All the Devils Are Here

by Bethany McLean; Joe Nocera

  Says another analyst: “I told Angelo that his Achilles’ heel was funding. In his typical way, Angelo said, ‘You’re all wrong.’”

  16

  Hank Paulson Takes the Plunge

  The head of investment banking at Merrill Lynch for much of the Stan O’Neal era was a charming, gregarious, politically shrewd executive named Greg Fleming. He was only thirty-nine years old when he took charge of Merrill’s investment banking arm—a job he got in the summer of 2003 after O’Neal fired Tom Patrick and then pushed out Arshad Zakaria, who had overseen investment banking. Fleming had a knack for getting powerful men to warm up to him; it was one of the reasons he was a good investment banker. After the 9/11 attacks damaged Merrill’s headquarters, he and about a hundred of his employees camped out on an empty floor provided by BlackRock, according to the Wall Street Journal. BlackRock was the big money management firm Larry Fink had founded in 1989 after leaving First Boston. A friendship soon developed between the two men, which, four and a half years later, helped bring about a $9.8 billion deal in which Merrill took a 49.8 percent stake in BlackRock, while Fink’s firm took control of Merrill’s money management unit.

  Fleming had befriended O’Neal in similar fashion. They had known each other since the mid-1990s, when Fleming was a wet-behind-the-ears investment banker and O’Neal was a man on the make. After O’Neal was named president—with the top job all but guaranteed—Fleming made a point of getting together with him. “We’d talk about what was going on, who was doing what. He actually became an adviser,” O’Neal told the Journal. “He helped educate me very quickly.”

  Fleming had been a believer in O’Neal early on, agreeing with his assessment that Merrill culture needed toughening up. Over time, however, his relationship with O’Neal got testier, especially as O’Neal became more isolated. After the BlackRock deal, the Journal wrote an article highlighting Fleming’s role; although O’Neal was quoted in it, Fleming got the strong sense that O’Neal resented the fact that he had gotten the publicity. Also, unlike most of the executives O’Neal surrounded himself with after l’affaire Patrick, Fleming was willing to speak his mind. Although Fleming had perfect pitch when it came to knowing just how far he could push O’Neal, unlike his peers in the executive suite, he did push. For instance, O’Neal desperately wanted to buy a mortgage originator, which many of Merrill’s competitors used to supply them with the raw material for mortgage-backed securities and CDOs. Fleming had successfully prevented Merrill from buying New Century, a company that would turn out to be one of the worst of the subprime lenders—and which Merrill had come “within a hair” of buying, according to one former executive. Fleming was the executive O’Neal said he could no longer have dinner with, because it was “too painful” to hear Fleming disagree with him.

  And one other thing: Fleming had a close relationship with Jeff Kronthal. As one of O’Neal’s top deputies, Fleming had gotten early word of the firing. He couldn’t believe it. Kronthal wasn’t just a good trader; he was probably the best trader Merrill had. He had been around mortgage-backed securities his whole career, going back to Salomon Brothers and Lew Ranieri. He was deeply loyal to Merrill, where he had worked for seventeen years. Though he didn’t have the title, he was clearly the head of trading at Merrill Lynch.

  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 from O’Neal in which he told Fleming he needed “to play ball.” When Fleming asked O’Neal why Kronthal had to be fired, O’Neal replied, “You don’t understand. Dysfunction is good on Wall Street.” Dow Kim told Fleming that under no circumstances was he to give Kronthal advance word that he was being let go. That was Kim’s job, and he would be doing it soon enough.

  It was the middle of July 2006. Fleming and his wife were in London. When they were out shopping one day, Fleming’s cell phone began ringing and ringing. It was Kronthal. At first, Fleming ignored the calls, but as they kept coming his wife asked him what was going on. When he told her, she urged him to stop ducking the calls and talk to his friend. Kronthal told Fleming he was hearing rumors that he and many of Merrill’s veteran traders were all going to be fired. Fleming hemmed and hawed, but by the end of their long, anguished, teary conversation, Kronthal knew that the rumors were true.

  Fleming didn’t speak to O’Neal for a month and a half. The ice was broken only when O’Neal pleaded with Fleming not to leave the firm, something he had been contemplating. Fleming did stay—in fact, he stayed right through the financial crisis, becoming Merrill’s president along the way and brokering the deal Merrill cut with Bank of America on the infamous “Lehman weekend” in mid-September 2008. But the Kronthal firing was something he never stopped thinking about. Not only because it betrayed “a lack of basic human dignity,” as Fleming would later put it. And not only because it was so unnecessary. To Fleming, that July day in 2006 when Kronthal and his team were fired was the day Merrill Lynch’s fate was sealed. Yes, Fleming knew he was biased, but given what later happened, 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 most of its competitors.

