Blood on The Street – Merrill Lynch et al Miss the Point of Security

Stan O'Neal, CEO of Merrill Lynch & Co will likely be “shot at dawn.” Sure he will resign, but if he didn’t, the board still would want “his head on a stick.”

He did three things that are each next to inexcusable as a leader of a publicly held business. 1. He led Merrill during a period when they lost billions in fixed asset trading. 2. He began an unauthorized probe to determine whether or not a merger with Wachovia Bank was possible, when 3. he stands to earn about $250 million because of a change of ownership provision in his employment contract. If he led that merger, he would get rewarded.

O’Neal is taking the heat for taking major risks in fixed assets such as mortgage backed securities, credit backed options and structured investment vehicles, all stuffed with mortgage derivatives. The risk he took was letting his financial engineers play poker with fake housing chips.

These MBS are hardly mortgage backed securities but commoditized principal payment, interest payment and risk bets on the underlying rights to collect the principal and interest represented by your’s and my mortgage. They have commoditized our castles and have indirect rights or security over these homes. The servicing or lending companies that lent the mortgage could unwind the deal and recover the value as the asset still exists. It is just the risk that is suspect.

Real estate is a fungible asset. When a bank or other financial institution lends money in the form of a mortgage, they take a security over it. They sell this security to the secondary market which derivatizes this into components of principal, interest and risk. They buy the paper, in turn funding mortgage lenders while the wizards of Wall Street derive huge fees, that is of course is if they are not holding vast amounts of paper in the process of transition from seller to buyer.

This is what happened to Merrill Lynch. They were caught with billions of dollars of derivative inventory in the process of being sold. Their delay in passing this through their books was brought about because of the uncertainly of value and the increased risk now attached to MBS derivatives. They revalued this paper down, hence the write down loss.

While all of this has happened, home sales have slowed, mortgage availability has tightened and home values in over-built regions with soft economies have dropped. Risk rating agencies like Moodys, S&P and Fitch have been telling us housing was in trouble, while at the same time telling their Wall Street clients and investors till recently that MBSs were a low risk.

If you are reading this, chances are you did not buy in one of these markets and do not invest in MBSs, so go back to bed, pull up the covers and sleep peacefully. Already in certain markets the popular media are beginning to report that the real estate value rout was maybe overblown? Not so for Stan O’Neal who will likely resign with a departure package of $50,000,000 for his mistakes. Oh, to be that smart.

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