Journalism in the Public Interest

The ‘Subsidy’: How a Handful of Merrill Lynch Bankers Helped Blow Up Their Own Firm

The builders of mortgage securities at industry giant Merrill Lynch couldn’t find buyers for their wares. So they paid another group at Merrill to take billions of dollars of the unwanted assets.


(Daniel Barry/Getty Images)

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 that had short-term benefits and long-term consequences. They formed 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. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.

The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt.

"It was uneconomic for the traders" -- that is, buyers at Merrill -- "to take these things," says one former Merrill executive with knowledge of how it worked.

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 and helped to sink the iconic firm. Merrill was sold to Bank of America, which was in turn bailed out by taxpayers.

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.

Washington is now grappling with new rules about how to limit Wall Street bonuses in order to better align bankers' behavior with the long-term health of their bank. Merrill's arrangement, known only to a small number of executives at the firm, shows just how damaging the misaligned incentives could be.

ProPublica has published a series of articles throughout the year about how Wall Street kept the money machine spinning. Our examination has shown that as banks faced diminishing demand for every part of the complex securities known as collateralized debt obligations, or CDOs, Merrill and other firms found ways to circumvent the market's clear signals.

The mortgage securities business was supposed to have a firewall against this sort of conflict of interest.

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. The bankers doing these deals had a saying: We're in the moving business, not the storage business.

Executives producing the securities were not allowed to buy much of their own product; their pay was calculated by the revenues they generated. For this reason, 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.

By creating more CDOs, banks prolonged the boom. Ultimately the global banking system was saddled with hundreds of billions of dollars worth of toxic assets, triggering the 2008 implosion and throwing millions of people out of work and sending the global economy into a tailspin from which it has not yet recovered.

Executives who oversaw Merrill's CDO buying group dispute aspects of this account. One executive involved acknowledges that fees were shared, but says it was not a "formalized arrangement" and was instead done on a "case-by-case basis." Calling the arrangement bribery "is ridiculous," he says.

The executives also say the new group didn't drive Merrill's CDO production. In fact, they say the group was part of a plan to reduce risk by consolidating the unwanted assets into one place. The traders simply provided a place to put them. "We were managing and booking risk that was already in the firm and couldn't be sold," says one person who worked in the group.

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, most of which was held by the new group.

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.

The super-senior was the top portion of CDOs, meaning investors who owned it were the first to be compensated as homeowners paid their mortgages, and last in line to take losses should people become delinquent. By the fall of 2006, the housing market was dipping, and big insurance companies, pension funds and other institutional investors were turning away from any investments tied to mortgages.

Until that point, Merrill's own traders had been making money on purchases of super-senior debt. The traders were careful about their purchases. They would buy at prices they regarded as attractive and then make side bets -- what are known as hedges -- that would pay off if the value of the securities fell. This approach allowed the traders to make money for Merrill while minimizing the bank's risk.

It also was personally profitable. Annual bonuses for traders -- which can make up more than 75 percent of total compensation -- are largely based on how much money each individual makes for the firm.

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. (De Silva and Margolis didn't respond to requests for comment.)

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. (As we reported in April with Chicago Public Radio's This American Life and NPR's Planet Money, Magnetar had helped create more than $40 billion worth of CDOs with a variety of banks, and bet against many of those CDOs as part of a strategy to profit from the decline in the housing market.)

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 same Journal article also reported that the new group had taken the majority of Merrill's super-seniors.)

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.)

The head of the new group, Roy, had arrived in the U.S. early in the year, having spent his whole career in Asia. He had little experience either with the American capital markets or mortgages. His new unit was staffed with three junior people drawn from various places in the bank. The three didn't have the stature within the firm to refuse a purchase, and, more troubling, had little expertise in evaluating CDOs, former Merrill employees say.

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.

But Roy and his team needed to be paid. As they were setting up the trading group, Roy raised the issue of compensation. "The CDO guys said this helps our business and said don't worry about it -- we will take care of it," recalls a person involved in the discussions.

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.

Sharing the bonus money for a deal or trade is common on Wall Street, arrangements known as "soft P&L," for "profit and loss." But it is not typical, or desirable, to pay a group to do something against their financial interests or those of the bank.

Roy made about $6 million for 2006, according to former Merrill executives. He was promoted out of the group in May 2007, but then fired in November of that year. He now is a high-level executive for Morgan Stanley in Asia. The co-heads of Merrill's CDO sales group, Ken Margolis and Harin De Silva, pulled down about $7 million each in 2006, according to those executives. De Silva is now at the investment firm PIMCO.

By early summer 2007, many former executives now realize, Merrill was a dead firm walking. As the mortgage securities market imploded, high-level executives embarked on an internal investigation to get to the bottom of what had happened. It did not take them long to discover the subsidy arrangement.

Executives made a sweep of the firm to see if there were other similar deals. We "made a lot of noise" about the Roy subsidy to root out any other similarly troublesome arrangements, said one of the executives involved in the internal investigation. "I'd never seen it before and have never seen it again," he says.

