Jed Horowitz Of DOW JONES NEWSWIRES
NEW YORK -(Dow Jones)- Months before Merrill Lynch & Co. (MER) preannounced a third-quarter loss and a writedown of $5 billion last week, it had been assuring investors and the press that its portfolios of mortgages and asset-backed securities were well-hedged and profitable.
The assurances were often made on background by senior executives reacting to rumors of big losses, rumors being spread by hedge funds that were undoubtedly shorting the stocks. As it turns out, many of the funds were prescient.
Investors are now questioning why Merrill would dissemble if the truth was going to come out weeks later. Similar questions could be asked about Citigroup Inc. (C) and UBS AG (UBS), which each wrote off fixed-income assets of $1 billion or more months after sending out soothing words about their franchises. Bear Stearns Cos. (BSC), whose mortgage woes triggered the summer credit crisis, similarly offered assurances that its mortgage portfolios were solid.
The answer may well be that top executives at the banks had no inkling of the riskiness of their trading strategies, and that subordinates may have kept them in the dark in hopes of a recovery in the credit markets that were battering their trading positions.
"They didn't understand or someone was willfully deceiving them," says Arthur Levitt, a former chairman of the Securities and Exchange Commission. "I don't think either is a very good excuse."
Another explanation is that the reassurances came before the unprecedented markets in August whipsawed esoteric structured securities and untested trading strategies. How else to explain Merrill Lynch Chief Executive Stanley O'Neal's cheerleading internal message to employees in July? It attributed the firm's strong second-quarter earnings to "a simple and critical fact: we go about managing risk and market activity every day at this company. It's what our clients pay us to do, and as you all know we're pretty good at it."
Or his pronouncement to a Dow Jones reporter in mid-April that reports about subprime mortgages "have exaggerated and misunderstood the nature of the business and how it's managed."
It's likely that traders overseeing the scarred fixed-income areas were hoping for relief before their firms began closing third-quarter books, analysts said. That was a risky strategy for the traders and their bosses, as it turns out, given the sudden sweeping of fixed-income management decks at Merrill, Citigroup, Bear Stearns Cos. and UBS AG.
O'Neal last week fired global fixed-income chief Osman Semerci and his North American lieutenant, Dale Lattanzio. He also severed all ties with former executive Dow Kim, who stepped down amicably last spring, and reneged on Merrill's previously announced intent to invest in Kim's nascent hedge fund.
Bear Stearns as long ago as April was offering sub rosa assurances that its subprime mortgage franchise was healthy. In August, it sacrificed co-president and fixed-income wizard Warren Spector. Once considered a likely successor to Chief Executive James "Jimmy" Cayne, Spector took the hit for the collapse of two subprime-stuffed hedge funds that have seeped into the firm's dominant mortgage-trading franchise.
Citigroup on Thursday fired its capital markets and trading head, Tom Maheras, in the wake of announcing an upcoming $5.9 billion writedown that took the markets by surprise. The bank also dumped one of his top lieutenants.
UBS is the only one of the big banks to have held its top executive responsible. In July, it fired Chief Executive Peter Wuffli after the collapse of a hedge fund unit, which he had helped engineer, cost the bank some $300 million in its second quarter. In reporting the charge in mid-August, UBS did warn that if "turbulent conditions continue," its investment bank would probably have "a very weak trading result." In October, it said it would take another $ 700 million of fixed-income losses in the third quarter, and it fired Huw Jenkins, its investment banking head.
The rapid fall of such stars is a reminder of the fickleness of fame and fortune on Wall Street. Many of the executives now out the door were widely lauded in the three years prior to last summer, as their fixed-income realms were sparking much of their companies' soaring profits. As recently as July 17, Merrill Chief Financial Officer Jeff Edwards singled out fixed-income head Semerci as one of its most important business heads "under our new management structure." He was based in London to help the firm capitalize on the growth of markets outside the U.S.
Michael Mayo, an analyst at Deutsche Bank Securities, said the fired traders were understandably sideswiped by August's rapid deterioration of asset values.
"Hedges don't always work, especially in extreme circumstances," said Mayo.
But banks who cited unprecedented conditions for their weak third quarters - presumably beyond the ken of their best risk mangers - are walking a fine line when they turn around a few weeks later and fire their top capital markets executives.
"You can't have it both ways," said Mayo, who told clients after Merrill's strong second-quarter results in July that the firm "navigated recent market problems quite well, and that the issues of market concern are not a major driver of earnings."
The layoffs and the losses, meanwhile, should serve as cautionary tales for investors in large financial companies.
"This market is characterized by an overwhelming number of synthetic and derivative products that are not adequately understood by people who build them and by people who buy them," Levitt said. "Investors in companies dealing in these opaque products probably bear risks that they never knew they were buying into."
-By Jed Horowitz, Dow Jones Newswires; 201-938-4047; email@example.com