Wall Street Hires CEOs to Troubleshoot Subprime Portfolios and Revamp Risk Management

Wall Street firms are counting on new CEOs to clean up the subprime mess in their portfolios and revamp their risk management technologies. But they also are selling stakes to sovereign wealth funds.

After booking multibillion-dollar losses in 2007, Wall Street firms are heading into 2008 with a mission to clean up their ongoing exposures to subprime mortgages and rein in their risk management practices. At the same time, newly appointed CEOs, including John Thain at Merrill Lynch and Vikram Pandit at Citigroup, are selling stakes in their blue chip brands to sovereign wealth funds to infuse much needed capital into the business after taking major write-downs in 2007.

With BlackBerrys in hand, CEOs jetted off to the Middle East and Asia to raise capital from sovereign wealth funds that have excess cash to invest. The bailouts will bolster Wall Street firms' capital ratios at a time when rating agencies still are downgrading the structured products that linger on their balance sheets. Brokerage firms that recorded the largest losses in subprime mortgages -- Merrill Lynch, Citigroup, UBS and Bear Stearns -- sold minority stakes to investment funds controlled by foreign governments, a trend that has inspired young traders to coin the phrase, "Shanghai, Mumbai, Dubai or Goodbye," suggesting that U.S. investment banks are becoming more dependent on foreign governments for solvency.

The question is: What will be the impact of the ongoing fallout from the global credit mess in 2008? Will firms have the financial wherewithal to continue to invest in algorithms, dark pools, low-latency trading technology and other advanced trading tools on which their futures depend? And how can firms be expected to innovate in an era of cross-asset trading if they are reluctant to take risks?

Merrill Lynch is counting on new CEO Thain, who reengineered the NYSE, to bring order to the firm's portfolio of subprime mortgages and collateralize debt obligations (CDOs), which led to a $2.24 billion loss and an $8.4 billion write-down in the third quarter of 2007. In December, Thain sold $6.2 billion of Merrill stock at a discounted price to an investment fund of the Singapore government and a U.S. mutual fund company, Davis Selected Advisers.

While Stan O'Neal, Merrill's former CEO, purged many of the senior traders that opposed his strategy, Thain is bringing back some top bond executives, including Jeffrey Kronthal -- who was ousted in mid-2006 by O'Neal -- to consult on the firm's portfolio of subprime mortgage securities. Perhaps these executives would have warned O'Neal not to keep the $40 billion in CDOs on Merrill's balance sheet that turned out to be junk? Rather than promoting people who don't have the right background, Thain "is seeking senior trading and risk-management executives to oversee the firm's trillion-dollar balance sheet," the Wall Street Journal reported in December.

In early January, James Cayne stepped down as CEO of Bear Stearns under pressure resulting largely from exposure to the credit crisis and the failure of two internal hedge funds. Cayne, who remains chairman, is expected to be replaced by the firm's president, Alan Schwartz.

The need for troubleshooters on the Street is aparent. Firms still need to fix their valuation processes, which left them unable to price the CDOs that contained subprime debt. And they still need to execute multileg transactions that span equities, bonds, derivatives and foreign exchange as hedge funds and asset managers demand these strategies. But as fixed-income products grow more complex, dealers must know when to commit capital to particular trades and when not to warehouse these securities in inventory.

But even as Merrill and other sell-side firms seek guidance on their fixed-income businesses and risk-management strategies, the sell side still is smarting from the global credit crisis, layoffs, higher borrowing costs and disappointed shareholders. At least the troubleshooting CEOs understand risk management better than their predecessors. They will build teams, repair morale and learn better techniques to hedge their risk in the future. With any luck CDOs will be lost in a dark pool.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio