Dear Senator Corker: Meet The HVol 4 And Basis (Prop) Trades That Destroyed Merrill Lynch

Tyler Durden's picture

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.

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Forbes's picture

Hey, the party is going just fine. Don't take away the punch bowl.

TraderMark's picture

Senator Shelby to Maria B: "Volcker rules! Dat's for the birds.  We gots a regulator who will take care of this."

nevermind that this regulator just missed the biggest bubble of all time.  Or didnt catch LTCM until it threatened the system.  Those errors will never happen again - screw Volcker and his so called "protecting the system".

(5 minute video)

Anonymous's picture

The Responsibility Party needs your help

1) No more too big to fail
Let savers win and gamblers lose

2) National Sales Tax of 12%
Get it done with these funds or don't do it

3) End the corporate lobby capture of Government

4) Exchanges for trade of all financial instruments that are truly regulated

Who's with me?

Cheeky Bastard's picture

They are all whores, with the exception of Paul, Kucinich, Sanders and Grayson ... 

VegasBD's picture

I thought the same bout Greyson. But then I signed up to receive his emails and now realize hes just another crummy congressman. Dont get me wrong, long the fact that he rips the Fed a new one everytime but that comes from the fact that hes a EuroPac Client (Peter Schiffs Company) and found it an easy way to raise large sums of money from the anti-fed crowd.

Cheeky Bastard's picture

Goddamit, sometimes I'm just so naive i want to hit myself in the face with a shovel ..

nopat's picture

At least it'll keep you from punching yourself in the dick...

milbank's picture

And the problem is???

Anonymous's picture

Whj dignify them by classifying them with whores?

Whores are saints with a ticket to heaven compared to what passes for a bureaucrat, our politicians, who are really our enemies, to be smote with extreme prejudice.

Cheeky Bastard's picture

i dont even consider them bureaucrats, but little, insignificant, shit-for-face aparatchicks, easily replaceable,  easily forgettable.  

milbank's picture

I totally agree.  Paul, Kucinich, Sanders and Grayson. 

These hearings expose the interrogators more than the interrogated.

Congress is a bought and paid for shitshow.

"We The People" are on our own.

ArkansasAngie's picture

And now Lanche Bincoln calls herself an independent fiscal conservative.

Ladies and gentlemen, boys and girls, we got some world class horse manure going on here.

Where in heck is John Wayne when you need him.

Miles Kendig's picture

Dealing with another Angie at Rio Bravo..

milbank's picture

Understand, John Wayne was a character who played characters in movies. In real life, Marion Morrison was no hero.  He was a right-wing racist wacko coward who, amongst other things, avoided going into WWII under a sham pretext so he could further his career while his competition was in uniform.  Some, like Stewart and Gable actually seeing action.

Of course, Marion had no problem with others dying to protect his hypocritcal hide.

jeff montanye's picture

thanks for the needed clarification.

Anonymous's picture

Maybe a revised Volcker Plan could just put an end to basis trades.

lizzy36's picture

You know what puts an end to bad trades:LOSSES owned by the entity who took the risk in the first place. 

jeff montanye's picture

as volcker's nyt oped makes clear he wants to do.

Miles Kendig's picture

Nothing but net!  WhoT!

Cursive's picture

Money is the lifeblood of politics.  Corker is getting plenty from the banksters and SCOTUS is more than happy to open the spigot wider.  I think it will backfire, anyway.  You can only beat a dog so long until he fights back.

Rainman's picture

The cowards and traitors are at least predictable. All for sale.

America needs a 21st Century Constitutional Convention. First order of business is to move the Nation's Capitol to Des Moine, then convert all D.C. public buildings into museums we can visit often and never forget how fukked up it all got.

Politicians perched in halls of taxpayer-owned opulence while they steal us blind is obviously not a good idea.

Anonymous's picture

Wouldn't Detroit be more appropriate?

Dburn's picture

The Mohave from May to Sept. No A/C. Tents and Flying Red Ant Protection (hah). $100 extra pay if they can hit a sidewinder rattlesnake from 100 Yards with a .22 derringer. Gives them something to do if they don't die of a heart Attack.  


"First thing you boys have to learn out here is ;

don't pick nothin' up. Ya hear?"



milbank's picture

Des Moines?  Lovely. Next you'll be wanting Larry Dickman for be President.

Screwball's picture

America needs a 21st Century Constitutional Convention. First order of business is to move the Nation's Capitol to Des Moine, then convert all D.C. public buildings into museums we can visit often and never forget how fukked up it all got.

I think your on the right track.  Let's change those buildings in D.C into prisons.  Let me check my calendar...ok...Monday is good for me.  You in?

Cognitive Dissonance's picture

Maybe not. Considering the rampant greed and corruption on display today, don't forget that once a constitution convention is opened, the ENTIRE constitution is up for revision. You can't restrain the convention to certain parts.

If the powers that be want even more power, this would play into their hands. Once they get the changes they want, they will use the corruption to ram it through the state houses, under martial law if need be.

Don't underestimate these guys.

Whatdoesitallmean's picture

His performance makes me sick, the bankers (GS/MS/JPM...) should be proud.

Miles Kendig's picture

This effort has left me better informed, refreshed, entertained and reflective of the current state of modern American conservatism.  Or what passes as such from the mouth of Senator Corker.

Anonymous's picture

Wealth without labor is dangerous. And the worst part is the middle/lower working class have lost their influence on the government.

