Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Merrill’s Mal de MER

The problem with management denying massive potential losses is that it is difficult to make a case for massive hedging. In the attached article: “The Predators’ Fall,” published in the March/April 2007 edition of Global Risk Review, I asserted Merrill Lynch’s highly-paid structured credit managers had their boots on the necks of risk managers (see section titled “The Risk Managers’ Dilemma”). I suggested that thwarted risk managers leave and short the positions they were trying to risk manage.

Stan O’Neal’s problem at Merrill Lynch was not risk management, but Merrill’s intractable internal political problems. Now Mr. O’Neal has a bigger problem. Astute shareholders, not to mention the SEC and Merrill’s board, may be curious why a large portion of the massive losses to be reported in 3Q did not show up earlier. Jeff Edwards, Merrill’s CFO, will have to account for his rosy statements in July that subprime exposure was “limited, contained and appropriate.”

Merrill must have been praying for a six sigma miracle when it issued its 1Q and 2Q numbers and accepted its managers’ excuses for not marking down its CDO positions. Merrill was one of the credit line providers to BSAM’s ill-fated structured credit funds. In April of 2007, credit line providers challenged the funds’ marks. Yet, it seems, Merrill was not so finicky when it came to marking its own books.

If Merrill’s risk managers ignored my suggestion and stayed, they are now rewarded with Mr. O’Neal blaming them for his problems. As Winston Churchill pointed out after the Dardanelles Campaign, few sensations are as uncomfortable as having responsibility without authority. Mr. O’Neal had the authority, but now it seems he would like “risk management” to bear the responsibility.

O’Neal ousted several senior managers and David Sobotka, a manager with no CDO experience, inherits the problem. Sobotka will have to deal with a legacy management that is prone to bluffing and suppressing rational dissent.

(See also my article in the winter 2006 edition of the Journal of Structured Finance on the games played in STCDO marking. Those were Merrill’s numbers I debunked).

Will Sobotka be able to manage the mess? Not so far. According to the Wall Street Journal, Merrill marked its books at “seriously depressed market prices.” Yet last week, Merrill marketed “AAA-rated” CDO paper – deserving a much lower rating in my opinion – at a gravity defying price. To be fair, perhaps Merrill is not marking its books at that price; it may simply have been asking its customers to donate a charitable contribution to its balance sheet.

Endnote: This is a short excerpt of a private client report.

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