Merrill’s Reckless Mortgage Bond Binge

A page one story in the Wall Street Journal, “Merrill Upped Ante as Boom In Mortgage Bonds Fizzled,” tells the sorry tale of how the brokerage giant did so much damage to itself via a pathological disregard for risk at the very time when the mortgage markets were about to sour. The firm is still taking losses from this misadventure; it’s expected to announce an additional $6 to $8 billion in writedowns for the first quarter.

Some items have been recounted elsewhere, such as Merrill’s misguided determination that there wasn’t much risk in hanging on to super senior CDo tranches. But this detailed account of how the securities firm went pedal-to-the-metal in pursuing MBS-related earnings, with no regard for downside, is stunning. Anyone who has been in the securities industry (at least in the days when firms were private and run by partners who were putting their life savings on the line every day) will see a reckless dismantling of normal checks and protocols. The disastrous outcome was inevitable.

And the cause of what looks like colossal stupidity is simple: bad incentives. Why be prudent when shareholders have no influence on your pay and the higher ups look only at calendar year results? Even though the US and other societies have seen this movie before, we seem compelled to repeat our experience rather than learn from it. George Akerlof and Paul Romer described the pathology in a 1993 Brookings paper:

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values…

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters’ current extractions with no regard for future losses….”

The new wrinkle this time is that formal bankruptcy may not be the end game. Having the firms become wards of the state produces the same result.

From the Wall Street Journal:

The first tremor that rattled Merrill’s profitable business of underwriting mortgage securities came at the end of 2005. As it repackaged mortgage bonds into securities called collateralized debt obligations, or CDOs….. [a]n AIG unit bore the default risk of the CDOs’ largest and highest-rated chunk, known as the “super-senior” tranche….AIG at the end of 2005 stopped insuring mortgage securities…..

Instead of scaling back its underwriting of CDOs, however, Merrill put the business in overdrive. It began holding on its own books large chunks of the highest-rated parts of CDOs whose risk it couldn’t offload…. It generated $44 billion in CDOs in 2006 — triple its 2004 output. Although not able to sell the bulk of the CDOs, it collected about $700 million for underwriting and trading these and other structured products. And its top ranking was considered in the calculation of executives’ bonuses.

Risk controls at the firm, then run by CEO Stan O’Neal, were beginning to loosen. A senior risk manager, John Breit, was ignored when he objected to certain risks taken in underwriting Canadian deals, according to people familiar with the matter….Mr. Breit sent a letter of resignation to Merrill’s chief financial officer…

Some managers seen as impediments to the mortgage-securities strategy were pushed out….Jeffrey Kronthal, who had imposed informal limits on the amount of CDO exposure the firm could keep on its books ($3 billion to $4 billion) and on its risk of possible CDO losses (about $75 million a day). Merrill dismissed him and two other bond managers in mid-2006….

To oversee the job of taking CDOs onto Merrill’s own books, the firm tapped Ranodeb Roy, a senior trader but one without much experience in mortgage securitie…. This led to an inside joke at Merrill. Mr. Roy is known as Ronnie. Some employees took to saying that if they couldn’t find a specialized bond insurer, known as a “monoline,” to take Merrill’s risk on the deal, they could resort to a “Ronoline.”….

In August 2006, one Merrill trader fought back when managers pushed to have the firm retain $975 million of a new $1.5 billion CDO named Octans….

The result was a heated phone conversation with Merrill’s CDO co-chief, Harin De Silva, who was out of the office. Mr. De Silva urged the trader to accept the securities….The alternative was to let the deal fall apart, which would leave Merrill holding the risk of all the securities that would have backed the CDO.

In the end, Mr. Roy’s group took the $975 million of securities on the firm’s books….a step that helped the firm hold its top rank in CDO underwriting and led to an estimated $15 million in fee revenue…

Pressures rose in early 2007 as the housing bubble lost air. Merrill set out to reduce its exposure, in an effort referred to innocuously as “de-risking.”

