Book Excerpt: Chain of Blame

When E. Stanley O'Neal was promoted to CEO of Merrill Lynch in the summer of 2002, he aimed to change the perception among institutional investors that the firm even though it had 15,000 retail brokers worldwide was solely an expert in selling stocks. More than anything else, O'Neal, a native of Alabama and the only African-American ever to head a traditional Wall Street firm, wanted to expand the

When E. Stanley O'Neal was promoted to CEO of Merrill Lynch in the summer of 2002, he aimed to change the perception among institutional investors that the firm — even though it had 15,000 retail brokers worldwide — was solely an expert in selling stocks. More than anything else, O'Neal, a native of Alabama and the only African-American ever to head a traditional Wall Street firm, wanted to expand the firm's presence in corporate finance — and bonds in particular.

“He came from the bowels of the organization,” said [Countrywide CEO] Angelo Mozilo, who counted O'Neal among his friends. (Countrywide was a corporate client of Merrill Lynch, borrowing money through commercial paper and warehouse lines. At various points in its history, Merrill had raised equity for Mozilo's company.)

Unlike many of his CEO predecessors at Merrill, O'Neal didn't start out at the firm as a retail stockbroker. Like Mozilo, the new Merrill CEO came from humble beginnings. His grandparents were slaves, his parents farmers. O'Neal himself worked on the assembly line at General Motors before moving up into the automaker's finance department and attending Harvard Business School, paid for by GM. “When Stan came in, there was a lot of angst in the organization,” said Mozilo. “Stan came from corporate.”

Two factions developed at Merrill: corporate, where O'Neal had worked, and equities. Shortly after taking over, O'Neal moved to cut costs, and eliminated 24,000 positions, including hundreds of middle managers and senior executives he considered unessential. It was one of the biggest housecleanings ever on Wall Street — and had nothing to do with a market correction.

Pat Flood of HomeBanc Mortgage remembered the housecleaning well. He had been selling millions of dollars' worth of mortgages to Merrill's trading desk in New York. The relationship went back at least five years. “When O'Neal came in, the message we got from Merrill was that they didn't know what they were going to be doing in mortgages, ” he said. “There was a lull there for a while, and during that lull Bear Stearns started paying up for our loans.” So long Merrill. Hello Bear.

During that lull it didn't take O'Neal long to realize one central fact about the bond market. As a financier who headed corporate finance (lending money to companies and markets), he quickly did the math and came to know what every other top player in mortgages already had ingrained in their memory banks: Residential mortgages represented the largest debt market not only in the United States but in the entire world. Americans owed $8 trillion on their homes — even more than the federal government owed on all its Treasury bonds (even with record deficits during the Bush years). And with Fannie Mae and Freddie Mac ailing, subprime volumes were taking off. In 2000, Wall Street firms had securitized $74 billion in subprime ABSs, or just 7 percent of all home loans originated that year.

Two years later that figure had more than tripled to $233 billion in ABSs. When Bill Dallas [First Franklin founder and CEO; founder of Ownit Mortgage Solution, part owned by Merrill] looked at the league tables that year, Merrill Lynch was ranked fourth from the bottom with just $8 billion in subprime securitizations. According to Dallas, who had been in meetings with O'Neal, the new CEO of Merrill Lynch was not happy about his company's standing in the league tables. “They wanted in — in a big way,” he said. “They felt left out.”

But to get into mortgages, Merrill was missing two essential ingredients: an aggressive trading desk with salespeople and traders who could court firms like Dallas' Ownit; his former shop, First Franklin; as well as every other subprime lender, many of which had their headquarters in Orange County. Almost every Wall Street firm that ranked high in the securitization league tables had loan traders or salespeople who were well known among the lenders they were buying loans from.

At Lehman Brothers there were Tim Fitzpatrick and Matt Miller. At Bear Stearns there were Mike Nierenberg and Jeff Verschleiser, with Baron Silverstein assisting on sales; at Deutsche Bank, Michael Commaroto and Paul Mangione, with John Groesbeck on sales; at Nomura Securities, Steve Katz; at Citigroup, Jeff Perlowitz was in charge of the desk. It was a club, and if they didn't personally know one another, they were, at the very least, aware of who the competition might be across town or two blocks to the south.

