Originate-and-Don't-Distribute at Merrill Lynch
Jake Bernstein and Jesse Eisinger:
The ‘Subsidy’: How Merrill Lynch Traders Helped Blow Up Their Own Firm: Two years before the financial crisis hit, Merrill Lynch confronted a serious problem. No one, not even the bank's own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating. Bank executives came up with a fix... a new group within Merrill, which took on the bank's money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them....
Within Merrill Lynch, some traders called it a "million for a billion" -- meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as "the subsidy." One former executive called it bribery. The group was being compensated for how much it took, not whether it made money. The group, created in 2006, accepted tens of billions of dollars of Merrill's Triple A-rated mortgage-backed assets, with disastrous results. The value of the securities fell to pennies on the dollar.... What became of the bankers who created this arrangement and the traders who took the now-toxic assets? They walked away with millions. Some still hold senior positions at prominent financial firms....
Banks like Merrill bought pools of mortgages and bundled them into securities, eventually making them into CDOs. Merrill paid upfront for the mortgages, but this outlay was quickly repaid as the bank made the securities and sold them to investors.... Executives producing the securities were not allowed to buy much of their own product... decisions to hold a Merrill-created security for the long term were made by independent traders who determined, in essence, that the Merrill product was as good or better than what was available in the market....
A month before the group was created, Merrill Lynch owned $7.2 billion of the seemingly safe investments, according to an internal risk management report. By the time the CDO losses started mounting in July 2007, that figure had skyrocketed to $32.2 billion.... The origins of Merrill's crisis came at the beginning of 2006, when the bank's biggest customer for the supposedly safe assets -- the giant insurer AIG -- decided to stop buying the assets, known as "super-senior," after becoming worried that perhaps they weren't so safe after all.... By the middle of 2006, the Merrill traders who bought mortgage securities were often clashing with the powerful division, run by Harin De Silva and Ken Margolis, which created and sold the CDOs. At least three traders began to refuse to buy CDO pieces created by De Silva and Margolis' division, according to several former Merrill employees....
In late September, Merrill created a $1.5 billion CDO called Octans, named after a constellation in the southern sky. It had been built at the behest of a hedge fund, Magnetar, and filled will some of the riskier mortgage-backed securities and CDOs.... In an incident reported by the Wall Street Journal ($) in April 2008, a Merrill trader looked over the contents of Octans and refused to buy the super-senior, believing that he should not be buying what no one else wanted. The trader was sidelined and eventually fired.... The difficulty in finding buyers should have been a warning signal: If the market won't buy a product, maybe the bank should stop making it.
Instead, a Merrill executive, Dale Lattanzio, called a meeting, attended by among others the heads of the CDO sales group -- Margolis and De Silva -- and a trader, Ranodeb Roy. According to a person who attended the meeting, they discussed creating a special group under Roy to accept super-senior slices. (Lattanzio didn't respond to requests for comment.)... Roy had reservations about purchasing the super-senior pieces. In August 2006, he sent a memo to Lattanzio warning that Merrill's CDO business was flawed. He wrote that holding super-senior positions disregarded the "systemic risk" involved. When younger traders complained to him, Roy agreed it was unwise to retain the position. But he also told these traders that it was good for one's career to try to get along with people at Merrill, according to a former employee.... Roy and his team needed to be paid....
The agreement, according to a former executive with direct knowledge of it, generally worked like this: Each time Merrill's CDO salesmen created a deal, they shared part of the fee they generated with the special group that had been created to "buy" some of the CDO. A billion-dollar CDO generated about $7 million in fees for Merrill's CDO sales group. The new group that bought the CDO would usually be credited with a profit between $2 million and $3 million -- despite the fact that the trade often lost money.... [I]t is not typical, or desirable, to pay a group to do something against their financial interests or those of the bank....
Eventually, Merrill would write down about $26 billion worth of CDOs, including most of the assets that Ranodeb Roy and his team had taken from De Silva and Margolis...
