Wednesday, April 16, 2008

Merrill Lynch what were you thinking (or not)?

The WSJ has a wonderful narrative today of how Merrill Lynch managed to get so badly hit by the mortgage-bond crisis: apparently it's going to take even more write-downs in the first quarter, making an unprecedented three successive quarterly losses. So much for the kitchen sink theory.

The story in short:

Merrill was making a lot of money structuring mortgage-backed bonds. The junky bits were popular, the super-senior tranches at the top of the waterfall, less so, and the risk there had to be laid off to insurer AIG. But at the end of 2005, AIG said it didn't want that risk any more. What did Merrill do? It simply self-insured, keeping those super-senior tranches for itself. That was the first mistake.

The MBS business was now riskier than ever for Merrill, because it was putting its own balance sheet at risk with each deal. So how did Merrill respond to the extra risk? By doing even more deals. That was mistake number two.

With all the new deals, Merrill's internal risk officers started getting worried. And how did Merrill respond to such concerns? By overruling the risk officers. Mistake three.

It wasn't just the risk officers who were worried, however: the bond desk was worried too. Merrill's response bond traders and executives like Jeffrey Kronthal who wanted to throttle back on the MBS business? It fired them. Mistake four.

Eventually, the MBS market started falling, and Merrill started "de-risking". Except instead of just selling risky assets, Merrill decided that the smart move would be to bundle them up into CDOs, sell off the risker tranches of the CDOs, and hold on to the safer bits. Mistake five.

When the CDO market dried up, Merrill moved to Plan B: simply insuring its assets against default. But its counterparty of choice, XL Capital, didn't want the business. And neither did MBIA. So Merrill turned to tiny ACA, an insurer with just $400 million of capital underpinning $60 billion of insured securities. Mistake six.

And that's just the big mistakes which managed to make it into the WSJ's story. Yes, it's a catalogue of incomeptence and nearsightedness and greed. But it's also a cautionary tale: if this can happen to Merrill, it can, realistically, happen to any investment bank. Financial services is a risky business to be in.

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