BAD NEWS BULLSThe Merrill Lynch headquarters at 4 World Financial Center, in Lower Manhattan; the charging bronze bull on Broadway and Whitehall Street. In the foreground, from left: Greg Fleming, former Merrill Lynch president; Stanley O'Neal, former chairman and chief executive officer; Tom Patrick, former executive vice-chairman; Arshad Zakaria, former head of global markets and investment banking; Ahmass Fakahany, former vice-chairman and C.O.O.; Osman Semerci, former head of fixed-income trading.
Excerpted from All the Devils Are Here, by Bethany McLean and Joe Nocera, to be published this month by Portfolio, a member of Penguin Group (USA) Inc.; © 2010 by the authors.
In the years leading up to the financial crisis of 2008, there was no more infectious disease on Wall Street than Goldman envy. Goldman Sachs, perhaps the most storied name in all of American finance, had gone public only in 1999, the last of the big firms to do so. After the I.P.O., Goldman’s mind-boggling profits were on full display. Starting in 2003, Goldman went on a run the likes of which had rarely been seen in American business. In just three years, its revenues more than doubled, to $38 billion, as its profits skyrocketed. In 2007, C.E.O. Lloyd Blankfein received a bonus of more than $68 million. Even junior traders made millions. Who wouldn’t be jealous of numbers like those? UBS, Citigroup, Credit Suisse, Lehman Brothers, Deutsche Bank—they were all stricken, to varying degrees, with Goldman envy.
No firm, though, had it worse than Merrill Lynch. And once the crisis struck, there was no firm for whom the disease would prove to be more fatal.
Writers Reading: Bethany McLean Reads from All The Devils Are Here.
It was odd, in a way. To most Americans, pre-crisis, the Merrill Lynch name was far more storied than Goldman’s. Certainly, it was far better known. Merrill was the “Thundering Herd” that was “Bullish on America.” It had offices in every nook and cranny in America, where brokers stood at the ready to sell middle-class Americans the stocks and bonds they needed to put their kids through college and build their retirement nest eggs. To most people, what Goldman did was a complete mystery. What Merrill did was something everyone could see and understand.
The firm had been founded in 1914 by Charlie Merrill, a short, prideful, almost messianic Wall Street figure who was convinced that the average man should be investing in stocks, and that investment firms should embrace the middle class instead of spurn it, as was the custom at the time. For most of its history, Merrill made its money by “bringing Wall Street to Main Street,” a phrase its founder coined.
There was nothing remotely wrong with this business model. Over time, Merrill became the largest brokerage firm in the country, employing, at its peak, some 16,000 stockbrokers. It made good, steady money, aided by the long bull market that began in 1982, and helped turn millions of Americans into investors. It also developed, over the years, a unique culture; its executives tended to be Irish Catholics (many of them ex-Marines), for whom drinking at lunch was not a vice, and cronyism was not only tolerated but almost expected. Merrill took care of its people, even those who were less than fully competent. “Mother Merrill,” its employees called the firm.
To be sure, Merrill also had all the other components of a modern Wall Street firm: an investment-banking division, lots of trading desks, a big fixed-income division, and so on. It was also one of the first firms to go public, in 1971, almost three decades before Goldman Sachs did. Even so, on Wall Street, the firm was never held in the same regard as Goldman and Morgan Stanley. Nor did it make the same kind of profits as those firms—especially Goldman Sachs.
Stan: The Man with the Plan
The man who wanted to change all that was E. Stanley O’Neal. Having joined the firm as a junk-bond trader in 1986, he had risen to become C.E.O. by 2002—just before Goldman began its magical run. Proud, prickly, intolerant of dissent, and quick to take offense at perceived slights, O’Neal had never worked as a stock broker and had no particular affection for the business that had long been Merrill’s heart and soul. His burning ambition was to transform its Mother Merrill culture, which he viewed (correctly) as bloated and soft—“not adequate to the times,” he once told a colleague—and he wanted to put new emphasis on trading. Most of all, O’Neal pushed Merrill to take more risks and bigger risks—Goldman Sachs—like risks. After all, wasn’t that how one made Goldman Sachs—like profits?