Traders, in the words of former Nomura executive Neil Spagna, “live in a small world” but control a huge business: mortgages. As Spagna once noted, “The traders put the deals together; they run the business. They're the ones responsible for the P & L.”

GOING FOR BROKE

According to Dallas and others, O'Neal's message to Merrill's mortgage department was clear: Go after the subprime business. Be number one. By 2004 Merrill began to move up in the ABS league table rankings. It was in that year that Countrywide's capital markets group, Countrywide Securities Corporation, blew away the competition, securitizing $72 billion in subprime and nonprime loans. Mozilo, who at first had resisted the subprime business, was now the chairman and CEO of not only the largest prime lender, but the fastest growing subprime originator — plus the top securitizer of non-Fannie/Freddie loans.

O'Neal grew anxious about the business. He felt he was missing the boat. “Stan didn't want to get left behind,” said Mozilo. According to Bill Dallas, O'Neal shoved aside the senior manager in charge of the mortgage department, replacing him with Michael Blum, who carried the title of managing director in charge of global asset-based finance.

It was the job of Blum and his team to take pools of receivables (loans or similar debt instruments), including mortgages, credit cards, car loans, and even loans made to movie studios, and turn them into “investments for sophisticated investors.” Sophisticated investors meant institutional investors — pension funds, insurance companies, and overseas banks and governments. Investments meant bonds. The message Dallas heard from O'Neal and the traders he was beginning to work with at Merrill was that the nation's number-one seller of retail stocks not only wanted to be number one in residential ABSs, but wanted to be number one worldwide. “Stan was the one driving it,” said Dallas.

With Blum now in charge of Merrill's mortgage effort, things began to change. In April 2004 Merrill hired a trader named George Davies to help ramp up the volume of loans coming through the firm's trading desk. One subprime executive who did business with Merrill remembered getting a phone call from Davies in 2004. “Merrill was on the prowl then,” said the executive. “Davies called me up and said, ‘We're buying.’” And buy Merrill did. But it wasn't just the fact that Merrill was now in the market, getting the word out to every subprime lender that would listen; it began paying more for loans than every other Street firm. In the lingo of mortgage trading, a loan bought at par is sold for 100 cents on the dollar. But during the subprime boom of 2002 to 2006, no lenders in their right mind would accept par for their loans.

The idea was to get as much as they could — 102, 103, 104, sometimes even 105 cents on the dollar. (This was a great deal for originators like Dallas' Ownit Mortgage, because not only was the company making points and fees from the consumer getting the loan, it was also getting a premium from Wall Street.)

If Merrill Lynch agreed to buy a $100,000 subprime mortgage for 105 cents on the dollar, that meant the originator of that loan would receive $105,000 back from Merrill. Merrill and other investment banks, by practice, rarely bought one loan at a time — they bought them in huge pools. (A pool consists of many mortgages, totaling tens of millions, if not hundreds of millions, of dollars.) Why would the Street pay $105,000 for a loan that had a principal balance of only $100,000?

There were two reasons: First, subprime mortgages carried higher interest rates than Fannie/Freddie loans, so investors would find the subprime bonds more attractive because of the higher yield and pay up for them. The other reason had to do with interest payments. During the first seven years of a loan, consumers pay mostly interest, and even on a $100,000 loan that can add up to thousands of dollars over time.

Some of the loans the Street were buying carried prepayment penalties where the consumer was charged a large fee for refinancing the mortgage. When it came to subprime, the ultimate quest of Merrill, Bear, and the other firms was to create a bond that could be sold to another investor. Bond investors don't like surprises — but they do like yield.

To entice Bill Dallas and other subprime executives into selling their loans to Merrill, its salesmen offered them a deal: If you agree to sell your loans to us, we'll offer warehouse financing for next to nothing. Merrill's warehouse chief was Jim Cason, who had been with the firm for a couple of years. With O'Neal's edict to grow the firm's subprime business, Cason's unit, by 2005, became one of the largest warehouse lenders to nonbank residential lenders in the nation. “The idea was to create a one-stop shopping place for subprime lenders,” said one warehouse executive familiar with Merrill's effort.

“Merrill would make no money on their warehouse business, but it would do it to get the securitization business.” As George Davies, the head trader, later admitted: “The idea was to secure product [mortgages].”

