An Inside Look at Walls Street's Junk Factory

Third is a series of interesting articles from, of all places, the Fox Business website:

From 2004 to mid 2007, Merrill Lynch was Wall Street’s biggest underwriter of CDO deals built on shaky assets such as loans from places that were essentially mortgage mills. CDOs again are pools of bonds, they are typically made up of dozens of bonds backed by hundreds, even thousands of loans.

Merrill reaped hundreds of millions of dollars in fees by assembling and selling these eventually soured securities.

For example, Merrill Lynch made a lot of money as a part owner of California-based Ownit Mortgage Solutions, a mortgage mill that eventually collapsed in December 2006, [Janet] Tavakoli (a professor at U. Chicago School of Business) points out. Merrill built and sold securities backed by Ownit’s loans.

Ownit issued crazy 45-year ARMs and no-income-verifications loans. In the words of William D. Dallas, its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”

Michael Blum, Merrill Lynch’s head of global asset-backed finance, sat on the board of Ownit Mortgage Solutions. When Ownit imploded in December 2006, Blum faxed in his resignation, Tavakoli says.

But Merrill continued to sell securities, or derivatives, based on Ownit’s loans well into 2007, even after Ownit collapsed, Tavakoli says.

For example, in early 2007, Merrill created a package of securities deals backed by loans issued by Ownit, Tavakoli says.

However, the securities were built on sand. Around 70% of the borrowers of these Ownit loans had not provided full documentation of either their income or assets, Tavakoli says.

Most of the loans were for the full appraised value of homes, meaning they were no down payment loans, loans given at a time when home prices were already starting to crumble.

But in her read of the deal documents, Tavakoli says Merrill only disclosed that Ownit went bankrupt, and did not mention it was Ownit’s largest creditor.

Can Merrill say it did an “arms-length” transaction with Ownit when a Merrill officer sat on the Ownit’s board and Merrill was Ownit’s largest creditor, Tavakoli asks?

In early 2007, both Moody’s Investors Service and Standard and Poor’s, the credit rating agencies, downgraded the Triple-A rated tranche of this Merrill deal to junk status, “an investment they had previously rated as ‘super safe’ with almost no possibility of loss. That meant investors were “likely to lose their shirts,” Tavakoli says.

Moody’s later forecasted that 60% of the original portfolio value could eventually be lost, Tavakoli says.

However, the SEC as a regulator of the investment banks had the power to stop this nonsense, but it did nothing to halt this securitization activity.

“Instead, investment banks accelerated securitization activity in the first part of 2007,” Tavakoli says.