Merrill Lynch Has Bond Loss of $250 Million
Merrill Lynch & Co. stunned the securities markets Wednesday by announcing that it will record a $250-million trading loss in mortgage securities this quarter, after what it called “significant unauthorized activity” by one of its top traders in the unusually turbulent market in those bonds.
Although a large Merrill Lynch trading loss had been rumored for weeks among professionals in the mortgage markets, many traders said its magnitude was entirely unexpected. The loss is understood to be the largest ever in the relatively new mortgage securities market.
Although several major investment firms are expected to report severe trading losses because of a nearly monthlong slump in the bond markets--particularly in mortgage and municipal bonds--Merrill Lynch’s setback is likely to raise questions about the giant firm’s procedures for supervising its bond traders.
“The size is incredible,” said one mortgage bond professional at another firm. “It’s hard to understand how the management could have let it get so big.”
Apparently in response to the announcement, Merrill Lynch stock dropped $2.625 Wednesday to close at $35.375.
The company, the nation’s largest securities firm, did not identify the trader in question but said that he had been discharged and that the matter had been referred to an unidentified regulatory agency.
Wall Street sources said that the trader is Howard A. Rubin, 36, who joined Merrill Lynch about two years ago after working at Salomon Bros., and that the regulatory body is the Securities and Exchange Commission.
If Rubin’s trading is shown to be seriously imprudent or if it involved some falsification of records, the SEC would have the jurisdiction to suspend or bar him from trading and might even refer his case to criminal authorities.
Known to Take Risks
Rubin, mortgage securities traders at other firms said, had been known as a relatively large risk-taker. He did not respond to messages left Wednesday on his telephone answering machine.
Rubin is understood to have been suspended last Friday, when the firm discovered its loss, and fired Tuesday. Sources said that the trader had purchased on Merrill Lynch’s behalf a huge quantity of mortgage bonds without fully reporting the purchase to the firm and that he was subsequently unable to sell them when the market plummeted earlier this month.
Although Merrill Lynch did not disclose the size of Rubin’s position, other traders said that, for the firm to suffer a $250-million loss, the original investment would have to have been as much as $3 billion to $4 billion, a position with which few, if any, individual traders on Wall Street would be entrusted.
Merrill Lynch reported the trading loss on a “marked-to-market” basis, meaning that it is still a paper loss based on the declining market values of the bonds in question. Theoretically, a recovery in the mortgage bond market could reduce the final figure if the firm is able to sell the bonds at higher prices than they fetch now.
No Overall Loss Expected
William Clark, a spokesman for the firm, said it does not expect to report an overall loss for the second quarter, ending June 30, because profits in other areas will exceed the bond trading loss.
Still, securities analysts immediately began slashing their profit estimates for the firm. One leading analyst, Perrin Long of Lipper Analytical Services, said he is cutting his second-quarter estimate for Merrill Lynch profits by more than half--to 35 to 40 cents per share from 80 to 85 cents. The firm made $1 per share in the first quarter, which ended March 31.
Merrill Lynch’s loss came when the mortgage securities market suffered an unprecedented plunge during the first few weeks of April. Because mortgage securities--which are essentially bonds backed by “bundles” of conventional mortgages issued by banks and savings associations and then sold to the bonds’ underwriters--had performed so well in the market over the last year, many investment firms had overstocked them.
Meanwhile, the mortgage bonds had become so complicated in design that their price movements relative to other securities had become unpredictable. This means that traders had found it more and more difficult to hedge their holdings of mortgage bonds through investments in other markets; consequently, the mortgage market had become even riskier.
These factors combined to set the stage for this month’s unforeseen violent plunge in mortgage bonds. When interest rates turned up at the beginning of April, a condition that forces bond prices down, the firms dumped immense quantities of mortgage bonds on the market, creating a wave of panic selling. Some bonds lost 10% of their value in slightly more than three weeks, traders say.
“The rate of change was so unprecedented that there were essentially no bids (no buyers),” one trader said. The violence of the collapse contributed to the sharp rise in home mortgage rates experienced by home buyers over the last few weeks.
Rubin, traders familiar with his activities said, had taken an exceptionally large position in an unusual form of mortgage securities derived from bonds issued by the Government National Mortgage Assn., a quasi-public agency that “bundles” home mortgages into securities and sells them on the public markets. The bonds are familiarly known as “Ginnie Maes,” after the acronym of the agency, GNMA.
Merrill Lynch and other firms had been breaking up the bonds for trading into two separate instruments: one representing the underlying mortgages’ principal, the other the mortgage interest. Rubin’s holdings were reportedly in the principal bonds, which fell particularly steeply in price.
Sources say Rubin had not reported his huge holdings of GNMA bonds to Merrill Lynch and was unable to sell the holdings as the bonds fell. Merrill Lynch finally learned of Rubin’s position after questions from other traders forced it to investigate, sources said.
Still, traders and other Wall Street professionals said the scale of the loss suggests that Merrill Lynch was inadequately scrutinizing Rubin’s trading, particularly as the mortgage markets became riskier and more volatile. At most firms, traders must report their overall trading positions at the end of each day, marked to reflect the closing prices of the securities in their portfolios.
“The question that comes to mind is about their larger controls on the mortgage-backed-securities traders,” Long of Lipper Analytical said. “If they hadn’t been asleep at the switch, maybe they could have cut their losses.”