By the time 2005 ended, Merrill was the seventh largest issuer of subprime ABSs in the United States out of a growing field that now included 25 securities underwriters. That year Merrill had bought and securitized $30 billion in subprime mortgages, and was just a few billion dollars behind its archrivals, Bear Stearns and Countrywide.

Even Washington Mutual, a thrift, had started a capital markets group to securitize all the subprime loans being funded by its Long Beach Mortgage subsidiary, the company it had bought a decade earlier, just 19 months after Arnall spun it off in an initial public offering (IPO). In April 2006 George Davies was hired away by WaMu, which was beginning to have its own ideas about becoming a major player in subprime securitizations. (“It was considered a major coup when we landed Davies,” noted one WaMu senior vice president.) Replacing Davies as head trader was John O'Grady.

O'Grady, said one Irvine-based mortgage executive, was “gung-ho and bullish for subprime.” He took O'Neal's edict on ABSs and ran with it. O'Grady didn't give the warm and fuzzies to some of the origination executives he was dealing with at the subprime shops, but most hardly cared — as long as Merrill kept paying more than anyone else for loans. “O'Grady looks like William F. Buckley with those glasses of his and all,” said one manager who traded with him. “It was like he was talking at you, but as long as they were bidding stuff up we sold to them. We had a name for O'Grady — we called him ‘The Irishman.’ He had to sign off on any deal [trade] over $50 million.”

SUBPRIME BECOMES PRIMETIME

By 2005, unbeknownst to most American borrowers, a handful of Wall Street firms had been in the business of actually originating residential loans for well over a decade. It was a well-kept secret — outside the mortgage industry, that is — because that's the way Wall Street wanted it. The last thing the brokerage side of Lehman Brothers needed was its equities business to be marred by negative headlines about its residential loan unit.

In the previous decade Lehman had launched a residential loan division called Aurora Loan Services, headquartered in the Denver suburb of the same name. Bear Stearns was also in the business through a company called EMC Mortgage of Irving, Texas. No one at Bear even knew what the initials EMC meant, but the going joke was that it stood for “Ed's Mortgage Company.” Ed was Ed Raice, EMC 's president.

EMC was born in the ashes of the savings and loan (S&L) crisis and was started as a way for Bear to invest in delinquent residential and apartment loans from the government. Over time, as the S&L crisis waned, EMC morphed into a subprime lender. Working in tandem with its parent, Bear Stearns, EMC originated its own loans but also bought large bulk packages of mortgages through such lenders as New Century and Option One Mortgage. The mortgages — to no one's surprise — were securitized by Bear's capital markets group in New York. Oh, and there was one other thing: EMC and Aurora didn't exactly have retail loan offices where a home buyer could walk in off the street and fill out a loan application. Both lenders originated mortgages only through loan brokers and small mortgage banking firms (mostly nonbanks) called correspondents. Having retail employees to pay would result in more full-time equivalents (FTEs) on the payroll — and that would, of course, eat into a managing director's bonus money.

Merrill Lynch also owned a mortgage company, but unlike Bear and Lehman it actually put its own name on the subsidiary and wanted everyone to know it — as long as they were a client of the firm's retail brokerage unit. And being that Merrill had 15,000 stockbrokers, chances were high-net-worth individuals (rich people) who bought and sold stocks through the Wall Street giant knew about it. Based in Jacksonville, Florida, Merrill Lynch Mortgage Capital, managed for many years by CEO Larry Washington, specialized in making mortgages to its own brokerage clients — people with (presumably) very good credit.

“They were going after high-net-worth individuals who were clients of its brokerage business,” noted Mozilo. To many who worked at Merrill in the [David] Komansky or [Dan] Tully eras [both predecessors to O'Neal], the idea that Merrill would originate subprime loans (much less lend money to nonbanks that played in the hard-money arena) was anathema. Merrill Lynch was about catering to the rich — not making mortgages to home buyers who lived from paycheck to paycheck. All that changed in October 2005 when Merrill revealed that it had invested $100 million in Bill Dallas's latest venture in subprime lending, Ownit Mortgage Solutions of Woodland Hills, California.