In early October 2007, Merrill began to purge executives and, slowly, to reveal its losses. The heads of Merrill's fixed income group, including Dale Lattanzio, were fired.

Days later, the bank announced it would write down $5.5 billion worth of CDO assets. Less than three weeks after that, Merrill raised the estimate to $8.4 billion. Days later, the board fired Merrill's CEO, Stan O'Neal.

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.

After Merrill revised its estimate of losses in October 2007, the Securities and Exchange Commission began an investigation to discover if the firm's executives had committed securities fraud or misrepresented the state of its business to investors.

But then the financial crisis began in earnest. By March 2008, Bear Stearns had collapsed. By the fall of 2008, Merrill was sold to Bank of America. In a controversial move, Merrill paid bonuses out to its top executives despite its precarious state. The SEC turned its focus on Merrill and BofA's bonuses and sued, alleging failures to properly disclose the payments.

As for the original SEC probe into Merrill Lynch's CDO business in 2007, nothing ever came of it.

ProPublica research director Lisa Schwartz and Karen Weise contributed reporting to this story.

I’m a former private detective who participated in the defense of public officials and “white collar” defendants during the 70’s.  I’ve never in my eleven year career seen conduct as egregious or this criminal as you reveal in this article.  It’s perhaps the civil equivalent to war crimes against humanity.  Why is ProPublica almost alone in these vital disclosures?

-J. Gala

And the answer to all of this is a bail out w/ tax payer dollars?  Lehman was allowed to fail and lo and behold we are still alive.  90% of us are still going to work every day.  Ironically, the earth did not stop spinning.  In fact, the company was dismantled and it’s valuable assets were bought by better run firms.  Imagine that - a market based economy free of Corporatism?  When will we actually wake up and realize Keynesian economics never has and never will work?  Perhaps when the largest capital market participants are actually allowed to reap what they sow?

Geoff Badenoch

Dec. 22, 2010, 5:41 p.m.

“Steal a little and they put you in jail; steal a lot and they make you king.”

One of the problems with the bailouts and smoothing over that was done with regard to the problems at the companies that do billions of dollars simply trading paper—and not really producing anything—is that no lessons were learned except to be less transparent the next time. Had some people gone to jail, had stockholders been wiped out, the resulting pain would have made people demand reform and accountability.  Sometimes the going to jail is an important part of learning the lesson.  As it is, I am expecting this to happen again in my lifetime.

I am a lifetime Democrat, but we have former President Clinton and congressional republicans in office at that time to thank for the Financial Services Modernization Act of 1999 for deregulating the banks. It was this repeal of the Glass-Steagall Act of 1933 from Roosevelt’s New Deal that allowed the banks and insurance companies to run amok.  I say, instead of using my tax money to bail out those who financially raped us all, it should be used to PROSECUTE those responsible for this horribly risky behavior. Why should those criminals profit so obscenely at the expense of those of us in the middle class that truly make this country the great power that it is? I’m glad the Justice Dept. has sued them. Let’s hope they prevail on the part of the American people. “Justice for All” in this matter is LONG over-due.

Kevin Schmidt

Dec. 22, 2010, 6:09 p.m.

Let them eat CDOs?

The French Revolution had a solution.

The biggest mistake many people make is denying that history can repeat itself.

AIG is mentioned as having purchased some of the CDOs.  So they were presumably burned.

I read where they used the money received from the sale of Credit Default Swaps to invest in the CDOs.  So they issued bad insurance policies in the form of CDS and were burned again.

AIG received billions from TARP and then paid out 100 cents on the dollar to Goldman Sachs, Deutsche Bank and others.  So the taxpayers got burned. 

How about a story on how much of the TARP money went to these financial insttutions and why?

Now we have the investors in the CDOs or the Trusts created by Deutsche Bank and others foreclsoing on the bad mortgages. 

Seems that the banks who bet against their own CDOs are the only winners.

Anita Mitchell

Dec. 22, 2010, 6:42 p.m.

Screw the Justice Department.  Public Citizen just said the Justice Department under Obama filed on amicus brief with the courts siding with Citibank over changing a credit card customer’s interest rate (without notifying them) when the customer was up to date on Citibank’s bill but missed a payment or fell behind on another creditor or utility bill. A small print black hole the Credit Card companies entitled “universal default.”  If you think the Justice Department is on our side…I say think again.
I think to really put the fear of God in some of these banks, let people from law firms like the ones that sued the asbestos or tobacco industries at them for 33% of the awards. These people are fearless, motivated by money, know every trick in the book and have a proven records of smelling deep pockets, wrong-doing, and turning it into gargantuan settlements for both the States (in the case of asbestos and tobacco) and themselves.  I want a litigator like Picard from the Madoff case or the tobacco litigation lawyers, not our Justice Department.  I think Justice gets in there to say “Hey, we got them.” and then fines them something they can eminently afford to pay and everyone wipes the sweat off their brows because “justice” has been done.  Justice Department just want to get in between banks and civil litigation if you ask me and delay civil suits as long as possible.  Let their investors litigate them.  They screwed us all but they had a fiduciary duty to their investors.

