By July 2001, O’Neal had been named president of Merrill Lynch. Komansky had planned to stay on as CEO for a few more years, until he turned sixty-five, but two events forced him out earlier. The first was 9/11. Several Merrill employees died in the attack, and the firm’s headquarters were badly damaged. During and after the attacks, O’Neal took charge while Komansky seemed paralyzed. “O’Neal filled the vacuum,” recalls one former executive. Concluding that Wall Street was unlikely to recover quickly after 9/11, O’Neal instituted big layoffs. Komansky cautioned him against such a move, fearing a public backlash so soon after the terrorist attacks, but O’Neal had no patience for such thinking.
Secondly, though, O’Neal simply wasn’t willing to wait a few more years to become CEO. He was ready now. Before being named president, he’d had rivals for the top job. He outmaneuvered them, and then, as president, pushed them aside. Once he became president, he cultivated key allies in the firm who had ties to board members; they began agitating for O’Neal to take over, arguing that the firm couldn’t wait to make the changes O’Neal had in mind. By the end of 2002, Komansky had turned over the reins to O’Neal. Though he had hoped to stay on as board chairman, Komansky soon acceded to O’Neal’s demand that he give up that role as well.
Thanks to all the jockeying around O’Neal’s ascension, the Merrill Lynch executive suite had become a very political place. His appointment as CEO didn’t end the palace intrigue. Strangely, though, the next round of intrigue came not from his many enemies in the firm, but from two of his closest allies. One was Arshad Zakaria, the head of global markets and investment banking. The other, Tom Patrick, who had been Merrill’s chief financial officer under Komansky, was effectively O’Neal’s number two, though he lacked the title of president. O’Neal had told the board he didn’t feel any need to fill the position.
Within a matter of months, Patrick began going behind O’Neal’s back to the board, pushing board members to insist that O’Neal name a president and promoting Zakaria for the job. (The reason behind Patrick’s ploy has always been a mystery, even to people at Merrill.) Although Zakaria did not openly join Patrick’s effort, he knew about the lobbying, and was lurking in the shadows. At least one board member was ready to do Patrick’s bidding.
But then, in July 2003, somebody whispered in O’Neal’s ear and told him what was going on. O’Neal responded fiercely. He went to the board, laid out what Patrick and Zakaria were doing, and demanded that the board back him—which it did. He then had Patrick escorted from the building. By early August, Zakaria was gone as well.
Almost every executive associated with Merrill Lynch at the time would later point to these firings as a critical event in the O’Neal era—and not for the better. O’Neal had always been insular; he was the kind of man who liked to play golf by himself. Now he became isolated. He had been wary; now he became suspicious of everyone around him. Patrick and Zakaria were extremely competent executives; he replaced them with more pliable lieutenants. He trusted no one but himself.
Although O’Neal didn’t realize it, this was not the way to compete with Goldman. Goldman’s executive committee members all participated in discussions about all the various businesses. O’Neal, by contrast, insisted that the company’s executives speak only to him about their businesses and not discuss the businesses with one another. The Goldman brass insisted on knowing bad news; Merrill executives trembled at the thought of giving O’Neal bad news. Whenever Goldman’s CEO had to make an important decision, he consulted with a handful of advisers to solicit their advice. O’Neal rarely asked for input when he was preparing to make a decision, and under no circumstances did he want to be challenged once he had made up his mind.
A few years after the ouster of Patrick and Zakaria, Greg Fleming, one of the few O’Neal lieutenants who had the temerity to disagree with him, was having dinner with him, pressing him on a handful of issues. As the dinner was concluding, O’Neal said, “This is getting too painful.”
“Stan, I don’t understand what you mean by ‘too painful.’ I’m just disagreeing with you,” replied Fleming.
“I don’t think we can have dinner anymore,” said O’Neal. They never did.
