That’s when O’Neal told him he wasn’t sure how much longer he would be Merrill’s CEO.
For Breit, it was a sobering conversation; he could see how shattered O’Neal was at the news. For O’Neal, it was an infuriating conversation. How could Breit convey this information so calmly? Wasn’t he supposed to be managing risk? Didn’t he bear at least some responsibility for what the mortgage desk had done? O’Neal still had no idea that Breit had been pushed aside. He thought Breit was still a risk manager on the front lines of the mortgage desk. The fact that he himself had put in place the dynamic that allowed good risk managers like Breit to be cast aside eluded him entirely.
And yet, having belatedly woken up to the magnitude of the problem, O’Neal absolutely understood what had to be done. Very simply, the firm needed to be sold—as quickly as possible. One thing he understood clearly is that when you face a black hole of write-downs, there is no way to know how deep the hole really is. The knee-jerk solution would be to raise capital—which, in fact, firms all over Wall Street were scrambling to do. O’Neal thought that was foolish. What would happen if it turned out not to be enough? You would never be able to raise additional capital; investors would be too fearful that the next round might be washed away, too. It would cause even greater panic. “I couldn’t look employees straight in the eye and say that everything is going to be okay,” he later told friends. “Just selling equity and waiting for the crisis to unfold just didn’t seem to be a winning formula.”
O’Neal would later tell Fortune magazine that Merrill was like “a fighter in the middle of the ring with your hands tied behind you and an opponent, whenever he chose, could just whale away on you, punch you right in the face. And there was no referee, so he could kick you in the balls, give you an elbow to the chin, and you could do nothing except stand there until he decided he was tired or finished or beneficent or whatever it was and turned away and walked out of the ring.” He added, “That seemed to me to be unbearable. We had to have alternatives.” The only alternative that made sense to him was a merger.
By the middle of September, O’Neal was talking to Merrill’s board members about the firm’s exposure to subprime risk. The directors were startled. Previously, they had always been told that Merrill’s subprime risks were minimal. Now they were hearing, for the first time, that the firm’s estimated loss was more than $1 billion. The board hired its own outside lawyer to advise it. A number of directors asked for tutorials on CDOs.
Even more startling to the directors was O’Neal’s demeanor. Almost overnight, he had gone from appearing unworried about Merrill’s subprime exposure to being deeply and openly pessimistic. People who saw him in the office said he appeared to be depressed. It was such a startling about-face that the Merrill directors had a difficult time taking him completely seriously. It was not that they didn’t think Merrill had a problem; it was that they thought O’Neal was panicking. But he wasn’t. This time, O’Neal was dead right.
In September, O’Neal arranged a secret meeting with Ken Lewis, the CEO of Bank of America, at the Time Warner Center in midtown Manhattan. O’Neal knew that Lewis had long lusted after Merrill Lynch—and, as his earlier purchase of Countrywide had shown, Lewis couldn’t say no to an acquisition he wanted. Ever since O’Neal had realized the depths of Merrill’s problems, he had been holding private conversations with Lewis about a possible deal. He had done so without informing any of his lieutenants or the Merrill Lynch board—O’Neal wanted to be able to go to them with a deal in hand. Lewis had even thrown out a number: $90 a share. At the secret meeting, O’Neal suggested bumping the price to $100. Lewis didn’t object.
It was after this meeting that O’Neal finally decided to sound out a board member about a possible merger with Bank of America. The director he spoke with was an old friend, financier Alberto Cribiore, whom O’Neal had put on the board in 2003. His response was extremely negative. “But Stan, Ken Lewis is an asshole,” replied Cribiore, according to the account O’Neal gave to Fortune. (Cribiore would later say he didn’t recall this conversation, but other Merrill executives back up O’Neal’s version.) Cribiore didn’t like the idea of Merrill Lynch losing its brand and identity to a bank based in Charlotte, and he still didn’t think it was necessary. He thought Merrill should raise capital and take a big write-down—exactly what O’Neal felt the company shouldn’t do. Strangely—and perhaps this had to do with O’Neal’s mental state—O’Neal concluded that if he couldn’t bring Cribiore around, he wouldn’t be able to bring any of the directors around. So instead of taking the deal to the full board, he dropped the idea. As the other directors found out he had approached Ken Lewis but never informed them, they were furious.
In early October, O’Neal finally did something he should have done much earlier. He fired Semerci and Lattanzio. The week before he was let go, Semerci received an e-mail from Fakahany praising him for his risk management efforts. Yet Semerci, at least, seems to have sensed that his firing was near. The loss estimates were growing. Too many other executives were complaining—and trying to show O’Neal that the situation was worse than he was portraying it. A group of them, fairly high up in the company, had come to call his estimates of triple-A losses “The Fantastic Lie.”
During August and September, Semerci methodically downloaded all his e-mail correspondence to O’Neal, Fakahany, Kim, and other top executives. Then, for reasons that people at Merrill Lynch still don’t understand, he withdrew from the bank almost $10,000 in sequential hundred-dollar bills, and taped the money into one of his desk drawers. He did the same with a Turkish passport—a passport he had never registered with the firm, as executives are supposed to do. (When he traveled for the company, he used a UK passport.)
