The Thundering Herd . . . “Were Pigs”

“The mortgage business at Merrill Lynch was an afterthought — they didn’t really have a strategy. They had found this huge profit potential, and everybody wanted a piece of it. But they were pigs about it.”

— William Dallas, founder of Ownit Mortgage Solutions, a lending business in which Merrill bought a stake a few years ago.

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There is a monster Gretchen Morgenson piece in the Sunday Times, titled,  How the Thundering Herd Faltered and Fell. Its about the rise and ignomius fall of Mother Merrill.

How did it happen? Bad mortgages.

TYPICAL of those who dealt in Wall Street’s dizzying and opaque financial arrangements, Merrill ended up getting burned, former executives say, by inadequately assessing the risks it took with newfangled financial products — an error compounded when it held on to the products far too long.

The fire that Merrill was playing with was an arcane instrument known as a synthetic collateralized debt obligation. The product was an amalgam of collateralized debt obligations (the pools of loans that it bundled for investors) and credit-default swaps (which essentially are insurance that bondholders buy to protect themselves against possible defaults).

Synthetic C.D.O.’s, in other words, are exemplars of a type of modern financial engineering known as derivatives. Essentially, derivatives are financial instruments that can be used to limit risk; their value is “derived” from underlying assets like mortgages, stocks, bonds or commodities. Stock futures, for example, are a common and relatively simple derivative.

Among the more complex derivatives, however, are the mortgage-related variety. They involve a cornucopia of exotic, jumbo-size contracts ultimately linked to real-world loans and debts. So as the housing market went sour, and borrowers defaulted on their mortgages, these contracts collapsed, too, amplifying the meltdown.

The synthetic C.D.O. grew out of a structure that an elite team of J. P. Morgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like I.B.M., General Electric and Procter & Gamble.

Regular C.D.O.’s contain hundreds or thousands of actual loans or bonds. Synthetics, on the other hand, replace those physical bonds with a computer-generated group of credit-default swaps. Synthetics could be slapped together faster, and they generated fatter fees than regular C.D.O.’s, making them especially attractive to Wall Street.

Michael A. J. Farrell is chief executive of Annaly Capital Management, a real estate investment trust that manages mortgage assets. A unit of his company has liquidated billions of dollars in collateralized debt obligations for clients, and he believes that derivatives have magnified the pain of the financial collapse.

“We have auctioned billions in credit-default swap positions in our C.D.O. liquidation business,” Mr. Farrell said, “and what we have learned is that the carnage we are witnessing now would have been much more contained, to use that overworked word, without credit-default swaps.”

The whole piece is worth a read . . .

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Source:
How the Thundering Herd Faltered and Fell
GRETCHEN MORGENSON
NYT, November 8, 2008
http://www.nytimes.com/2008/11/09/business/09magic.html

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