The Merrill culture, pre-O’Neal, had always been fearful of risk. There was a good reason for this: when the firm got too aggressive, it often got burned. Merrill, after all, was the firm that persuaded Orange County to trade derivatives in the early 1990s, resulting in the county’s 1994 bankruptcy—and a huge black eye (and a $30 million fine) for Merrill. In 1987, during the early days of mortgage-backed securities, a Merrill Lynch mortgage trader named Howard Rubin lost $250 million on one trade. That loss was big enough that Merrill stayed away from taking significant risks in the mortgage business for years. A decade later, during the Long-Term Capital Management crisis, Merrill struggled to maintain its liquidity, fearing at one point that its biggest retail money market fund might “break the buck,” a potential disaster. (O’Neal had been Merrill’s chief financial officer during the LTCM crisis.)
“Anytime a trader lost $50 million,” recalls a former Merrill trader, “it was like the Spanish Inquisition.” You couldn’t take big risks without accepting the possibility of big losses, and that was something that Merrill just couldn’t stomach. Taking a lot of risk just wasn’t part of its culture.
O’Neal pushed hard to change that, according to former Merrill executives. He was constantly asking the various desks why they weren’t taking on more risks. Sometimes when he saw the firm’s VaR number, he would actually get angry—it wasn’t high enough, which to him meant that Merrill wasn’t taking the kinds of risks it should be taking. He backed his department heads when they wanted to hire aggressive young turks while getting rid of those who didn’t have the risk appetite he was looking for. And he constantly compared Merrill’s performance to Goldman’s. “You didn’t want to be in Stan’s office on the day Goldman reported earnings,” recalls one of his former lieutenants.
Everybody on Wall Street had a big mortgage desk, Merrill Lynch included. By the time O’Neal became CEO, they were all beginning to focus on underwriting collateralized debt obligations that included at least some percentage of subprime mortgages. With this new CDO market up for grabs, Merrill decided to go all in. Within just a few years, Merrill was the dominant underwriter of CDOs, taking the business from nine CDO deals worth $2.2 billion in 2002 to thirty-eight deals worth nearly $19 billion in 2004. It went from fifteenth in the ranking to first. Between 2002 and 2007, Merrill Lynch underwrote one hundred CDOs, twenty-seven more than runner-up Citigroup. Merrill’s management viewed its number one ranking as proof positive it could play with the big boys, and that ranking became something to be preserved at all costs.
The man who had the ultimate authority over the mortgage desk for Merrill Lynch in those days was a veteran trader named Jeff Kronthal. He had spent his career around mortgage-backed securities; while still in his twenties, he had run the mortgage desk for Lew Ranieri at Salomon Brothers. Kronthal had joined Merrill in the late 1980s, just a few years after O’Neal, overseeing its trading desks until the mid-1990s, when he took over its derivatives business. Although he spent much of the 1990s pushing a reluctant Merrill to take more trading risk—he thought its tepid risk limits constrained its ability to make sizable profits—he also had a healthy fear of mortgage-backed securities. He had watched them get increasingly risky over the years. His essential view was that Merrill’s role should be to create structures that allowed investors to gain the exposure to risk they wanted to take. But Merrill itself should never assume those risks. “They are things you want to sell, not hold,” he used to tell the traders who worked for him.
In O’Neal’s push to have the firm take on more risk, Kronthal found himself in a tricky position. He had had a few run-ins with O’Neal over the years, but Patrick and Zakaria, both good friends of his, had persuaded him to stay. Once they were gone, Kronthal didn’t have any protectors in the executive suite.
From below, meanwhile, Kronthal was trying to keep the CDO team under control. That was no small task, either. The team was headed by Chris Ricciardi, an aggressive thirty-four-year-old trader. A decade before, while at Prudential Securities, Ricciardi had been part of a group that had first come up with the idea of bundling mortgages into a CDO. After successful stints at Prudential and then at Credit Suisse, Ricciardi and most of his team joined Merrill Lynch in July 2003, where he quickly ramped up the firm’s CDO business. Kronthal and his crew of veteran traders viewed Ricciardi warily. “He was dangerous,” says one former Merrill trader. “He didn’t care about rules. If one of his managers didn’t give him the answer he wanted, he sought out another manager. All he cared about was himself and his team. He was always threatening to leave and take his team with him.” Kronthal’s belief was: let him go. But Dow Kim thought Merrill needed ten more salesmen just like him. He was exactly the kind of aggressive risk taker that O’Neal wanted at Merrill.
