Toomre Capital Markets LLC("TCM") has previously written about Jeff Kronthal Returns to Merrill Lynch and the absolutely abysmal performance put in by former CEO Stan O'Neal in the TCM post Merrill Lynch's Stan O'Neal: Why Is He Even Still Employed? Ahead of Merrill Lynch's expected announcement of abysmal first quarter earnings, on Wednesday April 16^th 2008, The Wall Street Journal ran a front page story written by Susan Pullman (and others) entitled Merrill Upped Ante as Boom in Mortgage Bonds Fizzled. While the article sheds favorable light on Merrill Lynch's new CEO John Thain and (old TCM friend) Jeffrey Kronthal since their respective arrivals in December 2007, the article absolutely savages the former Merrill Lynch fixed-income and senior management. With the expected total write-downs now expected to approach $30 billion, it is very clear how absolutely out of control Merrill Lynch truly was since mid-2006 when Jeff Kronthal was famously relieved for not taking enough risk in the Collateralized Mortgage Obligation ("CDOs") business.

This article explains Merrill Lynch "revved up its production of complex debt securities -- despite a shortage of buyers for them -- in what turned out to be a misguided effort to limit its losses. Its torrid underwriting loaded Merrill with exposure to mortgage securities, whose top credit rating provided scant protection when investors fled. Then Merrill made another fateful move: trying to hedge some of its massive mortgage risk through bond insurers whose strength was questionable." Now among those that are keenly interested in learning what went wrong and when the Merrill Lynch managers knew the extent of their troubles is the Securities and Exchange Commission ("SEC"), which "is examining whether Merrill and other firms should have told investors sooner about the stumbling mortgage business last year."

From the article, in 2006 risk controls at Merrill Lynch were beginning to loosen. Apparently a senior risk manager, John Breit, then the head of market-risk management, was ignored when he objected to certain underwriting risks. It is suggested that as a result, senior Merrill Lynch management then demoted the head of market risk management position within the management hierarchy lead to Mr. Briet's resignation. The article continues,

Toomre Capital Markets LLC ("TCM") wrote yesterday in the post 'Moment of Truth' for Wachovia about Wachovia's surprise first quarter earnings loss and how much of the loss was due to their approximately $130 billion portfolio in pay option ARMs. On Tuesday April 15^th 2008, Slate has followed up with the sobering article entitled Here Comes the Next Mortgage Crisis. The subtitle to the article is Subprime was just the beginning. Wait until California's prime borrowers start handing their keys to the bank. For those who are more optimistic that the Capital Markets are nearing the end of the mortgage crisis, they would do well to read this very sobering article written by Mark Gimein.

The main thesis behind this article is that with the California residential real estate prices in a free fall, the phenomena of walking away from a home will sharply increase, even for those with strong credit ratings in the so-called "prime" mortgage category. TCM refers to this walk-away phenomena as "jingle mail" and sadly thinks that this phrase will become part of the national lexicon in the coming two years. The article states "Unfortunately, the crisis in California is going to get much worse, and there is no bailout that will solve it. Why? Because if the first stage of the foreclosure crisis was about people who could not afford their mortgages, the next stage will be about people who have every reason not even to try to pay their mortgages." [TCM emphasis added]

Later the article continues. "… for all the California homeowners who in the next year or two are going to find themselves with the choice of whether, faced with a huge new wave of interest resets and a historic decline in the value of their homes, they will simply walk away. First, those home prices: For a weird few months of the mortgage crisis, statisticians came up with peculiar numbers about home values, rolling out comforting stats showing single-digit declines. Well, that's over. Last month, the California Realtors' association (folks who in October managed to "project" that prices would fall 4 percent in 2008) reported that, actually, California house prices in February fell 26 percent from a year ago. In the places where the foreclosure boom has hit hardest, it's worse."

