Merrill Lynch Posts $250 Million of Mortgage-Issue Trading Losses

The article below was published in 1985! All the financial fiascos of the last 2 years had already happened then, including huge bank losses (by 1985’s standards…); process failures; rogue traders (or presented as such by their employers); untested financial engineering & lack of proper modeling of newly created securities; sudden markets illiquidity and investment banks stuck with their inventory (think of CDO warehouses); and the question of whether risky investments are appropriate for all investors.... I highlighted a few juicy sentences and added a couple of comments. Enjoy.

Merrill Lynch Posts $250 Million of Mortgage-Issue Trading Losses
by Steve Swartz
The Wall Street Journal, April 30, 1985

NEW YORK Merrill Lynch & Co. said it sustained an estimated $250 million pretax loss, largely because of unauthorized mortgage-securities dealing by a senior trader. The rest of the loss came from “subsequent market volatility" in the securities, the company added. The trader, Merrill executives said, had far exceeded his limits in acquiring mortgages that were packaged into a particularly risky form of securities. The value of some of those securities plunged recently when interest rates went up. Market experts said the trading setback was by far the biggest in recent memory, and was likely the largest in securities industry history. “This is a new world record," said the head of mortgage trading at a rival firm.
[..]

Merrill Lynch said the senior trader, whom it didn't identify, had been fired. However, executives at Merrill Lynch privately identified the trader as Howard A. Rubin.
[..]

The securities said to have caused the problems are created by splitting of the interest payments on the mortgages from the principal and selling each separately. They are known as “interest-only/principal-only" securities, or IOPOs.
[..]

People at Merrill Lynch said Mr. Rubin had accumulated for the firm's account an unusually large portion of the principal-only securities without notifying his superiors. When interest rates went up earlier this month, principal-only securities lost as much as 15% of their value over two weeks, traders said. “He just put them in his drawer," said one senior Merrill Lynch executive. “We didn't know we owned them." Mr. Rubin eventually told his superiors about the unauthorized trades, according to people at Merrill Lynch. Securities firms and banks usually allocate a specific amount of capital that can be risked in each area of trading.

Merrill Lynch's announcement also raised questions about the firm's controls. “This would suggest to me that Merrill's international controls are far less than they should be," said Perrin Long, an analyst at Lipper Analytical Securities Corp. and a frequent critic of Merrill Lynch management. Although Merrill Lynch said that the greater part of the loss stemmed from unauthorized trading, it declined to say how much. However, rival mortgage traders said that Merrill Lynch came to market early this month with more than $900 million in IOPOs at a time when the market was becoming unreceptive to IOPOs. The competitors say Merrill Lynch was largely stuck with the principal portion of the securities in its inventory when the price plummeted.

Merrill Lynch officials say they sold most of the $900 million to customers, except for a portion that was kept in the belief that the price would go up. [my comment: does that imply the other portion was dumped on customers knowing its price would go down??]
[..]

Principal-only mortgage securities are attractive in a market where interest rates are low and mortgage holders have an incentive to pay off early. That produces a quick profit for the security holder, who buys at a discount to principal. When interest rates rise, however, early payments on fixed-rate mortgages become less attractive and the profitability schedule of these mortgage securities is stretched out.

Merrill Lynch officials said Mr. Rubin was suspended a couple of days ago after disclosing his unauthorized trading to his superiors. The officials said Mr. Rubin kept the trades secret for 10 days. They said they were unable to independently monitor Mr. Rubin's trades because he never wrote out tickets for them, a violation of standard procedure.
[..]

The risk of stripped mortgage-backed securities has been a hotly debated topic on Wall Street since the technique was developed last summer. Many investment bankers believed the extraordinary volatility of the security wasn't well understood, and have been predicting that holders could get badly hurt if interest rates moved sharply. However, nobody was expecting a hit as large as the one Merrill took. Although the price of the securities the firm held has dropped dramatically in the last couple of weeks, it didn't fall more than about three points in any one day. Even if Merrill had known it had all the securities, however, selling them when the market began to drop might not have been as easy as it looked. An official at one major firm called the market for stripped securities, of which IOPOs are by far the most popular form, “the most illiquid $11 billion market in the financial world." Merrill Lynch has been selling its position gradually over the last 48 hours, and made its announcement after most of it was sold, market sources said. The firm was extraordinarily active in the Treasury market Tuesday, they added, leading to speculation it was trying to hedge what it hadn't yet sold.

Merrill Lynch officials won't say where they sold the securities, but the firm is rumored to have disposed of at least part through its retail system. Merrill Lynch has sold portions of other stripped offerings retail, but the question of whether retail investors understand a product that complex is a much-debated one.