According to someone who did business with him, Ricciardi was surprisingly mild mannered for someone with such an outsized reputation. “He didn’t have a lot of flash,” this person says. But he was a natural leader, the kind of person who, as a college student, had put together groups that made money painting houses. And, this same person says, “he was very smart and he could articulate a case.” One investor recalls looking at an early Ricciardi deal that included credit card receivables as well as mortgage-backed securities. It had a very limited default history. The investor asked what would happen to the security if the credit card defaults started to rise. Ricciardi had no good answer, and the investor walked away from the deal. But Ricciardi still managed to maneuver the rating agencies into giving most of the deal a triple-A rating.
Ricciardi knew exactly what he’d been hired to do. “The strategy has been to be a high-volume underwriter, with a focus on areas that are very popular,” he told a trade publication in early 2005. What was popular, of course, was subprime mortgages. To ensure that it had a steady source of subprime mortgages to securitize and then bundle into CDOs, Merrill took a 20 percent stake in Ownit, a mortgage originator founded by Bill Dallas. A Merrill executive joined the Ownit board. By 2006, says Dallas, Merrill was pushing him to make loans that would generate more yield for Merrill’s CDOs.
“They never told us to make bad loans,” Dallas says now. “They would say, ‘You need to increase your coupon’”—meaning make loans with higher yields. “The only way to do that was to make crappier loans.” Between the fourth quarter of 2005 and the first quarter of 2006, Ownit went from being a company whose loans were virtually all fully documented to becoming a company that was, in his words, “no-doc-centric. We became more of a subprime lender.”
In short order, Merrill would then create mortgage-backed securities out of the mortgages it bought, warehouse the new securities until they could be bundled into a CDO, and negotiate hard with the rating agencies—and tinker with the CDO’s structure—to get most of the security labeled triple-A. (E-mails would later reveal at least one instance in which Merrill specifically linked its fee to a high rating.)
Ricciardi and his team picked the firms that would manage the assets in the CDOs once they’d been created, and the investors who bought the tranches. They had big, sophisticated investors all over the globe lined up to buy Merrill’s CDO tranches. But Ricciardi was also not above pitching smaller-fry. According to the Wall Street Journal, “Merrill distributed some of its riskiest CDO slices through its global network of wealthy private clients.” In 2004, at New York’s Harvard Club, the Journal added, “salesmen described the merits of CDO investing to doctors, hedge-fund managers and businessmen.” Merrill’s risk managers, meanwhile, would hold regular meetings to try to figure out who Ricciardi was selling his CDOs to and whether the buyer was truly an appropriate investor.
Finally, Ricciardi was in the vanguard of the practice of rebundling the triple-B mezzanine portion of the CDO into new CDOs. Thus would triple-Bs be turned into triple-A tranches, which were much easier to sell. “Ricciardi could find someone to buy any piece of shit,” says a former Merrill executive.
Kronthal didn’t have any moral objection to the CDO business. Nobody on Wall Street did. But as an old hand at the business, he was keen to make sure that Merrill itself wasn’t warehousing too many CDO tranches. For instance, he imposed a $1 billion limit on triple-A tranches that could be held as an investment on Merrill’s own books. Largely because of Kronthal’s caution, by the spring of 2006, Merrill had around $5 billion or $6 billion in its total exposure to CDOs with mortgage-backed tranches. Most of the exposure consisted of securities Merrill was warehousing until they could be bundled into new CDOs. It was hardly a small number, but it was a manageable one. It didn’t put the firm at risk.
In early 2006, Ricciardi suddenly left Merrill. He jumped to Cohen & Co., a firm that managed many of the CDOs that Ricciardi had sold at Merrill. He became the firm’s president. For Dow Kim, his departure was a blow. Kim quickly assured the rest of the CDO staff that the firm would do “whatever it takes” to stay number one. He said the same to Stan O’Neal.