This sharp decline in California real estate prices is causing many of the mortgage products originated in the 2005-2007 to have current LTV's near or in excess of 100 percent. The article then continues to explain how the decline in real estate prices when coupled with coming "prime" option ARM resets is likely to leave many homeowners with the economic quandary of whether they should remain in "homedebtor" hell servcing more debt than the home is worth or in a nonrecourse state like California simply walk away. The article explains:

Tomorrow, on Wednesday April 2^nd 2008, Federal Reserve Chairman Ben Bernanke is scheduled to testify before the U.S. Senate Banking Committee. His testimony last July 19^th resulted in headlines like Subprime losses could hit $100 billion: Bernanke. After today's whopper of a $19 billion write-down from UBS, Bloomberg is now tallying total sub-prime losses at approximately $232 billion. What will tomorrow's headline be? Perhaps Chairman Bernanke might suggest that the subprime losses might hit $500 billion or even more?

Back on July 21, 2007, Toomre Capital Markets LLC ("TCM") created the post Does $50 Billion in Sub-Prime Losses Mean Anything? At the end of that post, Lars Toomre concluded with:

TCM worries that many investors do not fully appreciate how much the investment game of the past several years is changing. Liquidity is going to be a much more valuable commodity than many realize or appreciate. Perhaps the Great Unwind is truly approaching?

The Great Unwind reference was to the provocative research piece that Stefan-Michael Staimann and Susanne Knips at Dresdner Kleinwort put out in early 2007 detailing how closely hedge funds were linked to the investment banking industry and how that business model was likely unsustainable. They strongly declared:

We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).

On Tuesday, April 1^st 2008, UBS AG made its biggeest whopper of an announcement yet: If $10 billion was not enough for the fourth quarter 2007 write-downs, expect $19 billion more for the first quarter of 2008. As Lars wrote back in January 2008,

Is it just TCM? But did not a BILLION dollars used to mean an obscenely large, unbelievable amount of money? In a good year, a large global investment bank might make several billion dollars in earnings. How then is the market so numb to losses of three, five, seven, ten and even more billions in a single quarter? With such tremendous losses, any sane investor really has to question whether institutions such as UBS, Merrill Lynch, Citigroup, Morgan Stanley, Bear Stearns, CIBC and other global investment banks should be rated investment grade????

As the readers of the Toomre Capital Markets LLC ("TCM") Insights section might note, Lars Toomre has previously written about the travails on one of his former employers, UBS AG, in the posts UBS: Still Cannot Quantify Its Exposure to Sub-prime Crisis and What is UBS' Remaining Subprime/CDO exposure?. Before those posts, TCM had written UBS Has a "SMALL" VaR Risk Modeling Problem and UBS: What's Another $10 Billion Dollar Loss Worth?. These posts were made after UBS AG announced on December 10^th 2007 that it was going to be taking more about $10 billion in write-downs on its various mortgage security holdings.

As Lars described then, he can still hear Lew Glucksman (former Lehman Brothers chairman and head of Capital Markets when Dick Fuld headed money market trading) chortling "See you never can trust these financial institutions… Who knows what the fucking balance sheet is worth? Would you buy the common stock of a blind pool? NO!!!!"

Back on Saturday January 10^th 2008, The Financial Times reported in a story written by Miles Costello that UBS management apparently does not know what its CDO/sub-prime exposure is either. The article is entitled UBS admits that it still cannot quantify its exposure to sub-prime crisis and is well worth reading in full. A key section of UBS Management's January 11th 2008 letter to investors reads: "We cannot, at this time, accurately predict the future development of US residential mortgage markets and therefore the ultimate impact on our positions in sub-prime mortgage related securities," the bank told investors in a letter signed by Marcel Ospel, the chairman, and Marcel Rohner, the chief executive. At the time of that article, Lars wrote:

Something seems mighty odd with UBS' on-going disclosures about its CDO/sub-prime exposures. TCM strongly suspects that UBS has been less than completely forthcoming and that the CDO/subprime losses will be larger than the market consensus currently expects. The saying used to be "something does not smell right in Denmark." Perhaps it should be adjusted to say "something does not smell right in Zurich"? Time will tell.