Book Excerpt: Chain of Blame
The story of how Stan O’Neal rushed staid, old Merrill headlong into the sub-prime business.
“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.
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