Synthetic CDOs and Merrill's Fall

A fine piece by Gretchen Morgenson in the International Herald Tribune (as part of a series entitled “The Reckoning“):

How the thundering herd faltered and fell
By Gretchen Morgenson
Sunday, November 9, 2008
International Herald Tribune

“We’ve got the right people in place as well as good risk management and controls.”–E. Stanley O’Neal, 2005

There were high-fives all around Merrill Lynch headquarters in New York as 2006 drew to a close. The firm’s performance was breathtaking; revenue and earnings had soared, and its shares were up 40 percent for the year.

And Merrill’s decision to invest heavily in the mortgage industry was paying off handsomely. So handsomely, in fact, that on Dec. 30 that year, it essentially doubled down by paying $1.3 billion for First Franklin, a lender specializing in risky mortgages.

The deal would provide Merrill with even more loans for one of its lucrative assembly lines, an operation that bundled and repackaged mortgages so they could be resold to other investors.

It was a moment to savor for E. Stanley O’Neal, Merrill’s autocratic leader, and a group of trusted lieutenants who had helped orchestrate the firm’s profitable but belated mortgage push. Two indispensable members of O’Neal’s clique were Osman Semerci, who, among other things, ran Merrill’s bond unit, and Ahmass Fakahany, the firm’s vice chairman and chief administrative officer.

A native of Turkey who began his career trading stocks in Istanbul, Semerci, 41, oversaw Merrill’s mortgage operation. He often played the role of tough guy, former executives say, silencing critics who warned about the risks the firm was taking.

At the same time, Fakahany, 50, an Egyptian-born former Exxon executive who oversaw risk management at Merrill, kept the machinery humming along by loosening internal controls, according to the former executives.

Semerci’s and Fakahany’s actions ultimately left their firm vulnerable to the increasingly risky business of manufacturing and selling mortgage securities, say former executives, who requested anonymity to avoid alienating colleagues at Merrill.

To make matters worse, Merrill sped up its hunt for mortgage riches by embracing and trafficking in complex and lightly regulated contracts tied to mortgages and other debt. And Merrill’s often inscrutable financial dance was emblematic of the outsize hazards that Wall Street courted.

While questionable mortgages made to risky borrowers prompted the credit crisis, regulators and investors who continue to pick through the wreckage are finding that exotic products known as derivatives–like those that Merrill used–transformed a financial brush fire into a conflagration.

Read the rest of the article

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