Stan O’Neal was the kind of man who could bristle even at comments that were meant as praise, so it is no surprise that he never found the label “African-American C.E.O.” to his liking. Yet his was one of the great African-American success stories in modern business. O’Neal was born in the tiny town of Wedowee, in eastern Alabama, an hour due north of Auburn. It was, says a friend, “a tough town where it was dangerous for black people to look directly at white people.” O’Neal’s grandfather was a former slave. His father was a poor farmer, who moved his family to Atlanta when Stan was 13. They lived in a housing project while his father established himself as an assembly-line worker at a nearby General Motors plant. After high school, O’Neal was accepted by the General Motors Institute into a work-study program. G.M. then hired him as a shift foreman and, when he was accepted into Harvard Business School, gave him a merit scholarship. Once O’Neal had his M.B.A., General Motors put him in its treasury department and gave him a series of promotions. He shined at every stop.
Although he was clearly a comer at G.M., O’Neal took a job at Merrill because he felt that it offered him more opportunity. By 1990 he had been put in charge of the junk-bond desk, where he quickly impressed the top brass with both his effectiveness and his ruthlessness, something he would continue to do as he made his way up the ladder. As the head of the brokerage division when the Internet bubble burst, he laid off thousands of employees. As chief financial officer in the late 1990s, he sent his then boss, C.E.O. David Komansky, an analysis of the company that was far tougher and more clear-eyed than the Merrill culture was accustomed to—criticizing the firm’s low profit margins and concluding that “the root causes of our uncompetitive margins are both structural and cultural.” Far from being put off by O’Neal, Komansky was impressed.
By July 2001, O’Neal had been named president of Merrill Lynch. Komansky had planned to stay on as C.E.O. for a few more years, until he turned 65, but two events forced him out earlier. The first was 9/11. The firm’s headquarters, which were close to Ground Zero, were badly damaged in the attacks, and several Merrill employees died. During and after the attacks, “O’Neal filled the [leadership] vacuum,” says a former top Merrill executive. Concluding that Wall Street was unlikely to recover quickly, O’Neal instituted big layoffs. Komansky cautioned him against such a move, fearing a publicity backlash, but O’Neal had no patience for such thinking.
Second, O’Neal simply wasn’t willing to wait a few more years to become C.E.O. He was ready now. Before he was named president, he had rivals for the top job. He outmaneuvered them, and then, as president, pushed them aside. His appointment as C.E.O. didn’t end the palace intrigue, however. Strangely, though, the next round came not from his enemies in the firm but from two of his closest allies. One was Arshad Zakaria, then 41, the head of global markets and investment banking. The other, Tom Patrick, then 59, had been Merrill’s chief financial officer under Komansky. O’Neal had effectively made Patrick his number two, though without the title of president.
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 singularly important event in the O’Neal era—and not for the better. O’Neal had been insular before; 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 had been extremely competent executives; he replaced them with more pliable lieutenants.
Although O’Neal didn’t realize it, this was not the way to compete with Goldman. Goldman’s management-committee members all participated in discussions of the various businesses. O’Neal, by contrast, insisted that the company’s executives speak only to him about their businesses and not 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 C.E.O. had to make an important decision, he consulted with a handful of advisers. O’Neal rarely asked for input when making 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, one of O’Neal’s top lieutenants, Greg Fleming, was having dinner with him, pressing him on issues on which they disagreed. As the dinner was concluding, O’Neal said, “This is getting too painful.” Fleming replied, “Stan, I don’t understand what you mean by ‘too painful.’ I’m just disagreeing with you.”
“I don’t think we can have dinner anymore,” said O’Neal. They never had another meal together.
Mother Merrill, pre-O’Neal, had always been fearful of taking on a lot of risk. 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. 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 with Goldman’s. “You didn’t want to be in Stan’s office on the day Goldman reported earnings,” recalls one of his former lieutenants.
More important, everyone around him was creating C.D.O.’s as fast as they could. Kronthal’s boss, Dow Kim, headed all of fixed-income. “Stan was constantly pounding on him about why we weren’t making as much in fixed-income as Lehman or Goldman,” says a former Merrill executive. As O’Neal pushed Kim, Kim pushed Kronthal.
