Missing Pieces

How poor risk-management techniques contributed to the subprime mess.

Contrast these examples with Goldman Sachs, where risk reports to the CFO. Or with Lehman and Deutsche, where risk is an independent function that reports to the CEO. At those banks, risk management is vigilant, with frequent communication among business groups. Indeed, though we have not yet felt the full effect of this crisis, examples of how to manage risk (think Goldman) and how not to (Merrill, Citi) are already emerging.

Merrill’s Peril

On paper, at least, Merrill’s risk oversight was robust. According to the firm’s 2006 annual report, the then-CFO, Jeffrey Edwards, headed the risk-oversight committee and was charged with establishing risk-tolerance levels, authorizing changes in the firm’s risk profile, and putting in place proper risk-management processes. But in reality, the risk structure had problems. Risk was not integrated but split between a credit risk officer and a market risk officer, both of whom reported to the CFO, who then reported to the CEO.

That may work at a place like Goldman, where decisions are made collectively among executives. But at a firm with a strong-willed CEO, like Merrill, it can backfire.

People close to Merrill say that even if Edwards saw the risk, contradicting then-CEO Stan O’Neal was a dangerous game. “Either you did what he wanted or you were out,” says a Merrill employee. Ironically, it was O’Neal, a former Merrill CFO, who drove the firm to take more risk with its own capital. Relieved of his job in October, shortly before Edwards (who remains with Merrill as part of the Executive Client Coverage Group), O’Neal also had overseen the $1.2 billion acquisition of subprime-mortgage originator First Franklin in late 2006 as the sector was deteriorating.

Merrill may have also become addicted to the enormous fees it collected from underwriting collateralized debt obligations (CDOs), which reached nearly $1 billion in 2006 and 2007 combined. Because CDO investors demanded the lower-credit, higher-yielding slices of the securities, Merrill did not have enough of a market for the investment-grade tranches and began keeping them on its books. Its pre-crisis holdings peaked at an only partly hedged $41 billion. As with Morgan Stanley, Merrill apparently felt those tranches were reasonably safe. And that may have made Merrill reluctant to pay the high cost of such insurance, says Tanya Azarchs, banking analyst at Standard & Poor’s. “But by the time people realized what was happening, it was too late to do anything,” she says.

In December, Merrill appointed former Goldman president and NYSE head John Thain as CEO. He has since hired CFO Nelson Chai, also a former NYSE executive, and integrated market and credit risk under two co-CROs — former Goldman global risk officer Noel B. Donohoe and Edmond N. Moriarty, formerly Merrill’s chief credit officer. Both report to Thain. In addition, Thain has instituted weekly risk meetings and changed the compensation structure from one that encouraged risky bets to one that reflects “firm results first,” according to a January presentation.


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