  “It was one of the dumbest, most vindictive decisions I have ever seen,” Fleming would later say. And he was right.

  The reason Jeff Kronthal had to be fired was that, several months earlier, O’Neal had been persuaded to bring in a fast-rising bond salesman named Osman Semerci and give him a title—global head of fixed income, currencies, and commodities—that effectively made him Kronthal’s boss. Semerci, a thirty-nine-year-old British citizen of Turkish descent, had a reputation for being extremely driven and extremely aggressive—exactly the traits O’Neal wanted on the trading desks. Semerci wouldn’t be afraid to take big risks to generate big profits. He wouldn’t be excessively cautious the way Kronthal sometimes was.

  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 and look for a chance to get you.” 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 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 the bill. So as a condition of taking the promotion, he insisted that he be able to fire Kronthal and those close to him, and assemble his own team of executives and traders. O’Neal assented. He also insisted that he never have to report to Greg Fleming, whom he loathed. O’Neal assented to that as well.

  Dow Kim had been one of the men who convinced O’Neal to promote Semerci. The other was Merrill’s chief administrative officer, Ahmass Fakahany. Although Fakahany had spent his career on the administrative side of Merrill, overseeing such functions as human resources and computer systems, he wielded outsized 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 CFO, and had essentially hitched his wagon to O’Neal’s pony.

  By general consensus, Fakahany was deeply 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. He was backing Semerci more because he knew Semerci would appeal to O’Neal than because Semerci knew how to run a mortgage desk. In fact, Semerci knew very little about the credit markets. “He didn’t understa
nd U.S.-based risk,” says a former Merrill executive.

  O’Neal would later tell friends that nobody had recommended Kronthal for a promotion, while Semerci had been recommended by two of his top guys, Fakahany and Kim. But that remark just serves to illustrate how out of touch O’Neal had become. O’Neal had never been the kind of CEO who walked the trading floor. The intricacies of the firm’s trading positions held no interest for him, except to the extent they showed profits or losses. His constant demand that his trading executives take more risk was based mainly on his annoyance that Goldman Sachs and Lehman Brothers had more profitable trading desks, rather than on a deep understanding of what those risks entailed. His feel for the firm’s risk positions came primarily from reading the daily VaR reports. Whenever he went to Washington or attended conferences, he would hear about the riskiness of, say, leveraged loans, so he kept close tabs on that part of the business. But nobody ever mentioned possible problems with mortgage bonds—so he didn’t worry about them. By 2006, O’Neal 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 the firm’s most experienced mortgage traders and not harm the mortgage desk? Sadly, it seems that O’Neal didn’t think about it at all.

  The arrival of Semerci should have put Dow Kim on high alert, if only because he had no way of knowing whether Semerci was up to the job. Semerci was coming into his new position with a lot of pressure on him. Though Chris Ricciardi was gone, Merrill desperately wanted to maintain its position as the number one CDO underwriter. And, says a former Merrill colleague, Semerci felt another kind of Wall Street pressure: “Osman wanted to make a lot of money in a short period of time.”

  The CDO business was changing. AIG had stopped insuring super-senior tranches. The banks that had always bought the super-seniors weren’t buying them anymore. CDOs were becoming harder to sell to investors. Yet from the summer of 2006, when Kronthal and the other veteran traders were ousted, to the summer of 2007, Merrill Lynch continued to churn out CDOs. It retained its position as the number one underwriter. The mortgage desk reaped fees and posted 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; he had made all this money for the firm, he said, while derisking the portfolio. But he told no one how, exactly, he was accomplishing this. Incredibly, no one thought to ask. Instead, from the boardroom to the trading floor, everyone simply assumed that all was well—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 well 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 who specialized in evaluating derivatives risk. A calm, soft-spoken ex-physicist, Breit had joined the long march from academia to Wall Street, landing at Merrill Lynch in 1990. He was hardly antiderivatives; like most quants, he believed that derivatives were a useful tool. Nor was he 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 CEO was pushing the desks to take more risk, the institution still recoiled at a $50 million loss. Merrill’s schizophrenia about risk caused traders to seek out risks that wouldn’t show up in the risk models, Breit believed. “If the VaR is small,” he liked to say, “it means we are taking risk in things we can’t measure.” Breit used to tell Merrill management that VaR didn’t measure black swans—the rare but real risks that could destroy a firm. That was its fatal flaw.

