Too Big to Fail

by Andrew Ross Sorkin

  “I don’t agree with the way you characterized it,” Thain replied. “We raised $12.8 billion of new capital at the end of the year, we only lost $8.6 billion. We raised almost 50 percent extra and so we did raise more than we lost. The same actually was true at the end of the first quarter, we raised $2.7 billion, versus the $2 billion we lost. So we have been raising extra.”

  But that would not be enough.

  Several weeks after Merrill’s board had named Thain CEO, he was faced with an especially delicate task. Placing a call to his predecessor, Stan O’Neal (who had just negotiated an exit package for himself totaling $161.5 million), Thain asked if they might get together. Hoping to keep their meeting out of the newspapers, the two decided on breakfast in Midtown at the office of O’Neal’s lawyer.

  After a few pleasantries, O’Neal stared levelly at Thain and asked, “So, why do you want to talk to me?”

  Thain knew that if there was one person in the world who could explain what had gone wrong at Merrill Lynch, why it had loaded up on $27.2 billion of subprime and other risky investments—what, in other words, had gone wrong on Wall Street—it was O’Neal.

  “Well, as you know, I’m new, and you were the CEO for five years,” Thain said carefully. “I’d like to get your take, any insight on what happened here. Who everybody is, and all that. It would be very helpful to me and to Merrill.”

  O’Neal was silent for a moment, picking at his fruit plate, and then looked up at Thain. “I’m sorry,” he said. “I don’t think I’m the right person to answer that question.”

  O’Neal was out of a different mold than most of Merrill’s top executives, not least of all because he was African American—quite a change from the succession of white Irish Catholics who had headed the firm in the past. His was, by any measure, an amazing success story. O’Neal, whose grandfather had been born a slave, had spent much of his childhood in a wood-frame house with no indoor plumbing on a farm in eastern Alabama. When Stan was twelve, his father moved the family to a housing project in Atlanta, where he soon found a job at a nearby General Motors assembly plant. GM became Stan O’Neal’s ticket out of poverty. After high school he enrolled at the General Motors Institute (now known as Kettering University), an engineering college, on a work-study scholarship that involved his working six weeks on the assembly line in Flint, Michigan, followed by six weeks in the classroom. With GM’s support he attended Harvard Business School, graduating in 1978. After a period working in GM’s treasury department in New York, he was persuaded in 1986 by a former GM treasurer, then at Merrill Lynch, to join the brokerage firm on its junk bond desk. Through hard work and support from powerful mentors, O’Neal rose rapidly through the ranks. He eventually came to oversee the junk bond unit, which rose to the top of the Wall Street rankings known as league tables. In 1997 he was named a co-head of the institutional client business; the following year, chief financial officer; and in 2002, CEO.

  The firm for which O’Neal was now responsible had been founded in 1914 by Charles Merrill, a stocky Floridian known to his friends as “Good Time Charlie,” whose mission was “Bringing Wall Street to Main Street.” Merrill set up brokerage branches in nearly one hundred cities across the nation, connected to the home office by Teletype. He helped democratize and demystify the stock market by using promotions, like giving away shares in a contest sponsored by Wheaties. More than the mutual fund giant Fidelity or any bank, Merrill Lynch, with its bull logo, became identified with the new investing class that emerged in the decades after World War II. The percentage of Americans who owned stock—whether directly or indirectly, through mutual funds and retirement plans—more than doubled from 1983 to 1999, by which point nearly half the country were investors in the market. Merrill Lynch was “Bullish on America” (an advertising slogan it first used in 1971), and America was just as bullish on Merrill Lynch.

  By 2000, however, the “thundering herd” had become the “phlegmatic herd”—a bit too fat and complacent. The firm had gone on a shopping binge in the 1990s, accelerating its global expansion and swelling its workforce to 72,000 (compared to the 62,700 of its closest rival, Morgan Stanley). Meanwhile, its traditional power base, the retail brokerage business, was being undercut by the rise of discount online brokerage firms like E*Trade and Ameritrade. And because much of Merrill Lynch’s investment banking business was predicated on volume, not profits, the dot-com crash in the stock market the previous year had left Merrill vulnerable, exposing its high costs and thin margins.

