So today there was a great headline on Bloomberg News, “O'Neal Deemed Subprime CEO as Mortgages Mar Merrill Earnings” Now the article is referring of course to the esteemed CEO of Merrill Lynch Stan O’Neal.
Merrill has recently disclosed that the company is taking nearly 5 BILLION of write downs due to their activities in sub prime mortgage lending.
Now a little backround to the story that makes it so beautiful. Stan O’Neal has been lauded, as recently as March 2007, as a true visionary and master of Wall Street. Stan obviously also believed this was the case since he paid himself $48mm clams in 2006.
That’s a lot of clams
Yes, yes it is.
Now back in April of 2007, when Merrill came out with blockbuster first quarter earnings, Stan stood up proudly in front of the world and essentially said that the growing subprime disaster was well contained and CERTAINLY was not a threat to his company’s earnings.
Which is when you and I fell off our chairs laughing.
Right!
Because we knew that at a bare minimum, these jokers had bought First Franklin, a huge subprime lender at the end of 2006 for a whopping $1.3bb.
And when they made the timely, strategic acquisition, subprime loans were already defaulting at a rapid pace. A lot of loans were defaulting right out of the shoot! We call it EPD or early payment defaults. We also call those loans “air loans” because the money lent just vanishes into THIN AIR!
Anyway, by March of 2007, First Franklin, the new crown jewel in Merrill’s empire…is worth ummm NOTHING.
Now, I don’t know about you but I only took a year of accounting in college, but when you buy something for $1.3bb and it ends up being worth…nothing. You’re supposed to take that loss thru earnings.
Or for Christsake at least mention in the earning release that the asset may be “impaired” and can result in big losses in the future.
But Merrill insisted that everything is fine and contained.
Yeah, contained, contained as in, “It’s all contained right in your freakin’ building pal!!!"
Right! Now if it was just First Franklin, it would still be bad, but of course it was a lot worse. See, right as the wheels started coming off the subprime bus, Merrill was aggressively “winning” market share to become the top underwriter of sub prime mortgage CDO’s. They did about $25bb in the first half of 2007.
Now, you might ask, “what the hell is a CDO?” Well lucky for you, Uncle Richie and Uncle Eric are here to explain to you.
First lets take the basic principals of how the Street makes money “Structuring Assets” And pay attention to this because this is how we..or now they, make the lion share of their dough.
And a CDO is a “structured asset.”
The basic principal is find a situation where you can take two dimes and sell them to somebody or somebodies for a quarter.
And once you have “found” such a situation you keep doing it over and over like a lab rat hitting a button that makes the food pellets keep coming out!
You are probably asking, “how is this possible?” “Why would some one pay a quarter for something that really is only worth 20 cents.” The better question is, “How does Wall Street figure out how to take something, restructure it, and then sell it for more than it is really worth?”
The answer might be:
Finding the dopes that will misprice risk and pay more for an asset than it is worth (we call this “The bigger idiot theory”).
Finding mismanaged and undermanned rating agencies that will rate what you are selling much higher than they should.
Finding gigantic pools of money that are just dying to get a decent return on their money and will kid themselves into believing that they are getting a great deal.
Or in the case of many hedge funds, structure securities for them in such a way that they will get an outsized return and their money back BEFORE everyone finds out that its really a scam!
Find cheap money, ready to be lent freely to your customers to buy your overpriced asset so they can “leverage” and get an even greater return on their investment.
Now, in the subprime housing game, we had all of these things in abundance. So VIOLA!! You have a CDO machine that’s taking many billions of garbage loans and selling them for profits of 100’s of millions !!!
This thing got so good that The Street created “Factories” or as we like to call them “sausage factories”.
The raw product (like sausages…pigs lips and assholes!) were the subprime loans, that the Street either bought from mortgage lenders, or better, loans that were made by their own mortgage companies.
In Merrill’s case, like we said, they bought their own mortgage company, so:
Step 1: The Street either makes or buys loans to poor credit borrowers. For our example lets say $1bb of loans
Step 2: The Street, through the magic of modeling, forecasting and mostly by greasing the rating agencies like Moody’s and S&P, and these rating agencies got GREASED. They get paid a fee to rate bonds and they were making money hand over fist.