From below, meanwhile, Kronthal was trying to keep the C.D.O. team under control. That was no small task. It was headed by Chris Ricciardi, an aggressive trader in his mid-30s. After successful stints at Prudential and Credit Suisse, Ricciardi and most of his team joined Merrill Lynch, in April 2003. He quickly ramped up the firm’s C.D.O. business. Kronthal and his crew of veteran traders viewed Ricciardi warily. “He was dangerous,” says a 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 10 more salesmen just like him. He was the kind of trader O’Neal wanted at Merrill Lynch.
Ricciardi knew exactly what he had been hired to do. “The strategy is to be a high-volume underwriter, with a focus on areas that are very popular,” said Ricciardi in an interview with a trade publication in early 2005. What was popular was subprime mortgages. To ensure it would have a steady source of them to securitize and then bundle into C.D.O.’s, Merrill took a 20 percent stake in Ownit, a mortgage originator formed by Bill Dallas. By 2006, says Dallas, Merrill was pushing him to make loans that would generate more yield for Merrill’s C.D.O.’s.
“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.”
Kronthal didn’t have any moral objection to the C.D.O. business. Few on Wall Street did. But as an old hand at the business, he was keen to make sure that Merrill itself wasn’t putting too much of the C.D.O. risk on its own balance sheet. For instance, he had a hard-and-fast limit of $1 billion worth of triple-A tranches that Merrill could hold. The ratings agencies might have viewed those triple-A’s as riskless, but Kronthal certainly didn’t. By the spring of 2006, the firm had a total exposure of $5 to $6 billion—the vast majority of which were mortgage-backed securities that were being “warehoused” until they could be bundled into C.D.O.’s and sold to investors. 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, jumping to Cohen & Co., a firm that managed a number of the C.D.O.’s that he had constructed at Merrill. For Dow Kim, his departure was a blow, but he quickly assured the rest of the C.D.O. staff that the firm would do “whatever it takes” to stay No. 1.
Risky Business
Not surprisingly, they found just such a person to replace Ricciardi, a fast-rising bond salesman in London named Osman Semerci. O’Neal was quickly persuaded to bring him to New York and give him a title—global head of fixed-income, currencies, and commodities—that effectively made him Kronthal’s boss. Semerci, a 39-year-old British citizen of Turkish descent, had a reputation for being extremely driven and extremely aggressive—the traits O’Neal wanted on the trading desks. Semerci wouldn’t be afraid to take big risks to generate big profits. He surely would keep the Merrill C.D.O. machine humming.
Semerci also had a reputation for being a mean boss, which O’Neal didn’t mind at all. “He was in your face,” says a former Merrill executive. “He had a reputation internally that if you got on his bad side he would write your name down.” Merrill traders used to call it the blacklist; Semerci would actually walk the floors with a pen and clipboard in hand, writing down things he didn’t like. (Semerci declined to comment to VANITY FAIR.)
Kim was one of the two men who convinced O’Neal to promote Semerci, according to a source close to O’Neal. (A Kim defender says O’Neal was the one who insisted on Semerci.) The other was Merrill’s chief administrative officer, Ahmass Fakahany. Although he had spent his career on the administrative side of Merrill, overseeing such functions as human resources and computer systems, he wielded outsize power because he was indisputably the one executive who was close to O’Neal. “Fakahany was the one guy who could go into Stan’s office, close the door, and say, ‘Can you believe . . . ?’ ” says a former executive. He had worked in the Merrill finance office when O’Neal had been C.F.O., and had essentially hitched his wagon to O’Neal’s pony.
By most accounts, Fakahany was in over his head. He knew virtually nothing about trading—or about the complications of managing a balance sheet the size of Merrill’s. He was also in charge of Merrill’s risk-management function, another subject about which he knew next to nothing. (Fakahany declined to comment.) He evidently liked Semerci because he knew Semerci would appeal to O’Neal, rather than because Semerci knew how to run a mortgage desk. In fact, Semerci knew very little about the U.S. credit markets: “He didn’t understand U.S.-based risk,” says a former Merrill executive.