  The man tasked with shrinking Merrill back to a manageable size was O’Neal. Although colleagues had urged him to proceed slowly, especially in light of the trauma of 9/11, in which Merrill had lost three of its employees, O’Neal plowed ahead with little regard for the effects of downsizing on the firm’s morale and culture. Within a year, Merrill’s workforce had been cut by an astonishing 25 percent, a loss of more than 15,000 jobs.

  “I think this is a great firm—but greatness is not an entitlement,” O’Neal remarked at the time. “There are some things about our culture I don’t want to change…but I don’t like maternalism or paternalism in a corporate setting, as the name Mother Merrill implies.”

  The management turnover that accompanied his ascension was likewise startling: Even before he officially became chief executive in December 2002, almost half of the nineteen members of the firm’s executive committee were gone. It became clear that O’Neal would force out anyone whom he had any reason to distrust. “Ruthless,” O’Neal would tell associates, “isn’t always that bad.”

  If a colleague dared stand up to him, O’Neal was famous for fighting back. When Peter Kelly, a top Merrill Lynch lawyer, challenged him about an investment, O’Neal called security to have him physically removed from his office. Some employees began referring to O’Neal’s top-management team as “the Taliban” and calling O’Neal “Mullah Omar.”

  As well as by vigorous cost cutting, O’Neal had plans to make Merrill great again through redirecting the firm into riskier but more lucrative strategies. O’Neal’s model for this approach was Goldman, which had begun aggressively making bets using its own account rather than simply trading on behalf of its clients. He zealously tracked Goldman’s quarterly numbers, and he would hound his associates about performance. As it happened, O’Neal lived in the same building as Lloyd Blankfein, a daily reminder of exactly whom he was chasing. Blankfein and his wife had come to jokingly refer to O’Neal as “Doppler Stan,” because whenever they’d run into him in the lobby, O’Neal would always keep moving, often walking in circles, they thought, to avoid having a conversation.

  O’Neal did force through a transformation of Merrill that, in its first few years, resulted in a bonanza. In 2006, Merrill Lynch made $7.5 billion from trading its own money and that of its clients, compared with $2.6 billion in 2002. Almost overnight, it became a major player in the booming business of private equity.

  O’Neal also ramped up the firm’s use of leverage, particularly in mortgage securitization. He saw how firms like Lehman were minting money on investments tied to mortgages, and he wanted some of that action for Merrill. In 2003 he lured Christopher Ricciardi, a thirty-four-year-old star in mortgage securitization, from Credit Suisse. Merrill was an also-ran in the market for collateralized debt obligations, which were often built with tranches from mortgage-backed securities. In just two years Merrill became the biggest CDO issuer on Wall Street.

  Creating and selling CDOs generated lucrative fees for Merrill, just as it had for other banks. But even this wasn’t enough. Merrill sought to be a full-line producer: issuing mortgages, packaging them into securities, and then slicing and dicing them to CDOs. The firm began buying up mortgage servicers and commercial real estate firms, more than thirty in all, and in December 2006, it acquired one of the biggest subprime mortgage lenders in the nation, First Franklin, for $1.3 billion.

  But just as Merrill began moving deeper into mortgages, the housing market started to show its first signs o
f distress. By late 2005, with prices peaking, American International Group, one of the biggest insurers of CDOs through credit default swaps, stopped insuring securities with any subprime tranches. Ricciardi, meanwhile, having built Merrill into a CDO powerhouse, left Merrill in February 2006 to head a boutique investment firm, Cohen Brothers. With his departure, Dow Kim, a Merrill executive, sought to rally those who stayed behind on the CDO front. Merrill, he promised, would maintain its ranking as the top CDO issuer, doing “whatever it takes.” One deal Kim put together was something he called Costa Bella—a $500 billion CDO, for which Merrill received a $5 million fee.

  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’s board, and in discussing options to solidify the firm’s balance sheet, he mentioned he’d talked to Wachovia. Somewhat prophetically, he told them of the market turmoil. “If this lasts for a long period, we and every other firm that relies on short-term overnight and term repo funding will have a problem.” But the board did not focus on that last point. They were furious he had engaged in unauthorized merger talks. “But my job is to think about options,” he protested. Two days later the board met without him and agreed to force him out. Few were sympathetic. A former co-worker told the New Yorker: “I wouldn’t hire Stan to wash windows. What he did to Merrill Lynch was absolutely criminal.”