Semerci’s office was on the seventh floor. He was brought to the thirty-second floor to be fired. After the deed was done, and he was being escorted out of the building and into a waiting car, he told the HR personnel who were guiding him out of the building about the money. He asked that he be allowed to leave with it. Someone went to find the bills and gave them to him when they got outside. He also called his secretary, told her about the passport, and had her slip it into his jacket, which he had left in his office. She met him by the car and handed the jacket to him. With his money and his passport, Semerci flew to London, where he now operates a hedge fund.
Fleming, meanwhile, brought Breit and another risk manager back from exile and gave them the task of sorting out Merrill’s CDO business. Incredibly, it was the first time anyone at Merrill Lynch, independent of the traders themselves, had attempted to put a value on the firm’s massive CDO exposure.
Two days after Semerci and Lattanzio were fired, Merrill Lynch “preannounced” its earnings, telling investors, in advance of its third-quarter earnings call, that it would be taking a large write-down in its subprime mortgage book, which it estimated at around $5 billion. It was going to be the largest trading loss in Merrill’s history. This was the first investors would hear about Merrill’s subprime exposure—indeed, it directly contradicted everything Merrill had said previously about its CDO portfolio and its risk management capabilities. The stock plunged.
A few weeks later, O’Neal met with the board to go over the third-quarter numbers. In the intervening weeks, new executives who had been installed in the mortgage departments had concluded that the firm should use more pessimistic assumptions in coming up with its CDO valuations. They recommended a write-down of $8 billion instead of $5 billion.
In the days prior to the meeting—and despite the earlier, negative reaction from Cribiore about his having approached Ken Lewis—O’Neal had sounded out a second CEO about a possible merger: Ken Thompson of Wachovia. Like Lewis, Thompson was receptive. O’Neal thought a Wachovia merger would be more palatable to the board; Merrill was the bigger name, unlikely to be subsumed the way it would be in a Bank of America deal. O’Neal decided he would use a dinner with board members to make the case for a merger.
On their way t
o the board dinner, Fleming counseled O’Neal on how to approach the board. “You have to walk them through this,” he said. “You can’t just tell them we need to sell the company. They aren’t going to buy it. The company was performing tremendously until this quarter. That’s how they are viewing it.”
Shooting him a suspicious look, O’Neal responded, “Why are you saying that? Who are you talking to?”
“I haven’t talked to anybody,” replied Fleming. “I’m an investment banker. This is what I’ve done my whole career.”
But that kind of gentle persuasion just wasn’t in O’Neal’s toolkit. The dinner itself was “frosty,” according to one participant. The directors were angry. “There was no small talk, no humor.” The board members were served their food, and practically before they could take a bite O’Neal said, “I think we should sell to Wachovia.”
The board members were stunned. Their anger turned to fury. Some began grilling O’Neal on Merrill’s exposure; others complained that his approaching Wachovia was a terrible breach of corporate etiquette—a CEO is supposed to get a board’s permission before approaching another company. “Their reaction was vitriolic,” recalls one participant. “I’ve never seen that kind of interplay between a CEO and a board of directors.” The board had zero interest in pursuing a merger with Wachovia.
“I’m on the board of a public company now,” Komansky told The New Yorker. “If I thought the CEO was out trying to sell the company, I’d have a hard time having confidence in that fellow.” Well, maybe. But while O’Neal’s bedside manner may have been lacking, he was doing exactly the right thing in trying to sell Merrill Lynch. This time, it was the board that was in denial.
The board meeting took place Sunday and Monday, October 21 and 22, 2007. It wasn’t a lot of fun; the board had lost confidence in O’Neal and he was smart enough to see it. And the numbers Merrill was about to unveil were truly ugly. On Wednesday, October 24, the earnings were released. Merrill Lynch announced a net loss of $2.3 billion, which included a write-down of $7.9 billion in subprime mortgage securities.19 “The bottom line is, we got it wrong by being overexposed to subprime, and we suffered as a result of an unprecedented liquidity squeeze and deterioration in that market.” O’Neal accepted the blame.
The following evening, Jenny Anderson of the New York Times began calling and e-mailing various board members and executives, trying to confirm a rumor she had heard. She got Fleming on his cell phone around seven thirty. After a few pleasantries, she said one word to him: “Wachovia.” He gave her a quick “No comment” and got off the phone. But another source, later that evening, confirmed O’Neal’s approach to Wachovia, and she had the story in the paper the next day. O’Neal was already hanging by a thread; that story finished him off.
On October 29, four days after the Times broke the news of his approach to Wachovia, Stan O’Neal was gone. He took with him $161 million in retirement benefits and Merrill Lynch stock, feeling at once embittered, embarrassed, and frustrated. “I should have known better,” he told Fleming bitterly, shortly before he resigned. After he was gone, though, it wasn’t his mistakes he dwelled on, but the mistakes of the men he had surrounded himself with: Fakahany, Semerci, and Kim. He had trusted them and they had let him down. He never seemed to understand that he himself had planted the seeds of destruction by placing his trust in the wrong people. “The fixed income guys got us in ’98, and I swore they would never do it again,” O’Neal used to say, referring to the Long-Term Capital crisis. “But they did it again.” For this, he had only himself to blame.