Citi just raised my AA advantage cc balance interest rate by 400 basis points. I have been citi card holder for 20 years, with no bad days.... I called the bastards yeseterday to understand, said had to raise rates to keep loaning money in this environment. I said let me get this right, your bank is one of the primary crooks in the crime of the century and now you borrow money at .5% and want to charge me, a loyal, profitable customer 18.99%???

Banks are a souless entities. At what point do the people break into the bastille?

-Lunatic Fringe

Anonymous's picture

You must have been a very profitable customer - Citi raised mine to 29.99 - and then cancelled me a few months later (probably because I would pay in full every month and still get the 1% cash back)

perchprism's picture


They raised mine to 18.99% too.  I called and told them to cancel my card, so I was shunted to a supervisor to get me to change my mind.  "Tell us what you want us to do to keep you as a customer," the lady said.  "Hear that noise?" I replied.  "That's the sound of your credit card getting scizzored up.  There's nothing you can do."  Oh yeah, I said something too about how they were able to get money for nothing at the Fed discount window, and then turn around and charge me 19%---outrageous.

I now have two new cards--Chase and Discover--with 0% introductory that I transferred the Citi balance to.  0% for 8 months, enough time to pay it off.





Anonymous's picture

Exchanged many emails with Corker and his kid banking staffer. He's a financial services shill and has not only lost my vote, but will make sure my Tennessee bretheren know he is one.

Miles Kendig's picture

Here in the Shelby County portion of Marsha Blackburn's TN-7 district there is already an excess of 100K ready for Corker's opponent in 2012 due to Corker's total conflation of conservatism with kleptocraticism.  Too bad that whoever is opposite Corker on the ballot will most likely be an identical shill for the financial services industry.

Anonymous's picture

if you are looking for a credible opponent in
the dem or repub parties you are wrong wrong

jeff montanye's picture

what is the answer?  what kind of law or constitutional amendment would take the money whoring (somewhat) out of politics?  this seems like the root of the problem.  since major contributions seem to pay off 100 or 1000 to 1 the corporations and rich won't stop.  and since the politicians need enormous funds to finance campaigns they can't stop.  what stops it?  don't say pitchforks or beheadings because that's not happening and if it did it would be worse by orders of magnitude.  

Miles Kendig's picture

As long as the music is playing we must continue to dance - Chuck Prince, CEO Citi

Ya, too bad the concept of self restraint is lost to those in the public & "private" sectors who rely upon the policy of judicial exclusion to do their work.

Miles Kendig's picture

Credible?  ROFLMAO.  There is no such thing as credibility or loyalty to the Constitution to be found among the political class of the United States, a couple of noteworthy examples excepted.  Still, one must do what one can until more of society catches up.... Especially those whose oath to the same Constitution is actually considered binding.

IveBeenHad's picture

its a shame too that the guy spearheading the effort is like 90... its easy for his opponents to scream "crazy old man". 


another epic piece though. 

The great enemy of the truth is very often not the lie, deliberate, contrived and dishonest, but the myth, persistent, persuasive and unrealistic. 



Zippyin Annapolis's picture

Treasury should clarify-- if Geithner Really is In favor of the Volker proposal (wink, wink--not). Larry and Timmy thought crazy uncle Paul was safely locked up in the White House attic until the WH political spin doctors found the key--can you say "focus group"?

Anonymous's picture

Just out of curiosity, what was the answer when Corker asked the question? Was it just a dumb look or did the interviewee fire back with some evidence?

rawsienna's picture

Dont forget about the 40bb of Resi CDO exposure they had on their books at the end of Q2 2007 - Guess it was one of those custy trades that became a prop trade. 

Anonymous's picture

whomever survived that prop desk made a fortune in bonuses while some folks were thrown under the bus.

why isn't the public outraged that those guys are taking home giant paychecks at their expense after taking outsized risk?

Anonymous's picture

We are being completely and utterly SCREWED by people like Corker--the very people we elected to protect our interests!

VOTE this self-serving SCHMUCK out the first chance you get, Tennesee!!

andrew123's picture

Tyler, if the "Volcker rule" is that the regulators will enforce a prop trading ban, and that they will know "prop trading" when they see it, does the Volcker rule really have any teeth at all?  I am asking seriously, as you seem to think this is a big deal.  Won't GS claim its hft is really just market making, ie. "customer facilitation"?  Won't the same logic be applied to all its debt and derivative business, and to the extent regulators do think prop trading is going on, won't the fact that they always make money be used to argue for very lenient capital treatment?

Anonymous's picture

Volcker doesn't need to "fire back" at questions posed by transparently corrupt and ignorant Senators. Just sitting there, looking back, with his gravitas, is enough.

Anonymous's picture

Now that we live in the third world, y'all need a crash course in third world politicians.

no cnbc cretin's picture

I don't think Volcker is going to save this sinking ship. He might slow it down, that's all. Personally, the US is in a major Depression. That's the good part. But, when you include all the debt, gov., public, private, as well as no mfg'ing in this country, 70% of GDP is based on the consumer. Two bogus wars. The real national debt is around 80 trillion. Then add this to the mess: - not to mention the mass corruption going on in this country. - we're SCREWED! Seems to me the only way to fix it, is for a complete collaspe. That's the direction we're headed in anyway.

perchprism's picture


Realistically, when we know it'll take several years of disciplined austerity to get out of the hole, we know that's just not politically possible, right?  So the only alternative is to junk the system and start over.  Let it go, then, I say, and get it over with.