LOL, they act like this is news. This has been known for over a year and I’ve got news for you, practically every firm that was creating CDO’s in 06 had to do something similar.

Also, its not corrupt, its just really, really stupid.

Here’s what everybody already knows: A bunch of Mortgage Backed Securities are bundled up into a CDO and diced up into a bunch of tranches. In the article, they correctly point out that super senior was a problem. That is because the super senior tranches pay next to no interest. They were considered as safe as a checking account. So you had to sell the tranche at a loss to get rid of it.

Well here’s the problem. In 06, with high competition and rising interest rates the CDO market increasingly became less and less profitable. They were all competing with each other and that was driving the fee’s down very low. Before they could just sell Super Senior at a loss and still make money. Now they can’t which usually means, “Hey if you can no longer make a profit from it stop.” But if you excluded the sale of Super Senior it was actually still a good deal.

So here were your options
1. Sell the Super Senior debt.
2. Keep it on your balance sheet
3. Insure against it so that you can not be subject to your capital requirements
4. Create a Special Purpose Vehicle(SPV) to buy the assets

That’s the only choices you have. Well in 06 if you do number 1 you lost more money creating a CDO than you made.

2. If you keep it on the balance sheet you’re use up capital on a very low earning asset, and it accumulates to be a lot(a lot of companies did that).

3. If you insure against it at least then you have don’t reduce its exposure to capital requirements, but then it still accumulates and you have to pay the cost of insuring it. Furthermore, increasingly it became clear that they couldn’t go to the big boys like AIG anymore, and they had to go to monoline insurers who’s counterparty risk wasn’t worth squat in the event of problems. But since Super Senior was seen as incapable of any major changes in prices nobody cared.

4. Create an SPV to over pay for super senior. The problem is what group is going to want to overpay for anything. Different strategies were used. This is what the article is referring to with Merrill. Citi was the dumbest because they actually signed an obligation to buy back super senior if they ever took any loss to keep the price up.

So, since none of these companies were really getting rid of their Super Senior, it just built up and built up and was never removed as a liability to them. It eventually became the case that super senior was becoming a huge chunk of everything these banks held.

Then, when the crash started happening it wasn’t having to much of an impact on Super Senior because the tranche is just that safe. The problem was that major crashes in the lower tranches like junior and mezzanine were causing minor movements in senior, and it actually caused a tiny change in Super Senior values.

If pretty much a third of your bank is super senior tranches to a CDO and you are leveraged at lets say10 to 1(or more) a minor 5% downgrade in that super senior debt could blow up your entire company.

There you go. None of this was a root cause of the crisis, but now you know how it played out and what the authors apparently are struggling with.

Sorry for the length,

but I believe I actually succeeded in writing a better article than the original authors. So if you read the article you would probably enjoy my piece.

Jon, thank you for taking the time and effort to write this excellent overview.

Geoff Badenoch

Dec. 23, 2010, 1:49 a.m.

Thanks, Jon, for that illuminating contribution. Still, I wonder how all these invented instruments were carried on the books. What were the auditors thinking? What was the audit committee thinking? Even if it can be attributed to “black box” investing with no apparent downside, every little kid at some point in his or her life has been told, “if it seems too good to be true, it probably is.” They were blinded by greed and too clever by half.

Where it becomes problematic is that they were creating imaginary wealth and gambling with other people’s money to do it.  If there is no accountability or sanctions levied, it will happen again.

“CDOs, tranches, and Special Purpose Vehicles” may sound like sexy sophisticated lingo from the Wall Street lexicon, but they’re fabricated words and acronyms describing fabricated “financial products” invented by soulless sociopaths to enrich themselves while appearing to possess an arcane financial knowledge.  These morons can’t build a bridge, fix a leaky faucet, or play a musical instrument, let alone heal the sick.  But they certainly know how to take your money and invent reasons to keep most of it for themselves with no regard for what happens to you, the “investor”.  I’m not religious, but when the biblical Jesus threw the money-lenders from the temple, I think he acted God-like.  At least He appeared to possess a moral compass -a term just as foreign and arcane to investment bakers as “tranches” are to their victims.
For 40 years I’ve been listening to nonsensical financial jargon excreted from the mouths of lionized “experts” like Alan Greenspan, et al, with the same outcome: the patient (us) died on their operating table.

When will American wake up?  We have all been robbed and looted and conned and suckered. I’m an attorney who’s been defending people in foreclosure for years.  I’ve long said that the “deadbeats in foreclosure” are just canaries in our economic coal mine.  On my blog, I detail, with great specificity, how our entire legal and financial system has been corrupted through this process.  The fundamental breakdowns in the foreclosure and legal process are staggering.  The examples are mind blowing.  What people don’t get is that their 401k’s and retirement accounts have been looted….the evolving Fraudclosure Scandal is just one of the first symptoms of the much larger and far more destructive cancer that rots at our core…..We all need to do our job by not just reading these articles, but by spreading them to all our friends and points of contacts and urging them to do the same.
WE ARE AT WAR.  The good reporters and press that are doing their job are on the front lines and I am grateful for their work…KEEP AT IT!