Eleven months after his ouster, though, O’Neal got a small measure of satisfaction when Merrill was sold to Bank of America, for $29 a share, during the most traumatic weekend of the financial crisis. O’Neal sent Cribiore an e-mail, according to Fortune. “My former friend,” it read, “you should have helped me sell this business when we had the chance.”
A final coda: Not long after O’Neal was safely out the door, Greg Fleming brought Kronthal back to Merrill Lynch to help clean up the mess. The first day he walked out onto the trading floor, all the traders stood as one and cheered.
21
Collateral Damage
On July 11, 2007, two executives at AIG-FP had a private phone conversation to discuss their company’s subprime exposure. One of the executives was Andrew Forster, the Cassano deputy who had helped persuade his boss to stop writing new credit default swaps on triple-A tranches of multisector CDOs at the end of 2005. He was in AIG’s London office. The other man was Al Frost, who had helped lead AIG-FP into the business and who had marketed dozens of credit default swap deals until the spigot was turned off, at which point AIG was on the hook for some $60 billion worth of subprime exposure. He was calling Forster from AIG-FP’s office in Wilton, Connecticut.
“What are you focused on?” Frost asked nervously.
“What are we focused on?” replied Forster, seeming incredulous at the question. “I’m focused on CDOs and subprime.”
“Yeah, obviously.”
“Nothing else,” Forster continued. “And spending most of my time answering questions of … AIG, you know, Sullivan, Lewis, all the rest of it.” Sullivan was Martin Sullivan, AIG’s CEO. Lewis referred to Bob Lewis, the company’s chief risk officer.
What Frost and Forster knew—and Sullivan and Lewis didn’t—was that embedded in AIG-FP’s swap contracts were those collateral triggers. AIG-FP’s counterparties, who had been paying it millions of dollars over the years to insure their triple-A tranches, had the right to demand what amounted to cash margin calls if one of three things happened: if AIG’s rating dropped to single-A or below; if the ratings on the super-senior tranches AIG was insuring were lowered by the rating agencies; or if the value of the tranches fell—even without a ratings downgrade. In all the time FP had been writing credit protection on multisector CDOs, no one could ever imagine any of these things ever happening. AIG was just too strong financially, and besides, the super-senior tranches FP insured had plenty of subordination; the default rate on the underlying mortgages would have to be almost unimaginably high to ever reach the tranches that FP insured.
Even after FP stopped writing the business in 2005—indeed, even after the parent company’s rating was dropped to double-A after Greenberg’s departure—the division executives remained convinced they had nothing to worry about. FP executives took solace in the fact that the 2006 and 2007 “vintages” of subprime mortgages were far worse than the 2005 vintage that FP had wrapped. Tranches with those later mortgages, they believed, would be hit long before any of the tranches that AIG insured. A government official who began poking around FP’s swap business in 2005, not long after Greenberg left, recalls looking at the collateral triggers and thinking, “This is a company with 9 percent tangible capital and an earnings stream to die for. It would truly take an Armageddon scenario. You’re thinking, ‘This is never going to happen.’ There’s risk, sure, but there’s also risk I could walk out the door and a brick could fall on my head.”
By the middle of 2007, however, Armageddon looked a lot closer than it had in 2005. And Forster was clearly worried that downgrades—and collateral calls—were coming. All he had to do was look at what had happened to the Bear Stearns hedge funds to know that the unimaginable was now a very real possibility.
“Every fucking one, every rating agency we’ve spoke to … every time they come out with more downgrades we have to go and … analyze all the exposures we’ve got in the rest of it. So, you know, it’s fairly time consuming,” Forster said. “The problem we’re going to face is that we’re going to have just enormous downgrades on the stuff that we’ve got. So you know, we sort of sit there with a $60 billion CDO book, and now we’re sort of sitting and saying, it’s super-senior. It isn’t going to be too much longer before we’re saying, we’ve got, you know, $20 billion of single-A risk. And that’s going to happen. There’s no doubt about it.”
“Do you think it’s going down that far, sin
gle-A?” asked Frost.
“Oh, yeah,” said Forster. “It’s going to get very, very, very ugly.”
The conversation turned to another potential problem: given what the market was doing, the value of the super-senior tranches was getting hit even without a ratings downgrade. How was AIG going to avoid marking down the value of the securities it insured—which would also result in collateral calls?
“Is there an event that could cause us to [lower our marks]?” asked Frost.
Forster replied that the rumbling of downgrades by the rating agencies would inevitably cause counterparties to focus on AIG’s marks, which were still at par. “I mean, we have to mark it,” he told Frost.
“We’re fucked basically,” he concluded.
It took only two weeks after that conversation for Frost and Forster’s worst nightmare to come true. On July 26, a junior AIG-FP official sent Frost a short e-mail with the heading “Sorry to bother you.” (Frost had left for vacation.) It read, “Margin call coming your way. Wanted to give you a heads-up.”
All the Devils Are Here Page 43