It could have sold off billions of dollars’ worth of mortgage-backed bonds that it had stockpiled with the intention of packaging them into more CDOs. But with the market for such bonds slipping, Merrill would have had to record losses of $1.5 billion to $3 billion on the bonds, says a person familiar with the matter.

Instead, Merrill tried a different strategy: quickly turn the bonds into more CDOs.

Doing so was no longer a profitable enterprise….Still, executives believed that so long as all they retained on their books were super-senior tranches, they would be shielded from falls in the prices of mortgage securities….

In the first seven months of 2007, Merrill created more than $30 billion in mortgage CDOs, according to Dealogic, keeping Merrill No. 1 in Wall Street underwriting for this type of security.

By June, the market for mortgage securities was weakening faster. Two Bear Stearns Cos. hedge funds that invested in them were being forced by creditors — which included Merrill — to sell securities. That set prices tumbling across the credit markets. One Merrill trader recalls Dale Lattanzio, then co-manager of Merrill’s bond business, hustling around the firm’s football-field-sized trading floor ordering his traders to “sell everything — we’re too long.”

As the CDO business slid, Merrill’s top managers embarked on a new plan, referred to as the “mitigation strategy.” The aim was to find ways to hedge exposure through deals with bond insurers. This would reduce the size of write-downs Merrill would otherwise have to take.

Through August, Merrill insured $3.1 billion of CDOs against losses in a series of transactions with bond insurer XL Capital Assurance Inc.

In August, Merrill proposed that XL insure about $20 billion more of its CDO exposure….XL declined the additional business.

Merrill turned to another bond insurer, MBIA Inc. MBIA agreed to insure around $5 billion of the securities. But it wouldn’t cover interest payments; it would only cover principal payments when they come due in more than 40 years.

Continuing to scramble, Merrill got a tiny insurer called ACA Financial Guaranty Corp. to insure about $6.7 billion of its CDOs. The problem was that ACA was poorly capitalized. It was insuring more than $60 billion of debt securities — a third of which were mortgage-related — yet had only about $400 million of capital and few other resources to cover claims.

Some other firms, including Lehman Brothers Holdings Inc., had already set aside reserves against their hedges with ACA, concerned that ACA would be unable to cover losses on the bonds it insured. Lehman wrote down its exposure to ACA during the first half of 2007.

Merrill’s deals with the insurers helped it to show a reduction of about $11 billion in its CDO exposure in last year’s third quarter. Coupled with CDO-related write-downs of $6.9 billion in the quarter, this brought Merrill’s CDO exposure down to $15.8 billion, from $33.9 billion in June. The bond-insurer deals thus helped reduce Merrill’s third-quarter net loss, although it was a still-hefty $2.3 billion.

Even so, the numbers were worse than Merrill had previously indicated. In a late-October conference call with investors, Mr. O’Neal said that “we got it wrong by being overexposed to subprime” and that “both our assessment of the potential risk and mitigation strategies were inadequate.” Within days, he resigned as CEO.

In December, Standard & Poor’s cut its financial-strength rating of ACA to junk level. That forced Merrill to write down its CDO hedge with ACA by $1.9 billion in the fourth quarter, leaving questions about why it had turned to such a thinly capitalized partner.

XL Capital’s agreement to insure Merrill CDOs is embroiled in litigation. XL sought to walk away from the deal, contending Merrill had violated the terms. Merrill sued last month to force XL to honor the agreement.

In a countersuit, XL said the purpose of the bond-insurance deal was simply to enable Merrill to report that its CDO exposure was lower. “Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions,” the suit said. A spokesman for Merrill says XL “makes assumptions that are, very simply, wrong.”

Merrill’s new CEO, Mr. Thain, is seeking to regain investors’ trust by upgrading the firm’s risk controls. In one move, the firm in December rehired Mr. Kronthal, the risk-conscious bond executive Merrill had let go in 2006 when it was determined to increase its bet on CDOs. His new job: to help Merrill clean up its CDO mess.