“Stan wanted to be in the direct origination business,” remembered Dallas, who, along with his partners at CIVC Partners of Chicago [an investor in First Franklin, eventually bought by Merrill] were happy to take O'Neal's money. “They came and valued us at $500 million.” Suddenly, Merrill not only was in the business of lending to rich people (its clients) but now also owned 20 percent of Ownit, the youngest and fastest growing subprime lender in the nation. Dallas and his partners were hoping that Ownit, on track to fund $8.2 billion that year, would turn out to be another First Franklin, which under National City was coming off a $30 billion origination year. Merrill placed Mike Blum, the managing director in charge of global asset-based finance, on Ownit's board. As one Ownit executive noted: “Blum was intimately involved with us.” Merrill was now on the hunt to purchase stakes in other subprime lenders as well.

Alexander “Zan” Hamilton, a former investment banker in the mortgage group of Credit Suisse, recalled sitting in the executive dining room with Merrill's Mike Blum in New York, listening to him talk about the firm's plans to buy stakes in other subprime lenders as well. “It was all about the trading desk owning the originators,” said Hamilton.

In 2003 Hamilton left Wall Street and became CEO of LIME Financial Services of Lake Oswego, Oregon, a nonbank mortgage lender started by Fred Baldwin, a former partner of Bill Dallas. Dallas had merged an early incarnation of First Franklin into Baldwin's company, Trillium Mortgage. Prior to the merger, Dallas's First Franklin was an “A” paper lender only. Trillium was subprime. “Fred was the guy who taught Bill how to make subprime loans,” said Hamilton.

Meanwhile, Mozilo and O'Neal had become friends, serving on the President's Business Council and occasionally playing golf together. (In some press reports O'Neal, a member of at least four country clubs, had been described as a golf fanatic. His handicap was nine.) To those who knew him, O'Neal could be standoffish and had a reputation at times of being a bit of a loner, but he and Mozilo had a common bond: the mortgage business. Some analysts had even speculated that “Mother Merrill” (as the firm was once called for its maternal nurturing of executives) might even buy Countrywide.


Excerpted with permission from the publisher, John Wiley & Sons, Inc., from Chain of Blame. Copyright © 2008 by Paul Muolo and Mathew Padilla.

“Merrill would make no money on their warehouse business, but it would do it to get the securitization business.” As George Davies, the head trader, later admitted: “The idea was to secure product [mortgages].”

By the time 2005 ended, Merrill was the seventh largest issuer of subprime ABSs in the United States out of a growing field that now included 25 securities underwriters. That year Merrill had bought and securitized $30 billion in subprime mortgages, and was just a few billion dollars behind its archrivals, Bear Stearns and Countrywide.

Even Washington Mutual, a thrift, had started a capital markets group to securitize all the subprime loans being funded by its Long Beach Mortgage subsidiary, the company it had bought a decade earlier, just 19 months after Arnall spun it off in an initial public offering (IPO). In April 2006 George Davies was hired away by WaMu, which was beginning to have its own ideas about becoming a major player in subprime securitizations. (“It was considered a major coup when we landed Davies,” noted one WaMu senior vice president.) Replacing Davies as head trader was John O'Grady.

O'Grady, said one Irvine-based mortgage executive, was “gung-ho and bullish for subprime.” He took O'Neal's edict on ABSs and ran with it. O'Grady didn't give the warm and fuzzies to some of the origination executives he was dealing with at the subprime shops, but most hardly cared — as long as Merrill kept paying more than anyone else for loans. “O'Grady looks like William F. Buckley with those glasses of his and all,” said one manager who traded with him. “It was like he was talking at you, but as long as they were bidding stuff up we sold to them. We had a name for O'Grady — we called him ‘The Irishman.’ He had to sign off on any deal [trade] over $50 million.”

SUBPRIME BECOMES PRIMETIME

By 2005, unbeknownst to most American borrowers, a handful of Wall Street firms had been in the business of actually originating residential loans for well over a decade. It was a well-kept secret — outside the mortgage industry, that is — because that's the way Wall Street wanted it. The last thing the brokerage side of Lehman Brothers needed was its equities business to be marred by negative headlines about its residential loan unit.

In the previous decade Lehman had launched a residential loan division called Aurora Loan Services, headquartered in the Denver suburb of the same name. Bear Stearns was also in the business through a company called EMC Mortgage of Irving, Texas. No one at Bear even knew what the initials EMC meant, but the going joke was that it stood for “Ed's Mortgage Company.” Ed was Ed Raice, EMC 's president.