Myron Budnick

Dec. 23, 2010, 8:17 a.m.

It seems to be the way of the western world. Take all you can for as long as you can and leave it to your decendent’s to pay the Devil when payment comes due.
Enlightened self interest does not seem to exsist except for a very few like Bill Gates Warren Buffet and Ted Turner

Richard Schmidt

Dec. 23, 2010, 8:49 a.m.

But never forget the role played in the whole financial disaster by the accounting firms. They played right along, as they always do.  We need desperately to blow up the entire accounting industry and begin anew. One approach might be to create a new Federal agency that would be responsible for hiring accounting firms to audit the books of all publically traded companies. The companies would have no say in who would audit them. The new agency would change auditors every 3-4 years, much as the State Department changes its diplomats, to avoid them being corrupted.
It is clear that US audit companies are corrupted by the millions paid to them by the companies they audit. That relationship is at the core of a fundamentally corrupt system. The companies being audited would need to pay the federal agency a fee. Those fees would be used to contract with the audit firms.

@Jon - Thank you for your comment. It is a helpful framework for looking at traders’ behavior. If you consider the Merrill traders’ actions, isn’t it clear that De Silva, Margolis, and Lattanzio knew that the SPV was being filled with Super Senior tranches that were worth much less than what they were being booked at? How is this different than a rogue trader hiding his trades? Except here they were still earning vast sums in bonuses, and they bought off the managers of the Merrill SPV with soft fees for as long as they could, until the fees no longer covered the losses. Then the whole thing blew up. No wonder they were fired, but Merrill covered it all up because to disclose the true extent of the problem would have been to expose their vulnerability.
Lots of lessons to be learned here. Risk managers have to beware of being stuck with the back ends of complicated trades. Fee sharing can’t be permitted for trades that aren’t sold off. And in my opinion, it sounds like Lattanzio and others are guilty of criminal fraud against their former employer. And Merrill senior management didn’t disclose in a timely manner what they knew, or at least should have known.

Sheila Torres

Dec. 23, 2010, 8:52 a.m.

Thank you Mr. Gala and Weidner for your insightful comments. I agree wholeheartedly. I’m an educated woman who feels like a victim when I hear all this. No, I haven’t lost as much personally—I still live in my home of 10 years and I’ve never been late on a mortgage payment—but I’ve been out of work far too long, able to get only temporary or part-time employment to be able to keep up my financial obligations. Hanging on to our home is still a month-to-month issue even for a middle class family like us. I have a nagging suspicion that everything we are counting on: the 401ks we’ve worked hard to preserve, the pension plans we contributed to when we were fortunate enough to have them, and of course the Social Security program that we are legally required to fund, all those things we built to try to preserve a safe life for ourselves and our families, are all going to come tumbling down because of financial predators who can act with impunity. Perhaps this is what the middle class needs in order to pay attention to some of the pain that working class people have been feeling for years: lack of stable jobs, lower wages, little or no health insurance. Or perhaps to look at itself squarely in the face and ask: what role do I play in this mess? How have I contributed?  The question is: how do we combat this in a more immediate way that does not involve the Justice Department,  a team of lawyers and years of litigation? I would very much like to hear from others who have ideas about how we as individuals can change our everyday practices so that we can begin to starve this financial predator beast and the political machine that supports it.

William Yates

Dec. 23, 2010, 9:19 a.m.

There’s no difference between what Merrill did with it’s CDOs and Bernanke’s POMO programs. The left hand sells, the right hand buys, and we split the gains. The losses go the the people.

How can you expect the Justice Department to prosecute Merril’s actions when the same actions are official US Government policy?

It isn’t the way of the western world; it’s the way of the US.  Does it ever occur to Americans why European democracies have free education and health care?  It’s because they understand that democracy and capitalism are not synonymous.  Capitalism and “free markets” are Darwinist by nature and create as many losers as as winners.  The citizens of European democracies refuse to gamble with their lives, i.e. health care and education, by leaving them to “market forces”.  This isn’t “socialism”, it’s an obvious, intelligent, humane, and eminently democratic perspective which is apparently lost on American “conservatives” and the corporate owned media who label virtually all other western democracies as “socialistic”.  Americans don’t understand that relative to Germany, France, England, and about 30 other nations, Americans have shorter life spans, higher infant mortality rates, and more poverty.  Even Cubans live longer and have better health care and literacy than Americans.  The ruling elite in America has a “plantation mentality”. They want to own the plantation while their employees (formerly US citizens) pick cotton for them.  The Republicans, who lately claim to revere the US Constitution, have in fact, and especially since the Regan administration, eviscerated it.  This is a fact, not an opinion.  Anyone who has read The Bill of Rights and The US Constitution knows this.  But the dumbing down of America has robbed many voters of their critical faculties and left them vulnerable to the hysterical rants of right-wing talk show morons.  Wake up, America.  This isn’t “reality TV”. It’s your rights, your education, your health, your standard of living, your retirement, and your freedom that are at stake -now more so than at any time since World War II.

Good article, and also great comment by Jon.

For the rest of the commenters, pls remember that B of A bought ML. You as tax payers did not sustain a loss of any kind as a result of any of these shenannigans. To the extent TARP was used to aid B of A, it has been repaid with interest. 

This is not the droid you are looking for.

Ever pause to consider how much of these ill-gotten gains was funneled into the Republican machine that ran all of those fear/hate/anger ads before this last election?

lolll…quite a bit, I wager.  There is nothing a crook hates more than having to pay taxes on what he or she steals, and that makes the Republicans their natural choice, for even if the Republicans don’t repurpose the law to make the American people legal prey, they will shield ill-gotten gains from taxes.

@Geoff, with exception of an SPV(which is designed to get something off the balance sheet) all this was very much above ground. An auditor would see this CDOs, and CDSs on a balance sheet and it would be like anything. I’ll give you an example of one of the real causes(by no means the biggest). The Fed’s decision to allow insured CDO’s to be subject to lower capital requirements than if your not-insured(we all know the insurance is a CDS). The Fed thought they had a pretty good understanding what these things were. It was for the most part all very much above board. As much as they all act like it was a few bad apples, it wasn’t. The fact is that practically everybody that dealt in these products believed they were useful products. It wasn’t really sinister greed. It was stupid greed, when they couldn’t stop cheering these things on when the conditions changed, they exposed themselves to way to much of them.

@Richard, the accounting firms did exactly what they were supposed to in each of these companies. In Enron that wasn’t the case, but in the banking industries there were no situations where the accounting firms didn’t report something they saw. Example the creation of an SPV isn’t within an accountants job title to know or care about. And its not like it would make any difference in how they reported things if they did see an SPV that the firm created.

@David. Well they weren’t being filled with losses(at least at that time). The best analogy I can give you is: paying someone bonuses to put all of their money into a savings account earning 2% when everybody really wants to buy junk bonds because they have a higher interest rate. So it wasn’t a question right away at least, “Lets pay them to take our losses for us.” Those losses only really occurred later. At the time it was, lets pay them some money to buy our low interest tranches. Its just like valuing a bond. If everybody is demanding higher interest from bonds than you have to sell your bond at a discount in order for the buyer to receive the interest they want. In this case the face was lets say 2% and everybody wanted 5% on them. They paid someone to buy it at 2%.

I see from the comments that the argument of those who have benefited from the transformation of Wall Street and banking into a one-way wealth transfer machine is still “It wasn’t illegal.”.

Buying the Republicans - and the Democratic President - who brought about deregulation was one heck of a good investment, wasn’t it boyz?

@Jim Gala:  In an America that increasingly believes Christianity demands that we amass wealth, hate our neighbors and crush the poor; in an America that believes torture is just like fraternity hazing; in an America that believes War is Peace, Four Legs Good, Two Legs Bad, Ingsoc = double-plusgood, and all those other useful slogans; in this America, there’s no waking up from the nightmare.  Belief is more real than reality, and anything bad is all the result of Enemy Action.  We just have to sacrifice more and then things will be even better.

@ibsteve2u: So what do you think is more probably a larger culprit?

Paying a person to buy a low interest earning asset.


A bunch of 23 year old analysts at a crediting agency has a financial model in from of them. There is a part of the model that asks, “What assumption do you want to use for the appreciation of real estate?” And they type in 8% in perpetuity. Any security would get a good rating if you actually believed that real estate was going to go up 8% a year and never go down.

There is, of course, a lesson in both the details that entities such as ProPublica reveal about the sordid nature of modern banking and Wall Street as well as the latter entities’ counter-argument of “It wasn’t/isn’t illegal.”.

To whit, Wall Street and banking have been transformed; they are no longer a source of capital and a tool to be used to build America and bring all of us wealth and a brighter future.  Far from it; their new purpose is restricted solely to transferring wealth from those who have it to themselves.

ANYBODY’s wealth, be you rich or becoming dependent upon your IRAs and 401Ks as America’s corporations - owned and operated by those who also benefit from the machinations of Wall Street’s brokers and America’s bankers - destroy pensions and so force the American people to place their life’s work within the grasping hands of high finance in America.

If you deal with American banking or Wall Street, you have been warned:  Investing with or trusting them with your assets reveals only that you are a sucker; a mark and - thanks to the Republicans and the “Blue Dog” and other forms of neoliberal Democrats like Bill Clinton - their legal prey.

When they eat you, remember that you begged for it.

To respond to your question, “Jon”, I would say that both parties are morally and ethically culpable.

But I know the direction that will go:  The representatives of Wall Street - who knew full well that the (strangely young) analysts you quote were overstating potential but nonetheless foisted the instruments off on their customers - will peel off into an argument about “fiduciary responsibility”.

An argument that is - essentially - “Yeah, we knew we were moving sucker bets, but we stood to make money from it and ‘it wasn’t illegal’ for us to permit you to be stupid regardless of the fact that the names of our firms lent credibility to the instruments.”.

I.e., high finance in American in all of its forms - from retail lending, to wholesale packaging, stocks and bonds to Wall Street itself - is corrupt.

Again, the investment in the purchasing of the Republicans and neoliberal Democrats that brought about deregulation was the most lucrative investment in American history.  The fact that it has wrought only devastation is not the problem of those who benefit from it, eh? 

Because “it isn’t illegal”....

The cdo’s were managed,if you could call it that, in excel. The risk did not feed down into the firms market risk systems so little to no oversight was available on the risk amounts being carried or the mtm numbers.

Funny enough, a nice, state of the art trading system for cdo’s was completed in august 2007 ... Too late ...

LOL. Thanks for all the information, Steve, actually its the most informative piece I’ve read on the subject. You know you should go into journalism.

I’m getting bored. I hope you found the information useful. I’ve got a long drive a head of me, so everybody have a Merry Christmas.

@Laisee, interesting. The first I heard that, it makes sense though.

@mark at 9:35 AM.  I really don’t know the answer to this but are you positive that none of these investments or mortgage backed securities ended up at Fannie, Freddy or AIG or that AIG issued Credit Default Swaps to insure these obligations?

“swindle”: “To practice fraud as a way of obtaining money” “An act or instance of swindling : Fraud”
“swindle”: “Deception, Knavery, Dupe, Victimize, Defraud”
(Webster’s New World Thesaurus)
I should stop here because the above is what the whole scheme is/was based on.
Who cares what the internal scheme of things mechanical such as the why’s and wherefore’s of CDO’s, CDS’s, etc…...
The plain fact if you “follow the money” from mortgage originator to shareholders who were just as greedy for more “return on investment” to the heads of banks, financial institutions, internal departments, traders, buyers, sellers, the trail of fraud smacks you right in the face!
Those who perpetrated or participated in this grand fraud will always insist that it “....really wasn’t fraud, but just business”!
Wall Street will always use the argument that they have to protect their internal processes of how they analyze, get information and invest…what they use as their guidelines…they call it “proprietary information.”
Remember Gordon Gekko telling young Charlie Sheen, “I want you to stop giving me information; I want you to start GETTING me information”  “Tell me something I don’t know!”  “It’s my birthday!”
Laws were passed after the Great Depression to try to reign in the greedy excesses of our capitalist system…like FDIC, SEC, Glass/Steagal and also laws that tried to protect common labor also from those greedy excesses…..
For more than three decades our business world along with the corrupt politicians that we continue to elect to high office have eroded both those concepts terribly…...the final “coup de gras”  being the dismantling of Glass/Steagal during the Clinton Administration at the insistence of the same individuals like Greenspan, Rubin, Summers, Bernanke, Geithner, all who have come into this administration with the same corrupt ideas.
There have been many changes in banking/investment profit structures since the 1970’s (it’s a long, detailed but fascinating story) which of course include the continuing destruction of organized labor (the true middle class) which left that labor class with less and less assets to spend in this crazy consumer economy (buying more and more junk and bigger houses filled with that junk that they have to rent storage space offsite) which eventually proved a dilemma for business: How to sell more and more junk, including those McMansions to a dwindling middle class with less and less spendable income?
The answer (you guessed it!)...DEBT.  Debt, debt, and more debt until the whole crazy scheme has blown up not only in the faces of Wall Street (and the world who bought all the stinkie cheese mortgage backed securities) but also in the faces of the dwindling middle class, immigrants, the poorer part of our society.
The onus belongs on those who try to hide money in offshore accounts (SIV’s, etc), those who peddle snake oil mortgages or any other dumb investments, thoroughly corrupt politicians elected to be responsible to their constituents, but know as much about economics as I know about how the galaxy will perform in the next billion years…
My whole point is that there is enough blame to go around, but if nobody goes to jail because of outright fraud then the game is afoot for the next “great economic calamity” which as sure as the sun (still) comes up and goes down will happen.
This scheme morphed into one of the greatest FRAUDS ever in our history.
And, as one commenter wrote above the French had (may still have and use as things are going over there because of this fiasco) an instrument to “level the playing field”....the Guillotine!
Pro-Publica, keep up the good work.
Incidentally this is only a small part of the enormus information that is available about this FRAUD…..
There’s nothing like a good recession (depression) to focus the common peoples’ minds…and hopefully change their priorities.
We are a thoroughly corrupt nation with a thoroughly corrupt system.

@ Jon: Great comments, very succinct summary. Still shocking that ML was “making markets” inside its own shop, though.  Lattanzio deserved to be sacked for such silliness, guess Stan O’Neal was too busy wandering the golf course to care.

@Laisee: Seconded, amazing to see such huge $ volumes within “top tier” institutions tracked and managed with the same precision a homemaker uses on the family grocery bills.

Patrick Taylor

Dec. 23, 2010, 1:32 p.m.

As a former, and foreign banker I am amazed at the mess, and the lack of of litigation.

If I were a shareholder in MerrillLynch I now learn that people who were refusing to buy the rubbish were fired and senior managers colluded to keep the wheels turning - for the sake of their bonuses.

So the shareholders are investing in a weaker and weaker company whilst the managers grow rich on enormous bonuses based on fabricated sales.

Is that not against company law?

As for Jon - a wonderful example of a man who knows and is quite happy that Wall St. were not the root cause, which apparently exculpates the crooks who killed Merrill and their cronies.

I am afraid that there appears to have been wholesale corruption from the falsifying of mortgages upwards with everyone knowing the system is corrupted but all pleased to take a slice of the action. Shocking and distressing.

All of the above in the article would be moot if banks (and other finanical entitities) got NO BAILOUTS or subsidies from the federal government. Ever. Period.

Harold MacCaughey

Dec. 23, 2010, 3:20 p.m.

Until and unless persons do hard jail time for this nonsense, it will happen again.

Mott Williamson

Dec. 23, 2010, 4:10 p.m.

A wise man once provided this definition to me.  “Financial planning is the process where someone’s net worth is transformed into fees and commissions for the financial planner.” 

Unfortunately, that’s what we have today at almost every financial institution insofar as to how the institution and its employees interact with the public. 

Those in the “market-making” business tell different stories to different sides of a trade to maximize their share of the trade.  All they care about is the level of action so they can take their slice, the bigger the better! 

Yes, the companies had a sure sign that something was wrong when their balance sheets started filling up with “market-making” positions.  Accounting standards, and capital regulators too long let them get away with this as they did more and more business to book larger and larger fee-based profits. 

The profits claimed by all “market-makers” are, to a certain extent, funds due to either the seller or the buyer.  Most of the profits being claimed are invisible to both sides of the trade.  Maybe better disclosure of the fees and commissions charged will make a difference.  I am not holding my breath that it will.

Why is there no discussion of the blame for the countless people who bought homes without the ability to repay their mortgages?
And why have the ratings agencies generally escaped scot-free? They continued giving out AAA ratings to bundles of toxic mortgages….

Articles about the CDO market now name names and sometimes even note the current employers.  How is it, if these folks are so complicit, that they still have jobs?? If something so nefarious happened (and it seems clear that something smells rotten) then how are they still involved IN THE SAME MARKETS?? When big tobacco knowingly produced dangerous products designed to harm their users they would up attracting the worlds best civil action attorneys.  Dickie Scruggs sued the tobacco industry and changed the world and earned himself billions.  Where are ya Dickie?? This one seems like a short putt.

Joe - good call on personal responsibility. Folks took on mortgage debt without a gun to their heads, then strolled away when things didnt work out for them.  Regardless of what happened to Bear or Lehman or Merrill, if you signed a mortgage and bought a home, pay your damn bills.  Period.

BTW the rating agencies are not immune from the pain.  Far from scot free but there will be little satisfaction to the average guy because the feds couldnt even convict the two Bear hedge fund guys who laid themselves out. Remeber those two? All wegot from that was a perp walk and then a shellacking in court.  There will be no prosecutions, not now, not ever.


@joe and @too jersey
You guys have really been misinformed…or you haven’t read much about this whole scandal at all…at least not from factual source based reporting.
Turns out that many of these sub-prime loans were made to completely unsuspecting poor and low income minorites -specifically preyed upon by the mortgage lenders. These people, as ignorant as you are to the truth, took the supposedly good word of their “friends” in the banking industry. Thousands of people were completely duped into believing that a interest only backwards amoritizing loan was a good thing, and that the real estate market was surely infallable, so “if worst came to worst you could just refinance”. You might also want to think about the fact that many of these people “just walking away” from their payments and obligations, were completely crushed when various corporate interests, tied to the finance regime and economic collapse, decided to fire them, eliminate their pensions, steal their life savings, drop their health care,etc… Plus the incredible pressure and hype by the general corporate american engine for profits to incur as much debt as inhumanely possible, especially on the less fortunate.
Truly there is blame to go all around, and we are ALL a bit to blame for being so complacent and letting this all get out of control, but to try and impart any significant blame on the less fortunate is just shameful. Turn your minds towards more effective ideas. Blame yourself and Be the change if you really want to adress the situation.

This group was formed in 2006 and things went bad basically as soon as it was formed according to this article? The mortgage industry’s problems go back further to the ‘80’s long before this group was formed. In the ‘80’s the lending profile changed from what was a standard practice of evaluating loans for approval based on income and existing debt. For lack of a PC way to put it, certain people were not getting approved as often as others (more likely that some wouldn’t apply if they didn’t expect approval though). So, to meet quotas established by federal regulatory agencies, the rules had to be changes & then came loans to people who really couldn’t afford them. These are the loans ultimately packaged up to sell so more money was available to make more loans.

This didn’t do anything but make bad things worse, if this is accurate.

matthew weidner

Dec. 23, 2010, 6:14 p.m.

Only 43 comments?  How many people have read this story and why are we not pushing this out to EVERY SINGLE PERSON IN AMERICA TO READ?  I hate the Americans are so tuned out and feel an obligation to help get them tuned in.
If you’re reading this, please “like” this article and share it with all you know.
Amerika desperately needs more of this kind of reporting!

Anita Mitchell

Dec. 23, 2010, 6:35 p.m.

An FYI:  Segment just ran on Public Radio (WBEZ 91.5 Chicago “All Things Considered”) about Merrill Lynch and this “bonus sharing” scheme.  Segment said SEC looked into these reports, began an investigation, then dropped it. Forget the SEC and the Justice Department.

Again, Class Action Lawyers the answer here and they are already organizing to litigate all the big banks over these internal practices of maximizing bonuses and off-loading worthless CDOs and Mortgage-Backed Securities to entities within the company created specifically to receive the worthless, risky instruments.

They blew up their own company and ruined global economies for their bonuses.  Then they claimed no one could have seen this coming. Really?

Elaine Edzeee

Dec. 23, 2010, 6:51 p.m.

What role Dow Kim played?

Great article and great comments / discussion.  Thank you. 

So, now at age 63 with my mortgage paid off, my 401k down and no jobs on the horizon, what do I do?

The death of Merrill is simple to explain.  Look at their balance sheet and leverage ratios in 2004 and then again in 2007.  Their assets rose by over $300 billion (nearly doubling) while their leverage skyrocketed.  Remember that 2005/2006 was a time of record tight credit spreads, so many of these assets were bought at effectively all time highs.

When you buy $300 billion of assets at the top of the market, largely funded with short term credit and only a narrow (3-5%) equity capital cushion, it doesn’t take much to cause insolvency.

The few 10 billions of CDOs mentioned by this article are only a small slice of the real problem.
Moreover, it is quite common for syndication desks in all products (credit or equities) to reserve part of their fees for the traders that get stuck with inventory they can’t sell.  This is not evidence of a crime.

I feel I should also correct some if the errors in the post by “Jon”.

1) AAA “super senior” assets do not attract large capital requirements.  In fact, one of the reasons the crisis hit European banks so hard is that they had loaded up on AAA securities because the Basel capital rules required near ZERO capital to be held against these assets.

2) if a bank is leveraged 10 to 1 (say, $100 biliion in assets and $10 billion in capital) and had a third of its assets in CDOs ($33.3 billion) then no, a 5% drop in these assets WOULD NOT take the firm down.  Can nobody here do simple arithmetic and compare 5% of $33.3 billion to equity capital of $10 billion?
Jon has the right idea (small asset changes hurt at high leverage)-  except that 10 to 1 is not high leverage (Lehman was close to 30 to 1 sans balance sheet window dressing) and neither Merrill nor Lehman had anywhere close to 1/3 of their assets in CDOs.  So a bad example using incorrect math.

Finally, CDOs are not evil.  The concept is that a pool of individual credit risks could secure bonds higher-rated than most of the individual risks is neither radical nor new.

Think of the senior corporate bonds of a typical AA- rated bank.  What is a bank but a portfolio of loans. Many of these individual loans have low credit ratings and almost all those borrowers are below AA.  How then can the bank’s bonds be rated AA?  1) because of the portfolio effect and 2) because of the cushion of equity, preferred stock and subordinated debt that take “first losses”, protecting the senior bonds.  Sound familiar? 

In any case, I am all for punishing the execs of Lehman and Merrill and Countrywide and B of A (for overpaying for those last two insolvent firms) but we need not exaggerate minor scandals to excite financial neophytes when the causes of macro failure can easily be read in the firms’ balance sheets.  To put it another way, crowds with pitchforks denouncing CDOs and criminalising firms using underwriting fees to cushion trading losses will not prevent the next financial crisis.

Glenn Showalter

Dec. 23, 2010, 8:39 p.m.

Only in America do crooks like this get rewarded when they should have gone the way of Layman Brothers Inc. had it not been for a sugar daddy in Bank of America and choose to pay big money rather than wait for fire sale prices. I closed my account with BA.

Remember, these toxic CDOs were still Triple-A rated securities. Why aren’t S&P, Moodys and Fitch being held culpable, too? They made fortunes on these CDOs just like the bank jesters. Nope. Everyone walks away with a smile. No prison. No fines. No retribution. No justice.

The white-collar pigs got away scott free with the heist of the century.

This article is part of an ongoing investigation:
The Wall Street Money Machine

The Wall Street Money Machine

Enticed by profits and bonuses, Wall Street took advantage of complicated mortgage-based instruments to reap billions, only to exacerbate the eventual crash.

The Story So Far

As the housing market started to fade, bankers and hedge funds scrambled for ways to maintain the lavish bonuses and profits they had become so accustomed to, repackaging mortgages in complex securities called collateralized debt obligations. The booming CDO market masked how weak the housing market was, and exacerbated its collapse.

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