Dear Senator Corker: Meet The HVol 4 And Basis (Prop) Trades That Destroyed Merrill Lynch
In the past Zero Hedge had respect for Ten. Senator Bob Corker due to his opposition to the nationalization of the bankrupt automakers and making them yet another ward of the ever larger central-planning state. However, after today's hearing with Paul Volcker on the Prop trading ban, any respect we may have had for the Senator has promptly dissipated. While we understand that the pointless bashing of Volcker's proposal by Corker was predicated by his sizable lobby interest (over $21 million raised in the course of his career) and his talking points were undoubtedly a transliteration of a memorandum submitted by one of the Too Big To Fail banks that stand to experience substantial losses should the Volcker proposal pass, one line of argument in Corker's speech that is flagrantly flawed was Corker's naive rhetorical question whether there has been a single instance during the financial crisis where a commercial bank engaging in proprietary trading led directly to that institution failing or having to be bailed out by the taxpayer. Corker assumed the answer is no and kept pouncing on that answer. Well, Senator, you are wrong - meet Merrill Lynch, incidentally one of your biggest financial backers. Also, please meet Merrill's prop basis trade and its prop HVOL4 trade, which combined were the primary reason for the firm's $15 billion writedown in Q4 of 2008 and the subsequent bail out of the firm by Bank of America.
In January 2009, the Wall Street Journal ran an article titled "At Merrill focus is now on Montag, sales chief" in which the newspaper indicated that the bulk of the firm's losses were due to a recognition of a major prop position on Merrill's books gone horribly wrong:
In December, Mr. Montag and his team worked with Bank of America executives handling due diligence on the securities firm to understand the full extent of the losses, according to a person familiar with the situation. The problem then was brought to the attention of Mr. Lewis. Messrs. Montag and Thain have maintained that the losses stemmed largely from old positions that Merrill inherited from previous management.
Behind some of the [firm's $15.31 billion in losses] in the quarter are two related trades that Merrill hasn't discussed publicly in detail.Broadly, both trades are set up to generate returns from corporate bonds while hedging the exposure to the debt through derivatives using credit-default swaps. Those derivatives provide protection against defaults on the bonds.
Merrill, according to a person familiar with the situation, ran two versions of the trade. One was a plain-vanilla strategy while the other was a more complex version. According to this person, Merrill was one of the biggest traders in the complex trade among U.S. firms. European banks made similar trades.
The idea is that the two sides of the trades -- either the plain-vanilla version or the complex bet -- are supposed to move in tandem. For both trades, things went awry in the fourth quarter when bank-lending markets froze. That ultimately triggered a sharp drop in bond prices. The value of default insurance rose, but not enough to cover the drop in the bond pricesBroadly, both trades are set up to generate returns from corporate bonds while hedging the exposure to the debt through derivatives using credit-default swaps. Those derivatives provide protection against defaults on the bonds.
The trade in question is the basis trade, which incidentally also resulted in the blow up of Deustche Bank's prop trading group headed by one Boaz Weinstein, who lost a billion dollars on the exact same trade.
Zero Hedge previously discussed the implications of the basis trade blow up in depth as it pertains to Merrill Lynch, providing observations on how just one simple leveraged prop position (yes Senator Corker, prop) ended up destroying the bank.
So back to our original topic. How could Merrill lose $15 billion on
basis trades? And not just Merrill: Boaz Weinstein's group at Deutsche
Bank lost over $1 billion on this same trade, and basis trades are the
main reason why Citadel has lost over 50% in 2008. Anecdotally, basis trades on CDOs are the reason why AIG, and most of the U.S. insurance industry is in its current deplorable state.
would one go about estimating the P&L impact to these asset
managers? It is not difficult: as the basis explosion resulted in a
mismatch of DV01, or dollar equivalent change in 1 bps point in both
bonds and CDS, or, netted out via the basis trade itself, one can
calculate what the adverse MTM impact was on any notional position. If
we take the CIT example above, and we assume that Merill had a $10
billion notional basis position in the name (this is an
oversimplification but it was probably true for their overall basis
portfolio), and the spread blew out from 0 to 1,500 bps around the time
of the Lehman events, Merrill would have experienced a roughly $6
billion hit on the position (an average DV01 of $4MM), which implies
that a $15 billion loss could have been created as simply as
experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model:
if ML had leveraged its preexisting basis trades even 10x, the total
basis trade notional needed to create this loss would have been only $2.5 billion.
Is it inconceivable that ML had $25 billion in basis trades? Not at all
- after all they were a preeminent CDS trading powerhouse and had one
of the most active basis trade prop desks.
And just in case the basis trade only accounted for a majority (but not all) of the losses, the Merrill HVol 4 prop trade, which cost at least another $1 billion, sealed the coffin. From the Financial Times
Mounting losses at Merrill during December almost derailed the acquisition. Ken Lewis, BofA’s chief executive, threatened to walk away from the deal unless the US government provided $20bn in extra capital. The deal closed on January 1 after federal officials pledged their support.
People familiar with the matter said BofA had dispatched Neil Cotty, its chief accounting officer, during the fourth quarter to work with Merrill’s finance team. They said Mr Cotty played an active role in preparing accounts, wielding influence with Merrill executives who were set to report to him and other BofA officials after the deal closed.
With Mr Cotty’s involvement in December, the people familiar with the matter said, Merrill took a fourth-quarter writedown of $1.9bn in leveraged loans and a $2.9bn reserve against an exposure to derivatives linked to asset-backed securities.
Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m, said a source familiar with the matter.
In a statement issued by BofA, Mr Cotty said: “While BofA had access to Merrill’s financial information in the fourth quarter and had input into many accounting policy and valuation issues, Merrill management was responsible for these decisions regarding the marks and other valuations.”
It is thus extremely short-sighted of Mr. Corker to make such unjustified rhetorical questions all for the sole purpose of making the Volcker proposal seem disingenuous. The truth is that prop trading was the sole culprit for Merrill's collapse and the resultant purchase of the firm by a taxpayer-subsidized Bank Of America. It is extremely ironic that Volcker, who is trying to prevent the kind of 11th hour taxpayer rescue in the future, should be the target of your polemics. However, when there are financial interests to be defended, many of them undoubtedly critical to the very firm who handed you the question sheet that you used when interrogating Mr. Volcker, we fully understand that your allegiance lies with Wall Street and its continued way of kleptocratic life, and not with your constituency which will once again have to spend billions if not trillions of hard-earned dollars to bailout the very same Goldmans who are currently doing their best to make Volcker seem like an old fool.
Luckily for your electorate, and for the US taxpayer in general, there are those who are happy to call you on your male bovine excrement when the time comes. And this is just one such time.