Semerci was also someone who couldn’t tolerate anyone who might be a threat to him. Kronthal, the most respected trader at Merrill Lynch, certainly fit that bill. The year before, he had been Merrill’s highest-paid non-executive employee, with a bonus of more than $20 million—a sum that attested to the profits his desks were making for Merrill Lynch. Other traders looked up to him, and took their cues from his analysis of the market. This was intolerable to Semerci. He insisted that Kronthal and those close to him be fired, and that he be allowed to assemble his own team of executives and traders. Kim and Fakahany—and O’Neal—all assented. (O’Neal would later deny that Kronthal was fired, but at least a dozen former Merrill executives, including several direct participants, dispute O’Neal’s recollection.)
By then, Greg Fleming—the man O’Neal stopped having dinner with because it was too “painful”—had become a member of the executive team. As the head of investment banking, he had nothing to do with Dow Kim’s fixed-income division. Indeed, O’Neal had made it very clear that Fleming was to keep his nose out of Kim’s business. But Kronthal was someone with whom Fleming had a close relationship. When he heard that Kronthal was about to be fired to make way for Semerci, he was stunned.
Fleming’s first instinct was to try to get the decision reversed. He asked O’Neal to move Kronthal and his team to Fleming’s jurisdiction and let them continue to run the credit desks. After thinking it over, O’Neal said no; Fleming recalls an early-morning phone call in which O’Neal told him he needed to “play ball.” When Fleming asked why Kronthal had to be fired, O’Neal replied, “You don’t understand. Dysfunction is good on Wall Street.”
By the middle of July 2006, Kronthal began to hear rumors that he was going to be fired. He, too, couldn’t believe it. He called Fleming, who was in London, vacationing with his wife. At first, Fleming ducked the calls, but when he told his wife why Kronthal was calling, she insisted he speak to his old friend. When Kronthal asked if he was going to be fired, Fleming hemmed and hawed. But by the end of their long, anguished conversation, Kronthal knew the truth. The next day, Dow Kim called him into his office and gave him his walking papers. The deed was done.
O’Neal would later tell friends that nobody had recommended Kronthal for a promotion, while Semerci had been supported by two of his top guys, Fakahany and Kim. But that remark just serves to illustrate how out of touch O’Neal had become. He had never been the kind of C.E.O. who walked the trading floor. By 2006, he was so divorced from his own firm that he failed to appreciate the utter lunacy of Semerci’s desire to clean house. Did he really think Semerci could get rid of Merrill’s most experienced mortgage traders and not harm the mortgage desk? Sadly, it seems that O’Neal didn’t think about it at all.
To Fleming, that day in July 2006 was the day Merrill Lynch’s fate was sealed. Yes, Fleming knew he was biased, but given how events played out, it seemed irrefutable. Prior to that day, Merrill may well have avoided the subprime problems that would soon bring Wall Street to its knees. After that date, Merrill was doomed to make the same mistakes as its competitors. “[Firing Kronthal] was one of the dumbest, most vindictive decisions I have ever seen,” Fleming would later say.
Not that anyone else at Merrill realized it at the time. Sure enough, with Semerci running the show, Merrill Lynch continued to crank out C.D.O.’s as if off an assembly line and retained its position as Wall Street’s No. 1 underwriter of them. It did so even though the business had begun to change dramatically. For one thing, the insurance giant A.I.G. had stopped writing credit-default swaps (a form of insurance) on the triple-A tranches, which had been an important reason that banks and other institutions had been willing to buy them. For another, investors were becoming harder and harder to find. Some of them had had their fill of triple-A tranches of C.D.O.’s. Others were becoming leery of the risk. Yet no one in a position of authority—not Dow Kim, not Ahmass Fakahany, and not Stan O’Neal—ever seemed alarmed that Osman Semerci could keep the machine going under these circumstances.
Instead, the mortgage desk continued to reap fees and post profits. The traders themselves made big bonuses. Whenever anyone asked, Semerci would tell Merrill executives that the firm had very little exposure to subprime-mortgage risk. From the boardroom to the trading floor, everyone simply assumed that all was well and that the business was being run the same way it had always been run. But it wasn’t.
There was one person at Merrill Lynch who might have asked the right questions, had he been in a position to do so. His name was John Breit, and he was a risk manager. A calm, soft-spoken former physicist, Breit had joined the long march from academia to Wall Street, coming to Merrill in 1990. He was not the kind of risk manager who feared all risk. On the contrary, he was one of the people who believed that Merrill had shot itself in the foot by being too risk-averse in years gone by.