A few months later, in April, Merrill’s directors and top executives went to Pebble Beach for an off-site. During one of the working sessions, the discussion centered on Merrill’s fixed-income department. “The world has changed,” O’Neal told the assembled executives, according to several people who were there. Fixed income and credit, he added, were no longer cyclical in nature. There was going to be an ongoing demand for fixed-income products. “We need to continue our ability to take risk and manufacture products,” he said.
By then, Kronthal was beginning to fear the mortgage market was becoming overheated. His bosses, starting with O’Neal, felt otherwise. They wanted more people like Ricciardi, not fewer. They wanted to buy a mortgage originator, just like Lehman and some of the other firms had. They wanted to raid other firms to bring in aggressive young talent. Kronthal thought the hour was getting late, and Merrill would be better served pulling back.
At the off-site, Kronthal and his team gave a series of presentations outlining the risks—and the possibilities—in Merrill’s various fixed-income desks. In 2005, Kronthal had been Merrill’s highest-paid nonexecutive employee, with a bonus of more than $20 million. That sum was a testament to the profits his desks were making at Merrill. To the board that day, Kronthal and his team were portrayed as the graybeards, the seasoned hands who knew how to take smart risks.
Six weeks later, they were all fired.
12
The Fannie Follies
George W. Bush believed in homeownership, too. In June 2002, nine months after 9/11, the president traveled to Atlanta, where, in an African-American church on the city’s south side, he unveiled his homeownership agenda. Entitled “Blueprint for the American Dream,” it promoted homeownership among minorities. The administration’s goal, Bush said, was to raise the number of minority homeowners by 5.5 million by 2010. “Part of being a secure America is to encourage homeownership,” he said, thus making homeownership seem somehow a part of the battle against terrorism.
Sitting in the audience that day was a man named Franklin Delano Raines, the chief executive of Fannie Mae. It was a triumphant moment for Raines, and not only because he was a minority himself—the first African-American CEO of a Fortune 500 company. Along with Leland Brendsel, the chief executive of Freddie Mac, Raines had gone to Atlanta that day at the behest of the White House, which wanted him to be part of the administration’s orchestration of the events of that day. (The two men flew back on Air Force One.) For all the controversies that had dogged the GSEs, the new administration seemed t
o be signaling that it could live with Fannie and Freddie just the way they were. A few months later, at a White House conference on minority homeownership, the president went out of his way to praise Raines’s stewardship of Fannie Mae.
And yet, if Raines thought he could rest easily, he was dead wrong. Within a year, the Bush White House would be engaged in a bitter war with Fannie and Freddie. By the end of 2004, the war would cost Raines his job, while Fannie Mae would be forced to restate billions of dollars in earnings in one of the largest accounting scandals in American history.
These events created an envious amount of Sturm und Drang in Washington. But ultimately, very little changed. The administration had started the war because it feared that Fannie and Freddie had become so big they posed a systemic risk to the financial system. The White House wanted to force the GSEs to pare back the risks on its books. Yet the “intifada,” as Raines would later call it, arguably wound up making matters worse, because it helped push the GSEs into buying riskier mortgages at exactly the wrong time. Just as important, this intense focus on the dangers Fannie and Freddie posed to the system allowed Congress and regulators to turn a blind eye to the systemic risks that were building up, inexorably, in the private market. After all, if clipping the wings of the GSEs was your primary objective, then you wouldn’t be inclined to look skeptically at their private competitors, would you?
Frank Raines, as everyone called him, was the quintessential postmodern Horatio Alger; born poor, he attached himself to the meritocracy and rode it for all it was worth. He grew up in Seattle, his father a custodian for the city parks department, his mother a cleaning woman for Boeing, a company whose board Raines would later serve on. After he became Fannie Mae’s CEO, Raines liked to recall that his father didn’t make enough money to get a thirty-year fixed-rate mortgage. The only way he could buy a home was to pay an exorbitant rate of interest to a hard-money lender.
All the Devils Are Here Page 23