Right! Record earnings for the rating agencies.
Anyway The Street manages to create the argument that if you put all these borrowers into a big pool, they will be diversified, meaning they all won’t default at the same time.
After all, they are different people. They live in different states. All real-estate is local (something Greenspan was fond of saying) meaning that even if some start defaulting in California, the lousy borrowers in Florida have no correlation to the poor bastards in California…so they don’t default…hence, “diversified”!
Oh, and lastly, REAL ESTATE PRICES NEVER FALL NATIONALLY …AGAIN BECAUSE EACH MARKET IS UNIQUE UNTO IT SELF they took it one step further and got the rating agencies to agree, housing prices, even locally, NEVER decline at all!
Step 3: With the rating agencies ready to bless 80% of “refuse” as AAA top quality, prime meat and 15% as “pretty good quality chow” The Street is off to the races.
Step 4: They sell 80% of this drek, (so $800mm) now magically converted to AAA, to money managers, Freddie Mac, Fannie Mae, Hedge Funds, High Quality Money Market managers (which are supposed to be the highest of high quality investors) for $800.5MM.
Step 5: The remaining 15% (150mm) you sell to hedge funds and dopey cash rich foreign investors. With the hedge funds you lend them anywhere from 80% to 50% of the money they need to buy your “pretty good quality” bonds. You sell that for lets say $152MM.
Step 6: The remaining $50mm, you don’t get a rating on. But its ok because that “residual piece is where you can make your real money. That you either keep yourself and mark it up to $60mm, or better yet, actually sell it for $60mm to hedge funds, private equity guys, foreign central banks(!!!).
So to summarize, The Street sausage factory took in $1bb of loans to crappy borrowers (or to keep with the sausage theme, scraps from the slaughter house floor) and sold them for $1,000,012,500….a $12.5mm profit!
Now just keep that sausage factory humming. Everybody’s happy. The streets making tons of money, the rating agencies are getting nice fat fees to rate the bonds, customers from every part of the financial world are getting these great bonds and making money AND people who never had a home before, or at least a real nice home…are getting money….for next to nothing! Houses are getting built, millions of people are either selling homes, making homes, buying stuff for the home….you get the picture.
Now the only problem is God forbid our sausage factory BACKS UP! How can this happen?
Well, lets say that the rating agencies were WRONG. Maybe it didn’t matter if a crappy credit lived in California or Nevada. They’re ALL THE SAME GUY. They can’t pay the mortgage after the introductory low rate ends. They never could.
But wait! Its okay because like Chairman Greenspan said, real estate is all local. AND what everyone began to actually believe….Real estate doesn’t go down. It may not go up as fast some years..but not DOWN!
So even when this bad credit defaults…we’ll just sell the house at a profit and move on.
BUT WAIT! Actually real estate prices DO GO DOWN.
Now the defaults are coming in and the rating agencies realize…holy crap, a TURD really is a TURD and all the billions of stuff we rated AAA…really isn’t. Sorry everyone, our bad….DOWNGRADE!
Now the investors, many of whom thought they actually owned risk free AAA bonds…..actually don’t. They own garbage. So they have to sell.
All at the same time!
Right! So soon everything starts falling apart and about 12 markets simultaneously seize up.
Meanwhile at the Merrill Lynch sausage factory, they have lots and lots of pig lips and A-holes stuffed into the machine that suddenly can’t move along. Nobody wants the sausages that come out the other side because well, suddenly those sausages taste a lot like……shit!
What’s the stuff worth in the sausage factory pipeline? Ummm, nothing. BOOM! The machine overloads and blows-up with loans flying everywhere where equity pieces that stayed at the factory go from being worth $60mm to being worth 10 cents.
Oh, and all those guys that you sold sausages, I mean bonds to …the guys that you lent a good portion of the money for them to buy the bonds…cant pay. So you kind of own those pigs too.
Like prodigal sons..they come back to the factory…to also get market down…TO NOTHING.
And so boys and girls that’s how we go from Stan O’Neal’s “contained, no big deal scenario” ToStan being labeled a “SUBPRIME CEO”!!!