EMC was born in the ashes of the savings and loan (S&L) crisis and was started as a way for Bear to invest in delinquent residential and apartment loans from the government. Over time, as the S&L crisis waned, EMC morphed into a subprime lender. Working in tandem with its parent, Bear Stearns, EMC originated its own loans but also bought large bulk packages of mortgages through such lenders as New Century and Option One Mortgage. The mortgages — to no one's surprise — were securitized by Bear's capital markets group in New York. Oh, and there was one other thing: EMC and Aurora didn't exactly have retail loan offices where a home buyer could walk in off the street and fill out a loan application. Both lenders originated mortgages only through loan brokers and small mortgage banking firms (mostly nonbanks) called correspondents. Having retail employees to pay would result in more full-time equivalents (FTEs) on the payroll — and that would, of course, eat into a managing director's bonus money.

Merrill Lynch also owned a mortgage company, but unlike Bear and Lehman it actually put its own name on the subsidiary and wanted everyone to know it — as long as they were a client of the firm's retail brokerage unit. And being that Merrill had 15,000 stockbrokers, chances were high-net-worth individuals (rich people) who bought and sold stocks through the Wall Street giant knew about it. Based in Jacksonville, Florida, Merrill Lynch Mortgage Capital, managed for many years by CEO Larry Washington, specialized in making mortgages to its own brokerage clients — people with (presumably) very good credit.

“They were going after high-net-worth individuals who were clients of its brokerage business,” noted Mozilo. To many who worked at Merrill in the [David] Komansky or [Dan] Tully eras [both predecessors to O'Neal], the idea that Merrill would originate subprime loans (much less lend money to nonbanks that played in the hard-money arena) was anathema. Merrill Lynch was about catering to the rich — not making mortgages to home buyers who lived from paycheck to paycheck. All that changed in October 2005 when Merrill revealed that it had invested $100 million in Bill Dallas's latest venture in subprime lending, Ownit Mortgage Solutions of Woodland Hills, California.

“Stan wanted to be in the direct origination business,” remembered Dallas, who, along with his partners at CIVC Partners of Chicago [an investor in First Franklin, eventually bought by Merrill] were happy to take O'Neal's money. “They came and valued us at $500 million.” Suddenly, Merrill not only was in the business of lending to rich people (its clients) but now also owned 20 percent of Ownit, the youngest and fastest growing subprime lender in the nation. Dallas and his partners were hoping that Ownit, on track to fund $8.2 billion that year, would turn out to be another First Franklin, which under National City was coming off a $30 billion origination year. Merrill placed Mike Blum, the managing director in charge of global asset-based finance, on Ownit's board. As one Ownit executive noted: “Blum was intimately involved with us.” Merrill was now on the hunt to purchase stakes in other subprime lenders as well.

Alexander “Zan” Hamilton, a former investment banker in the mortgage group of Credit Suisse, recalled sitting in the executive dining room with Merrill's Mike Blum in New York, listening to him talk about the firm's plans to buy stakes in other subprime lenders as well. “It was all about the trading desk owning the originators,” said Hamilton.

In 2003 Hamilton left Wall Street and became CEO of LIME Financial Services of Lake Oswego, Oregon, a nonbank mortgage lender started by Fred Baldwin, a former partner of Bill Dallas. Dallas had merged an early incarnation of First Franklin into Baldwin's company, Trillium Mortgage. Prior to the merger, Dallas's First Franklin was an “A” paper lender only. Trillium was subprime. “Fred was the guy who taught Bill how to make subprime loans,” said Hamilton.

Meanwhile, Mozilo and O'Neal had become friends, serving on the President's Business Council and occasionally playing golf together. (In some press reports O'Neal, a member of at least four country clubs, had been described as a golf fanatic. His handicap was nine.) To those who knew him, O'Neal could be standoffish and had a reputation at times of being a bit of a loner, but he and Mozilo had a common bond: the mortgage business. Some analysts had even speculated that “Mother Merrill” (as the firm was once called for its maternal nurturing of executives) might even buy Countrywide.


Excerpted with permission from the publisher, John Wiley & Sons, Inc., from Chain of Blame. Copyright © 2008 by Paul Muolo and Mathew Padilla.

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish