This month’s Vanity Fair has an extract from a new book on the financial crisis by business journalists Bethany McLean and Joe Nocera. If this piece is anything to go by, All The Devils Are Here will have to go straight onto my reading list.
As Gillian Tett did in her book Fool’s Gold, McLean and Nocera start their story way back in the 1990s when the credit derivatives and the banking practices that went with them were first developed. There are not many reviews available yet but, from what I’ve seen, it seems that this book will go into some detail about the American mortgage market and how its collapse triggered the financial crisis. So far, Gillian Tett’s book is the best account of the financial crisis I have read. If you want to understand the forces which led to the financial crisis, you need to look back over the last fifteen to twenty years. Tett’s book did that and it looks as though McLean and Nocera will take a similar perspective.
The extract in Vanity Fair tells the story of Merrill Lynch’s collapse and suggests that the bank’s CEO Stan O’Neal was extremely autocratic and yet, at the same time, did not really understand his bank’s credit derivatives operation. A lethal combination.
Goldman’s management-committee members all participated in discussions of the various businesses. O’Neal, by contrast, insisted that the company’s executives speak only to him about their businesses and not with one another. The Goldman brass insisted on knowing bad news; Merrill executives trembled at the thought of giving O’Neal bad news. Whenever Goldman’s C.E.O. had to make an important decision, he consulted with a handful of advisers. O’Neal rarely asked for input when making a decision. And under no circumstances did he want to be challenged once he had made up his mind.
I call this the Godfather style of management; I have seen it in a number of companies. Like Vito Corleone, the boss receives his lieutenants one at a time for secret conversations. The wider business of the organisation is never discussed collectively and, therefore, only the boss has the total picture.
When things began to go wrong, the weaknesses of this management style became clear.
Semerci [the head of Merrill’s C.D.O operation] responded in exactly the way you would expect of someone whose multi-million-dollar bonus was completely dependent on his ability to continue manufacturing subprime C.D.O.’s. He implied that the market was in the middle of a little rough patch, but there was nothing to worry about. Incredibly, O’Neal appeared to accept his analysis.
Semerci claimed the risk on the firm’s books amounted to no more than $83 million—a claim that other Merrill executives viewed as implausible. But when they tried to warn O’Neal that Semerci’s loss estimates were too low, they were met with a steely glare, according to several former Merrill executives. Behind Semerci’s back, these executives began calling his loss estimates “the Fantastic Lie.”
It seems inconceivable now that O’Neal himself had so little understanding of what lay ahead.
David Komansky would later tell The New Yorker (for a 2008 profile of O’Neal) that he simply didn’t believe that O’Neal had no idea about the firm’s C.D.O. exposure. Hard though it may be to believe, that does appear to be the case. “Stan was no longer dug in,” says a former executive. At the same time Goldman executives were canceling vacations to deal with the burgeoning subprime crisis, O’Neal was often on the golf course, playing round after round by himself. Always a loner, he had become isolated from his own firm. He had no idea that key risk managers had been pushed aside or that the people he had put in important positions were out of their depth. Amazing as it sounds, the C.E.O. of Merrill Lynch really didn’t have a clue.
In less than a year, Osman Semerci and his team had taken Kronthal’s $5 to $6 billion worth of exposure and turned it into a $55 billion exposure. Almost all of it was triple-A tranches. It is almost unimaginable that he could have done that with no one seeming to notice. But that’s what happened: with investors suddenly scarce, the only way Merrill could keep the C.D.O. machine operating was to buy the triple-A’s itself. So that is what Semerci did.
With a strange combination of autocracy and ignorance, the C.E.O. appears to have refused to listen to doubters and yet given some people in the organisation the freedom to make disastrous decisions. When those decisions went wrong, no-one dared to tell the boss.
The end reads like a tragedy. You could almost feel sorry for Stan O’Neal, until you remember that he walked away with $161.5 million. John Breit, Merrill’s sidelined head of risk, brought him the bad news:
The two men had known each other for more than a dozen years; they had even worked together on occasion. O’Neal knew that Breit understood risk as well as anyone at Merrill. “I hear you have a model,” O’Neal began, “a model that shows bigger losses than the mortgage desk.” No, Breit replied, he didn’t have a model, just a back-of-the-envelope calculation. Then he gave O’Neal his number: $6 billion in losses. And he added, “It could be a lot worse.”
O’Neal looked like he was going to throw up. “What about all the protection we bought?” he asked. “What about the risk models?”
Ah, yes, the protection that many banks thought they had bought when they insured their mortgage-backed securities against default. It looks fine if you take each contract individually but if the whole system fails and the firms that have insured you and lots of other banks collapse, then your ‘protection’ is useless.
He kept asking how this could have happened. After the two men talked for a few more minutes, Breit shook O’Neal’s hand and wished him luck. “I hope we talk again,” he said.
“I don’t know,” replied O’Neal. “I don’t know how much longer I’ll be around.”
For Breit, it was a sobering conversation; he could see how shattered O’Neal was at the news. For O’Neal, it was an infuriating conversation. How could Breit convey this information so calmly? Wasn’t he supposed to be managing risk? Didn’t he bear at least some responsibility for what the mortgage desk had done? O’Neal still had no idea that Breit had been pushed aside. He thought Breit was still a risk manager on the front lines of the mortgage desk. The fact that he himself had put in place the dynamic that allowed good risk managers like Breit to be ignored eluded him entirely.
And so Merrill Lynch was sold to Bank of America which, in turn, had to be bailed out by the U.S. taxpayer. It was a story repeated with slight variations across the western world. A combination of hubris and denial, which seems to have been epitomised by the behaviour of some senior managers at Merrill Lynch, brought the world to the brink of financial armageddon.
At the time of the banking collapse, a former colleague of mine remarked that it was like watching a disaster movie and, at the same time, being in it. Stories like this feel similar. If the rest of the book is as good as this article, Bethany McLean and Joe Nocera have written a rollicking good read. But it’s worth remembering that we were all in this story. Most of us were bit-part players whether we wanted to be or not and many of us finished the performance with severe injuries.