  One morning in late June, New York’s mayor, Michael Bloomberg, left his brownstone apartment on Seventy-ninth Street, hopped into the back of his black Suburban, and headed to Midtown for a breakfast date. With his security detail waiting outside, Bloomberg, wearing his usual American flag lapel pin, strolled into New York Luncheonette, a tiny diner on Fiftieth Street across from a parking lot, and greeted John Thain. The restaurant was one of Bloomberg’s favorites; he had recently brought a long-shot presidential hopeful, Barack Obama, there.

  Although Bloomberg didn’t know Thain very well personally, he had had a long and fruitful association with Merrill Lynch, which had supported his eponymous financial-data company since its inception. Bloomberg, who had been a partner at Salomon Brothers, the bond-trading powerhouse, and was in charge of the firm’s information systems, started his terminal business in 1981; Merrill, which helped finance it, was the first customer to buy one of his machines, which delivered real-time financial data for traders. In 1985, Merrill acquired 30 percent of Bloomberg LP for $30 million, though it later reduced its stake by a third.

  When Michael Bloomberg became mayor of New York, he placed his 68 percent stake of the company into a blind trust and stepped away from managing it—even if, in reality, it was closer to a half-step, especially when it came to critical company matters—like the one John Thain was about to broach. Thain, desperate for more capital and sufficiently convinced after the Larry Fink debacle that he should try to keep the firm’s BlackRock stake, wanted Bloomberg to buy back Merrill’s 20 percent holdings in his company. If the mayor declined to make the purchase, however, it was unclear whether Merrill would have the right to sell its share on the open market. The contract had been written in 1986 and they both knew it was murky.

  Tucked away in a corner booth, the two men sipped coffee and chatted amiably. As former bond traders and ski enthusiasts, they hit it off surprisingly well.

  “We’d probably be looking to do this over the summer,” Thain said, trying to remain somewhat noncommittal so as not to convey any sense of panic. Within half an hour, they had an agreement to move forward.

  It was the lifeline he had been hoping for, and as soon as he bid the mayor farewell, Thain raced back to the office to tell Fleming to start work on the project immediately.

  CHAPTER EIGHT

  Jamie Dimon’s 10:00 a.m. meeting was running long.

  “Tell Bob I’ll be there in a minute,” he told Kathy, his assistant.

  Robert “Bob” Willumstad and Dimon both had once been part of Sandy Weill’s team of financial empire builders. At different points in time, each had been considered Weill’s heir apparent at the behemoth Citigroup they had all helped create, though ultimately, neither would be given a chance to assume its leadership. The two had remained close in the decade since Dimon had been forced out.

  A tall, white-haired executive who could have been the archetype of the Manhattan bank
er, Willumstad sat patiently on this early June day in the waiting room on the eighth floor of JP Morgan in the old Union Carbide offices. A glass cabinet displayed replicas of two wood-handled pistols with a resonant history: They had been used by Aaron Burr and Alexander Hamilton in the 1804 duel that killed Hamilton, the first U.S. secretary of the Treasury.

  Like Dimon, Willumstad had been outmaneuvered by Weill and, after leaving Citi in July 2005, went on to start a private-equity fund, Brysam Global Partners, which made investments in consumer finance businesses in Latin America and Russia. His partner, Marge Magner, was another Citigroup exile. Under Dimon, JP Morgan had become the largest investor in Willumstad’s fund, whose offices were just across Park Avenue from JP Morgan’s own headquarters. While under his and Magner’s direction, Brysam had become a profitable firm. Willumstad held another, much more important position: He was the chairman of the board of American International Group, AIG, the giant insurer, which was the reason for his visit to Dimon this day.

  “I’ve been thinking about something and could use your advice,” Willumstad, a soft-spoken man, said to Dimon after he had finally been ushered into his office. He revealed that the AIG board had just asked him if he’d be interested in becoming CEO; the current CEO, Martin Sullivan, would likely be fired within the week. As chairman, Willumstad himself would be responsible for paying a visit to AIG’s headquarters the following day to warn Sullivan that his job was in jeopardy.

  “I like what I’m doing,” he said earnestly. “No one’s looking over my shoulder.”

  “Except for me!” Dimon, one of his biggest financial backers, countered with a laugh.

  Willumstad explained that he had been pondering accepting the top position over the past several months, ever since the credit crisis had engulfed AIG, and it had become increasingly clear that he might be given an opportunity to run the company. That prospect had left him painfully conflicted: While he had always wanted to be a CEO, he was sixty-two and now had the time to pursue outside interests, like auto racing.