Andrew Sorkin - Too Big to Fail - The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

By 2000, however, the “thundering herd ” had become the “phlegmatic herd”—a bit too fat and complacent. The firm had gone on a shopping binge in the 1990s, accelerating its global expansion and swelling its workforce to 72,000 (compared to the 62,700 of its closest rival, Morgan Stanley). Meanwhile, its traditional power base, the retail brokerage business, was being undercut by the rise of discount online brokerage firms like E*Trade and Ameritrade. And because much of Merrill Lynch’s investment banking business was predicated on volume, not profits, the dot-com crash in the stock market the previous year had left Merrill vulnerable, exposing its high costs and thin margins.

The man tasked with shrinking Merrill back to a manageable size was O’Neal. Although colleagues had urged him to proceed slowly, especially in light of the trauma of 9/11, in which Merrill had lost three of its employees, O’Neal plowed ahead with little regard for the effects of downsizing on the firm’s morale and culture. Within a year, Merrill’s workforce had been cut by an astonishing 25 percent, a loss of more than 15,000 jobs.

“I think this is a great firm—but greatness is not an entitlement,” O’Neal remarked at the time. “There are some things about our culture I don’t want to change … but I don’t like maternalism or paternalism in a corporate setting, as the name Mother Merrill implies.”

The management turnover that accompanied his ascension was likewise startling: Even before he officially became chief executive in December 2002, almost half of the nineteen members of the firm’s executive committee were gone. It became clear that O’Neal would force out anyone whom he had any reason to distrust. “Ruthless,” O’Neal would tell associates, “isn’t always that bad.”

If a colleague dared stand up to him, O’Neal was famous for fighting back. When Peter Kelly, a top Merrill Lynch lawyer, challenged him about an investment, O’Neal called security to have him physically removed from his office. Some employees began referring to O’Neal’s top-management team as “the Taliban” and calling O’Neal “Mullah Omar.”

As well as by vigorous cost cutting, O’Neal had plans to make Merrill great again through redirecting the firm into riskier but more lucrative strategies. O’Neal’s model for this approach was Goldman, which had begun aggressively making bets using its own account rather than simply trading on behalf of its clients. He zealously tracked Goldman’s quarterly numbers, and he would hound his associates about performance. As it happened, O’Neal lived in the same building as Lloyd Blankfein, a daily reminder of exactly whom he was chasing. Blankfein and his wife had come to jokingly refer to O’Neal as “Doppler Stan,” because whenever they’d run into him in the lobby, O’Neal would always keep moving, often walking in circles, they thought, to avoid having a conversation.

O’Neal did force through a transformation of Merrill that, in its first few years, resulted in a bonanza. In 2006, Merrill Lynch made $7.5 billion from trading its own money and that of its clients, compared with $2.6 billion in 2002. Almost overnight, it became a major player in the booming business of private equity.

O’Neal also ramped up the firm’s use of leverage, particularly in mortgage securitization. He saw how firms like Lehman were minting money on investments tied to mortgages, and he wanted some of that action for Merrill. In 2003 he lured Christopher Ricciardi, a thirty-four-year-old star in mortgage securitization, from Credit Suisse. Merrill was an also-ran in the market for collateralized debt obligations, which were often built with tranches from mortgage-backed securities. In just two years Merrill became the biggest CDO issuer on Wall Street.

Creating and selling CDOs generated lucrative fees for Merrill, just as it had for other banks. But even this wasn’t enough. Merrill sought to be a full-line producer: issuing mortgages, packaging them into securities, and then slicing and dicing them to CDOs. The firm began buying up mortgage servicers and commercial real estate firms, more than thirty in all, and in December 2006, it acquired one of the biggest subprime mortgage lenders in the nation, First Franklin, for $1.3 billion.

But just as Merrill began moving deeper into mortgages, the housing market started to show its first signs of distress. By late 2005, with prices peaking, American International Group, one of the biggest insurers of CDOs through credit default swaps, stopped insuring securities with any subprime tranches. Ricciardi, meanwhile, having built Merrill into a CDO powerhouse, left Merrill in February 2006 to head a boutique investment firm, Cohen Brothers. With his departure, Dow Kim, a Merrill executive, sought to rally those who stayed behind on the CDO front. Merrill, he promised, would maintain its ranking as the top CDO issuer, doing “whatever it takes.” One deal Kim put together was something he called Costa Bella—a $500 million CDO, for which Merrill received a $5 million fee.

But Jeffrey Kronthal, a Merrill executive who had helped recruit Ricciardi to Merrill, had been growing increasingly concerned that a storm was threatening not just extravagant projects like Costa Bella, but the entire CDO market, and he began to urge caution. He insisted the firm maintain a $3 billion ceiling on CDOs with subprime tranches. Kronthal’s wariness put him directly in the path of O’Neal’s ambition to be the mortgage leader on Wall Street—a situation that was clearly untenable. In July 2006, Kronthal, one of its most able managers of risk, was out, replaced by thirty-nine-year-old executive Osman Semerci, who worked in Merrill’s London office. Semerci was a derivatives salesman, not a trader, and had had no experience in the American mortgage market.

Despite its ongoing management turmoil, Merrill Lynch kept ratcheting up the volume of its mortgage securitization and CDO business. By the end of 2006, however, the market for subprime mortgages was perceptibly unraveling—prices were falling, and delinquencies were rising. Even after it should have recognized an obvious danger signal when it was no longer able to hedge its bets with insurance from AIG, Merrill churned out nearly $44 billion worth of CDOs that year, three times the total of the previous year.

If they were worried, however, Merrill’s top executives didn’t show it, for they had powerful incentive to stay the course. Huge bonuses were triggered by the $700 million in fees generated by creating and trading the CDOs, despite the fact that not all of them were sold. (Accounting rules allowed banks to treat a securitization as a sale under certain conditions.) In 2006, K im took home $37 million; Semerci, more than $20 million; O’Neal, $46 million.

In 2007, Merrill kept its foot firmly on the gas pedal, underwriting more than $30 billion worth of CDOs in the first seven months of the year alone. With his bets paying off so incredibly well, though, O’Neal had overlooked one critical factor—he hadn’t made any preparations for an inevitable downturn, having never paid much attention to risk management until it was too late. Merrill did have a department for market risk and another for credit risk, though neither reported directly to O’Neal; they were the responsibility of Jeffrey N. Edwards, the chief financial officer, and of Ahmass Fakahany, the chief administrative officer, a former Exxon financial analyst and an O’Neal favorite.

Before long, however, the fault lines started to show. Kim, who oversaw the mortgage division, announced in May that he was leaving the firm to start a hedge fund. Responding to doubts voiced by some of their colleagues that the firm’s strategy could be sustained, Semerci and Dale Lattanzio became defensive. On July 21, at a meeting of the board, they insisted that the firm’s CDO exposure was nearly fully hedged; in a worst-case scenario, they maintained, the firm’s loss would amount to only $77 million. O’Neal stood up and praised the work of the two executives.