Page 233 - untitled

 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

similarly rated mortgage-backed securities, they were in demand, and that is why
CDO managers packed their securities with other CDOs. 
And Merrill continued to push its CDO business despite signals that the market
was weakening. As late as the spring of , when AIG stopped insuring even the
very safest, super-senior CDO tranches for Merrill and others, it did not reconsider
its strategy. Cut off from AIG, which had already insured . billion of its CDO

bonds —Merrill was AIG’s third-largest counterparty, after Goldman and Société
Générale—Merrill switched to the monoline insurance companies for protection. In
the summer of , Merrill management noticed that Citigroup, its biggest com-
petitor in underwriting CDOs, was taking more super-senior tranches of CDOs onto
its own balance sheet at razor-thin margins, and thus in effect subsidizing returns for
investors in the BBB-rated and equity tranches. In response, Merrill continued to
ramp up its CDO warehouses and inventory; and in an effort to compete and get
deals done, it increasingly took on super-senior positions without insurance from
AIG or the monolines. 
This would not be the end of Merrill’s all-in wager on the mortgage and CDO
businesses. Even though it did grab the first-place trophy in the mortgage-related
CDO business in , it had come late to the “vertical integration” mortgage model
that Lehman Brothers and Bear Stearns had pioneered, which required having a stake
in every step of the mortgage business—originating mortgages, bundling these loans
into securities, bundling these securities into other securities, and selling all of them
on Wall Street. In September , months after the housing bubble had started to
deflate and delinquencies had begun to rise, Merrill announced it would acquire a
subprime lender, First Franklin Financial Corp., from National City Corp. for .
billion. As a finance reporter later noted, this move “puzzled analysts because the

market for subprime loans was souring in a hurry.” And Merrill already had a 
million ownership position in Ownit Mortgage Solutions Inc., for which it provided a
warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net-

work. Both of those companies would cease operations soon after the First Franklin
purchase. 
Nor did Merrill cut back in September , when one of its own analysts issued a
report warning that this subprime exposure could lead to a sudden cut in earnings,

because demand for these mortgages assets could dry up quickly. That assessment
was not in line with the corporate strategy, and Merrill did nothing. Finally, at the
end of , Kim instructed his people to reduce credit risk across the board. As it

would turn out, they were too late. The pipeline was too large.

REGULATORS: “ARE UNDUE CONCENTRATIONS
OF RISK DEVELOPING?”
As had happened when they faced the question of guidance on nontraditional mort-
gages, in dealing with the rapidly changing structured finance market the regulators
failed to take timely action. They missed a crucial opportunity. On January , ,
one year after the collapse of Enron, the U.S. Senate Permanent Subcommittee on In-