The story of John Breit

 

Financial institutions have “risk managers,” whose job is, in essence, to worry about such matters as we’ve been discussing. A risk manager assesses the risk to an institution’s portfolio or portfolios, assigns the appropriate number, and (to the extent his organization allows) does generally try to mitigate it. Speaking a bit roughly, there are four things to do about any given risk: avoid it, mitigate it, transfer it, retain it.

If a risk manager persuades his superiors that a particular proposed merger comes with a lot of risk, because a “due diligence” review shows the potential target company has a lot of off-balance-sheet liabilities, then he may scuttle the merger entirely. Mission accomplished.

If he can’t scuttle the merger, he can at least suggest ways in which the risks of the merger may be reduced, by for example making it a condition of any deal that the target entity spin off its more troublesome subsidiaries first.

When it can be neither avoided nor reduced, risk can often be transferred. If you’re worried that you own a flammable piece of property, you buy fire insurance. This doesn’t eliminate or even reduce the chance of fire, but it makes that chance somebody else’s problem.

Finally, the default choice is that the identified risk is simply retained. 

One obvious problem with this job description: the risk manager doesn’t himself make any readily discernible contribution to the bottom line, certainly not in quarter-by-quarter terms. Indeed, in a boom period the risk manager may well lessen the bottom line by virtue of doing his job well.

One sign of a bubble is that the services of risk managers are devalued. They lose the nice corner office and end up in a broom closet. This was John Breit’s situation at Merrill Lynch in 2007.

Breit (pictured above) the head of “market risk” at Merrill. At the peak of his prominence in the councils of Mother Merrill, in 2002, he reported directly to the company’s CFO and could also as needed communicate directly with the board of directors. The board, in turn, understood that Breit was intimately familiar with the particulars of their complex derivatives positions. His analyses carried weight.

 

But by 2006, people weren’t even bothering to be polite to old wet-blanket Breit anymore. This was a pity, because the company was becoming ever more dependent on the sorts of instruments he understood at least as well as anyone around. Key examples were collateralized debt obligations (pools of non-mortgage but securitized debt) and even CDOs Squared (pools of the pools of non-mortgage debt).

In August 2007, Dale Lattanzio, the head of Merrill’s operations with CDOs pressured two junior analysts to sign off on a new piece of accounting trickery that would let Lattanzio and in turn those to whom he had to report take a more optimistic view of the value of the CDOs on Merrill’s balance sheet.

The two pressured quants reported Lattanzio’s approach to Breit. This startled Breit into a thorough inquiry into Lattanzio’s operations, and he soon discovered that the CDO operation stood to cost Merrill not the mere millions that Lattanzio was admitted were at risk, but billions.

There was $55 billion worth of exposure, and $40 billion of that had been added just in the preceding year, since Breit had been in effect consigned to the broom closet.