Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Merrill Lynch

John Thain: Lack of Perspective and Judgment

On Thursday January 22nd 2009, John Thain, the former CEO of Merrill Lynch, resigned from his new post at the merged Bank of America Corporation. Bank of America Chief Executive Ken Lewis flew to New York to talk with Mr. Thain on Thursday, and they mutually agreed "that the situation was not working out" and that he would resign, said Bob Stickler, a spokesman for Bank of America.

Some privately say though that Mr. Thain was fired after the banking giant lost confidence in his leadership, particularly during the transition period since the acquisition was announced in the hours following the collapse of Lehman Brothers on September 14th 2008. Apparently Mr. Thain failed to tell the acquiring bank about mounting losses at Merrill in the fourth quarter. Those losses apparently totaled more than $15 billion and which were much larger than Bank of America had factored into its acquisition analytics.

The shareholder votes were held on December 7th approving the merger. At the time, the large Merrill losses were not disclosed. Sometime later in December, the Merrill Lynch merger team and not Mr. Thain himself informed Bank of America of the losses, quite a bit apparently attributable to soured trading positions. These losses prompted Bank of America to seriously consider walking away from the deal and eventually led to another contribution from the TARP fund earlier this month.

Press reports indicate that Mr. Thain at the time was off skiing in Vail, Colorado. When he returned, apparently on a head count adjusted basis, the Merrill bonus pool was distributed to firm employees three days before the merger was concluded. That bonus pool is said to have been down less than ten percent from the 2007 levels. That is right! Less than a ten percent year prior when most other firms distributed pools that were less than half of the prior year!! Mr. Thain also was apparently scheduled to shortly depart for Davos, Switzerland where the World Economic Forum will be held later this month. This was despite strong hints from others at Bank of America that such a trip would not be appropriate at this time.

Initial Reflections on Demise of Lehman Brothers

The weekend of September 14th 2008 certainly will be known as a most remarkable weekend for American high finance. Both Lehman Brothers and Merrill Lynch have disappeared; the first to bankruptcy, the second to a Fed-directed merger with Bank of America. Several people have contacted Lars Toomre to ask various questions about might lie ahead in the near and longer-term future, and what "I" might know.

As a former employee of Lehman Brothers, I am sad to see that franchise disappear seemingly into thin air. Yet as readers of this blog no doubt are aware, I have been very contemptuous particularly of the former Capital Market managements of Citigroup, Merrill Lynch and UBS and their risk management teams. Clearly, the leaders of those firms really did not understand what types and amounts of risk they were taking on with all of their accumulation of sub-prime mortgages, CDOs, SIVs and other structured finance products. Why they had to own so many billions of these products made no sense except if they were making the bet that they could make a spread between the asset yields and where those products could be funded.

Back in the late fall of 2006 and early winter of 2007, I became extremely worried about the irrationality of the fixed-income markets. On February 5th 2007, I wrote the post It's All Fun and Games Until Someone Gets Hurt where I highlighted

Toomre Capital Markets LLC has been quite concerned about the irrationality of the United States fixed-income markets. Recently, the current coupon mortgage-backed security has traded with a negative option adjusted spread ("OAS"). Buyers of the current coupon MBS apparently were paying little heed to the fact that the underlying mortgages could be pre-paid. Rather the demand for nominal yield far outweighed the risk of prepayment. It will be very interesting to observe what happens with this market sector in the coming months as the Federal Reserve seemingly remains on hold. Is it a time to reach for yield? Or is it a time for safety ahead of one of the bond market's periodic up-heavals?

That post was followed up by one the next week entitled Hedge Funds, Investment Banks and the Value of Liquidity? In that post, I wrote "The financial markets now are full of much liquidity. Are investors, speculators and their bankers appreciating and pricing in liquidity risk? Toomre Capital Markets LLC would suggest that liquidity risk presently is greatly under-valued in the search for 'alpha', absolute return and portfolio yield. The stretch to get ten percent return (after fees) appears to be making rational people start to do irrational things."

Apparently, the folks running Lehman Brothers were not fully paying attention to what they were doing with their mortgage business. Somewhere in my reading of the past few days, I saw reference to why Michael Gelband resigned as the head of Lehman Brothers fixed-income division in June 2007. Apparently, the Lehman Brothers COO Joe Gregory did not want to reduce the risk profile of the fixed-income business (and may even have wanted to expand the risk even further to help fund the firm's global expansion plans).

Lehman Brothers - Fannie Mae Pairs Trade and a Cup of Coffee

Toomre Capital Markets LLC ("TCM") is an active consultancy in the areas of structured finance, risk management and financial engineering. As a result, we have many conversations with numerous people across the spectrum of clients, prospects, former associates and other industry contacts. In the past several months, many of these conversations have touched upon Lehman Brothers, especially given Lars Toomre's personal history of working there and back in the 1980's running that firm's very influential ABS and mortgage derivatives trading business(es).

Given that that specific business area in the fixed-income markets is at the heart of the current credit crunch in the Capital Markets, many have asked more privately just what Lars has been thinking about the on-going market developments. Lars has specifically made a point (until now) on refusing to comment publically about Lehman Brothers and the recent sacking of his former boss, Joe Gregory, who until recently was the President of Lehman Brothers.

On Friday July 11th 2008, yet another contact queried what Lars thought about the on-going melt-down in financial equity securities, particularly those currently in the news such as Fannie Mae, Freddie Mac, Citigroup, Washington Mutual, Wachovia, Lehman Brothers, Merrill Lynch and Morgan Stanley. We talked through the various plus and minuses of these potential investments. This contact, who runs a multi-billion dollar portfolio on a leveraged basis, then asked Lars to put on his theoretical trading hat and suggest some specific trades. Lars demurred.

Value of the Investment Banking Franchsises??

Toomre Capital Markets LLC ("TCM") has been rather quiet in recent weeks about the investment banks and the on-going credit crunch started by sub-prime mortgages and the bursting of the real estate bubble. While some in the industry (like Dick Fuld, CEO of Lehman Brothers, and John Mack, CEO of Morgan Stanley) have suggested that the credit crunch is closer to the end, Lars Toomre and Toomre Capital Markets LLC have subscribed to the view that the collapse of Bear Stearns was just the nasty end to front edge of a massive credit deleveraging hurricane.

In the time since the Federal Reserve helped to broker the sale of Bear Stearns to JP Morgan (with some $29 billion dollars of potential assistance) on March 17th, the capital markets have stabilized. Credit default spreads have narrowed from extreme wide spreads. The equity markets rallied from the March lows. Also, in many fixed-income product sectors, spreads to risk-free securities have significantly narrowed from oversold conditions. In short, the massive oversold (or biased) positions in the Capital Markets have had time to return to more stable conditions.

Or at least that was the case until the last ten days or so when slowly conditions have started to deteriorate again. Are these deteriorating conditions indications of another wave of the credit hurricane about to hit the Capital Markets? Time will tell. TCM suspects that market participants are about to learn that various financial firms did not perform well during the second quarter and that there will be further asset write-downs in various portfolios where liquidity has been sharply curtailed due to the credit crunch. Such news will be no great surprise.

Amidst the turbulence of the various news reports about layoffs, resignations and common stock declines, TCM has begun to wonder just where is there value in the major investment banks [Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers] and their universal bank counterparts [Barclays, UBS, Deutsche Bank, and Credit Suisse]. What are these franchises really worth in a world of sharply reduced liquidity and where new regulations on risk and capital are likely to be imposed? Assuming that these institutions go back to the "old days" of client flow trading, aren't each of these franchises worth significantly less than their current market values? Reader comments and thoughts are welcome.

Merrill Upped Ante as Boom in Mortgage Bonds Fizzled

Toomre Capital Markets LLC("TCM") has previously written about Jeff Kronthal Returns to Merrill Lynch and the absolutely abysmal performance put in by former CEO Stan O'Neal in the TCM post Merrill Lynch's Stan O'Neal: Why Is He Even Still Employed? Ahead of Merrill Lynch's expected announcement of abysmal first quarter earnings, on Wednesday April 16th 2008, The Wall Street Journal ran a front page story written by Susan Pullman (and others) entitled Merrill Upped Ante as Boom in Mortgage Bonds Fizzled. While the article sheds favorable light on Merrill Lynch's new CEO John Thain and (old TCM friend) Jeffrey Kronthal since their respective arrivals in December 2007, the article absolutely savages the former Merrill Lynch fixed-income and senior management. With the expected total write-downs now expected to approach $30 billion, it is very clear how absolutely out of control Merrill Lynch truly was since mid-2006 when Jeff Kronthal was famously relieved for not taking enough risk in the Collateralized Mortgage Obligation ("CDOs") business.

This article explains Merrill Lynch "revved up its production of complex debt securities -- despite a shortage of buyers for them -- in what turned out to be a misguided effort to limit its losses. Its torrid underwriting loaded Merrill with exposure to mortgage securities, whose top credit rating provided scant protection when investors fled. Then Merrill made another fateful move: trying to hedge some of its massive mortgage risk through bond insurers whose strength was questionable." Now among those that are keenly interested in learning what went wrong and when the Merrill Lynch managers knew the extent of their troubles is the Securities and Exchange Commission ("SEC"), which "is examining whether Merrill and other firms should have told investors sooner about the stumbling mortgage business last year."

From the article, in 2006 risk controls at Merrill Lynch were beginning to loosen. Apparently a senior risk manager, John Breit, then the head of market-risk management, was ignored when he objected to certain underwriting risks. It is suggested that as a result, senior Merrill Lynch management then demoted the head of market risk management position within the management hierarchy lead to Mr. Briet's resignation. The article continues,