  Breit had also 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. Traders came to believe the formulas were not an approximation of reality but reality itself. Which is also why firms needed good risk management departments, he believed. The risk managers were the ones who imposed the reality checks that the traders preferred to ignore.

  But ever since Fakahany had been put in charge of it, Merrill Lynch’s risk department had been in steep decline. Historically, the top risk executives at Merrill reported directly to the chief financial officer. That was fine when Merrill had a strong CFO like Tom Patrick, who knew that part of the job was to adjudicate the inevitable disputes between the risk managers and the trading desks over what constituted too much risk. As head of Merrill’s market risk, Breit had reported to Patrick.

  Once Fakahany took over risk management, the risk officers’ influence began to wane. Within a year, Breit lost his access to the board. Fakahany seemed to view the 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 explains. A number of good risk managers either left Merrill Lynch or became traders.

  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 sent Merrill’s CFO, Jeff Edwards, a letter of resignation and he left the firm.

  He was away for only a few months, however. Late that spring, one of the fixed-income desks suffered a big loss. 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. Although Breit rejoined the firm’s risk oversight committee, he had no real authority within the firm. 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. Once Semerci took over, everything changed. The spy network dried up. Dow Kim, who wanted to leave and start a hedge fund—O’Neal had asked him to stay after the Kronthal firing—was losing interest. (He would leave the following spring.) Breit got tossed off the risk committee. 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, like virtually everyone else at Merrill Lynch, Breit had no idea what Semerci was doing with Merrill’s CDO business. 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.

  Toward the end of 2006, Merrill Lynch took a final step in its ongoing quest to be the dominant Wall Street player in subprime mortgages. It finally bought that mortgage originator O’Neal had been hankering for. The company was First Franklin, a unit of National City Corporation that had made $29 billion in mortgage loans the year before, virtually all of them subprime.12 The purchase price was $1.3 billion. Now Merrill would have its own source of mortgages that it could securitize to its heart’s content. Or so the company hoped.

  The Merrill executive who had been handed the job of landing a mortgage company for Merrill was Michael Blum. In truth, Blum was not a big fan of the First Franklin purchase, though he had dutifully completed it. In 2005, he and his staff held a meeting with O’Neal to lay out Merrill’s possible options for getting into the mortgage origination business. O’Neal was eager to get going; Lehman Brothers already made four times what Merrill made in mortgages, in part because it owned BNC Mortgage, the eighth largest subprime company in the country. Blum thought the firm should start up its own originator rather than buy one. “Buying something will be painf
ul because they are not well-managed companies and they are at the bottom of the food chain,” he told O’Neal, according to people who were in the meeting.

  O’Neal asked him how long it would take to build a subprime company from the ground up. Three or four years, replied Blum. O’Neal gave Blum a steely look. “I’m fifty-four fucking years old,” he replied, “and I don’t have three or four years.”

  Blum was also astounded by the price Merrill was willing to pay. (After the deal was announced, David Daberko, National City’s CEO, told Dow Jones News Service that the deal “is exactly what we were hoping for.”) But Merrill was so eager to get in the game that it would likely have paid even more; Blum could take comfort only in the fact that it wasn’t New Century. First Franklin was supposed to be one of the better-run subprime companies.

  Almost immediately after the deal was completed, First Franklin began taking losses. Like all the subprime originators, it had kept the residuals and posted gains that reflected an optimistic estimate of their value. Now, as delinquencies rose, those gains were being reversed. In a meeting in January 2007, as Blum was going through the losses in the residuals book, Dow Kim suddenly looked up from his BlackBerry with some news. “Lehman Brothers just had a record quarter in mortgages,” he said, according to someone at the meeting. “I guess they’re just smarter than we are,” Blum replied.

  And so it went. In a February meeting, Blum and his team argued that delinquencies were likely to get worse. He wanted Merrill to start hedging its exposure. Dale Lattanzio, whom Semerci had installed to run the CDO business after Ricciardi, brought out a series of charts, using the 1998 Long-Term Capital Management failure as his worst-case scenario. If something like that were to happen, he said, Merrill could lose as much as $70 million. Anything short of that scenario, the firm would be fine.