The problem with O’Neal’s Merrill, Breit believed, was that, even as the C.E.O. was pushing the desks to take more risk, the institution still recoiled at a $50 million loss. That schizophrenia caused traders to seek out risk that wouldn’t show up in the risk models, Breit believed. He had learned over the years that, by the standards of a physicist, Wall Street was quantitatively illiterate. Executives learned terms like “standard deviation” and “normal distribution,” but they didn’t really understand the math, “so they got lulled into thinking it was magic.”
But ever since Fakahany had been put in charge of it, Merrill Lynch’s risk department had been in decline. Fakahany seemed to view the inevitable, important disputes between traders and risk managers as “squabbling among children,” as a former risk manager put it. Slowly, risk management went from being primarily a front-office function—meaning that risk managers sat on trading desks—to a back-office function, where they looked at models and spreadsheets and had very little interaction with the traders. “And they started to make less money,” a former risk manager later explained.
In early 2005, Fakahany decided to push the risk-management function down a notch further. He promoted the executive who was head of credit risk to be a kind of risk czar, to whom all the other risk managers would now have to report, instead of to Fakahany directly. Furious at what he saw as the degradation of the risk function, Breit quit.
He was away for only a few weeks, however. Late that spring, one of the fixed-income desks suffered a big loss. Dow Kim tracked down Breit and asked him to return to Merrill, where he would have a desk on the trading floor and work for him personally. Because Kronthal and the other veteran traders knew him and trusted him, Breit was able to develop what he called his “spy network,” to keep apprised of the risks the desks were taking. But once Semerci took over, in the summer of 2006, everything changed. The spy network dried up. Dow Kim, who wanted to go off on his own and start a hedge fund, was losing interest. (He would leave the following spring.) Semerci’s traders wouldn’t tell Breit anything. Eventually, he was moved off the trading floor entirely and given a small office elsewhere in the building.
Which also meant that, though he was one of the few people left at Merrill with the knowledge and background to sniff out problem trades, he was shut out entirely.
“The Fantastic Lie”
In the summer of 2007, two Bear Stearns hedge funds collapsed—in retrospect, this is the moment when the financial crisis began. It should also have been a terrifying moment for Stan O’Neal. The funds had been heavily invested in triple-A tranches of C.D.O.’s backed by subprime mortgages. Indeed, Merrill had pulled around $800 million of triple-A collateral out of the Bear funds (which helped trigger their collapse) only to discover that it couldn’t resell the vast majority of the tranches in the marketplace. Nobody wanted them.
Yet Semerci responded in exactly the way you would expect of someone whose multi-million-dollar bonus was completely dependent on his ability to continue manufacturing subprime C.D.O.’s. He implied that the market was in the middle of a little rough patch, but there was nothing to worry about. Incredibly, O’Neal appeared to accept his analysis. He did, however, ask Semerci to try to hedge the position, which Semerci insisted the mortgage desk was already doing. Indeed, at a board meeting in July, Semerci claimed the risk on the firm’s books amounted to no more than $83 million—a claim that other Merrill executives viewed as implausible. But when they tried to warn O’Neal that Semerci’s loss estimates were too low, they were met with a steely glare, according to several former Merrill executives. Behind Semerci’s back, these executives began calling his loss estimates “the Fantastic Lie.”
It seems inconceivable now that O’Neal himself had so little understanding of what lay ahead. He was a very smart man, a tough, seasoned Wall Street executive. One of the formative experiences of his career had been the Long-Term Capital Management disaster, when the 1998 implosion of that $4.6 billion hedge fund nearly took down all of Wall Street. Merrill had been particularly exposed to that crisis and it remained seared in O’Neal’s memory. He knew how a series of events could spiral into catastrophe. He saw how, in a crisis, “everything is correlated”—meaning that securities that were supposed to act as hedges suddenly started falling in tandem, exacerbating the losses. Panics have their own momentums, their own rhythms. It didn’t matter how much cash you said you had; if your counterparties lost faith in you, you were finished. O’Neal liked to say he never forgot those lessons. Yet now it appeared as if he had.
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