FCIC: Merrill Lynch hid $30.4 billion in mortgage securities

Written by Biloxi

In the Financial Crisis Inquiry Commission report , the panel focused on interviews with Merrill Lynch executives and power-point presentations that they produced that demonstrated that top Merrill Lynch officials knew the company was heavily exposed to collateralized debt obligations, a type of security often composed of the riskier portions of mortgage-backed securities, but did not disclose that information to investors. Merrill Lynch hid from analysts and investors that it had $30.4 billion in mortgage-related securities on its books as the financial crisis was about to explode. Merrill Lynch CEO Stanley O’Neal was "startled" by that amount according the commission's documents and interviews. Here is an excerpt of the findings from the commission report or FCIC report:

Former CEO O’Neal told FCIC investigators he had not known that the company


was retaining the super-senior tranches of the CDOs until [Dale] Lattanzio’s


[co-head of the American branch of the Fixed Income] presentation to the Finance


Committee. He was startled, if only because he had been under the impression that


Merrill’s mortgage-backed-assets business had been driven by demand: he had


assumed that if there were no new customers, there would be no


new offerings. If customers demanded the CDOs, why would Merrill have to retain


CDO tranches on the balance sheet? O’Neal said he was surprised about the retained


positions but stated that the presentation, analysis, and estimation of potential


losses were not sufficient to sound “alarm bells.” Lattanzio’s report in July


indicated that the retained positions had experienced only $73 million in losses.




Over the next three months, the market value of the super-senior tranches plummeted


and losses ballooned; O’Neal told the FCIC: “It was a dawning awareness


over the course of the summer and through September as the size of the losses were


being estimated.”




On October 21 , Merrill executives gave its board a detailed account of how the


firm found itself with what was by that time $15.2 billion in net exposure to the super-


senior tranches—down from a peak in July of $32.2 billion because the firm had


increasingly hedged, written off, and sold its exposure. On October 24, Merrill announced


its third-quarter earnings: a stunning $7.9 billion mortgage-related writedown


contributing to a net loss of $2.3 billion. Merrill also reported—for the first


time—its $15.2 billion net exposure to retained CDO positions. Still, in their conference


call with analysts, O’Neal and Edwards refused to disclose the gross exposures,


excluding the hedges from the monolines and AIG. “I just don’t want to get into the


details behind that,” Edwards said. “Let me just say that what we have provided


again we think is an extraordinarily high level of disclosure and it should be sufficient.”


According to the Securities and Exchange Commission, by September 2007,


Merrill had accumulated $55 billion of “gross” retained CDO positions, almost four


times the $15.2 billion of “net” CDO positions reported during the October 24 conference


call.


On October 30, when O’Neal resigned, he left with a severance package worth


$161.1 million—on top of the $91.4 million in total compensation he earned in


2006, when his company was still expanding its mortgage banking operations.

However, the FCIC panel  revealed in its report that Merrill Lynch executives first officially informed its board about the CDOs the company had been accumulating in a July 22 meeting with directors.

And the FCIC report shared this interesting nugget of the Bank of America-Merrill Lynch merger on how then Bank of America CEO Ken Lewis tried to back of the merger deal and how he didn't learn of Merrill Lynch's loss beofre shareholders' vote. Here is the story:

The following Monday - Sept. 15, 2008 - Bank of America officially announced it would buy another shaky investment bank, Merrill Lynch, leaving Lehman to collapse.


The deal was troubled from the moment it was conceived. That week, nervous investors started yanking money out of Merrill and other investment banks in favor of large commercial banks like JPMorgan Chase, which were seen as safer and more liquid, according to the FCIC report.


Lewis tried to back out of buying Merrill in December, after Merrill's projected quarterly losses mounted from an estimated $5 billion to $12 billion. Lewis told the FCIC, as he has told a House committee and the New York attorney general's office, that he didn't learn until Dec. 14 that Merrill's losses had accelerated so dramatically - in other words, nine days after he asked shareholders to vote on the deal.


In his testimony, [then Merrill Lynch CEO John] Thain told the FCIC that Merrill provided daily profit and loss reports to Bank of America and that bank executives should have known about losses as they occurred. In 2009, Bank of America paid $150 million to settle regulators' claims that they didn't properly inform shareholders about problems at Merrill.


Lewis had to approach Paulson and Fed chairman Ben Bernanke when he wanted out of the Merrill deal, and when they protested, Lewis eventually backed off. Lewis says he didn't tell Thain or anyone else at Merrill about the deliberations because he didn't want to create an "adversarial relationship" if he didn't have to, he told the FCIC.

In the end, Bank of America acquired Merrill Lynch with the assistance of government-bailout money during the height of the financial crisis in 2008. Yet, Merrill hid billions in mortgage securities from the investors. Bank of America has two albatrosses that will be costly to the company: Merrill Lynch and Countrywide. The loser from these deals are the investors that will be left holding the bag.