, and of Ahmass Fakahany, the chief administrative officer, a former Exxon executive and an O’Neal favorite.
Before long, however, the fault lines started to show. Kim, who oversaw the mortgage division, announced in May that he was leaving the firm to start a hedge fund. Responding to doubts voiced by some of their colleagues that the firm’s strategy could be sustained, Semerci and Dale Lattanzio became defensive. On July 21, at a meeting of the board, they insisted that the firm’s CDO exposure was nearly fully hedged; in a worst-case scenario, they maintained, the firm’s loss would amount to only $77 million. O’Neal stood up and praised the work of the two executives.
But not everyone agreed with that optimistic assessment. “Who the fuck are they kidding? Are you fucking kidding me with this?” Peter Kelly, Merrill’s outspoken lawyer, asked Edwards after the meeting. “How is the board walking away without shitting their pants?”
As market conditions worsened, it became clear that the metrics they were using had no grounding in reality. Two weeks after the July board meeting, Fleming and Fakahany sent a letter to Merrill’s directors, briefing them on the firm’s deteriorating positions.
O’Neal, meanwhile, became withdrawn and brooding, and began to lose himself in golf, playing thirteen rounds, often on weekdays and almost always alone, at storied clubs like Shinnecock Hills in Southampton.
Merrill’s CDO portfolio continued to plummet through August and September. In early October, the firm projected a quarterly loss of roughly $5 billion. Two weeks later, that figure had ballooned to $7.9 billion. Desperate, O’Neal sent an overture to Wachovia about a merger. On Sunday, October 21, he had dinner with Merrill