US: Undisclosed Losses at Merrill Lynch Lead to a Trading Inquiry

One Merrill Lynch trader apparently gambled away more than $120 million in the currency markets. Others seemingly lost hundreds of millions on tricky credit derivatives.

But somehow all this red ink did not spill into plain view until after Merrill earmarked billions for bonuses and staggered into the arms of Bank of America.

Inside Bank of America headquarters here, executives are asking why. The bank is investigating how Merrill accounted for wayward trades in the final, frantic months of 2008 - and why at least one big loss was slow to appear on Merrill's books.

Of particular concern are the activities of a Merrill currency trader in London, Alexis Stenfors, whose trading has come under scrutiny by British regulators, according to people briefed on the investigation. The loss Mr. Stenfors is believed to have incurred so alarmed Bank of America that this week the bank examined the books of other traders who were on vacation.

Bank of America's embattled chief executive, Kenneth D. Lewis, is trying to bridle Merrill's traders, whose rush into risky investments nearly brought down the brokerage firm. But questions over the Merrill losses - in particular, who knew about them, and when - keep swirling. Merrill hemorrhaged $13.8 billion during the final three months of 2008 alone.

Bank of America's shareholders did not learn of that gaping hole until after they approved the merger of the two companies on Dec. 5. Nor was the extent of the loss fully known when Merrill paid out $3.6 billion in bonuses, which were based on estimates of the firm's performance as of Dec. 8. When the problems became clear, Bank of America was forced to seek a second, multibillion-dollar rescue from Washington.

The epicenter of the trouble is Merrill's markets operation, headed by Thomas K. Montag. Mr. Montag, a former Goldman Sachs trader who was brought in by John A. Thain, Merrill's fallen chief executive, has become a divisive figure inside Bank of America. He is trying to retain his top producers amid the furor over Merrill's bonuses. He flew to Charlotte this week to strategize with deputies from around the world.

"There is a massive cultural disconnect in the trading area," said Brad Hintz, an analyst with Sanford C. Bernstein & Company. "You have Bank of America, where it would seem foreign to ride a motorcycle without wearing a helmet, and at Merrill, the legacy is still there, from the C.D.O.'s and the risks they took on."

For Mr. Stenfors, 38, 2008 looked like a very good year. He recorded a trading profit of about $120 million, and his reward was a handsome bonus, according to people familiar with the matter.

But three weeks ago, while Mr. Stenfors was on vacation, Bank of America risk officers discovered irregularities in his trading account. He appears to have lost a substantial amount on his currency bets, according to a Bank of America executive who was briefed on the matter and spoke on the condition that he not be named because of the delicate nature of the inquiry.

Reached in London on Thursday, Mr. Stenfors characterized the matter as a "misunderstanding" and declined to elaborate. He remains a Merrill employee, and his lawyer, Ian Ryan, said Mr. Stenfors was cooperating in the investigation.

When the discrepancy came to light a few weeks ago, Bank of America dispatched risk-management executives to investigate. David Gu, the bank's chief of interest rates and currencies, who does not directly oversee Mr. Stenfors, initially dismissed Bank of America's concerns, according to a person briefed on the conversations. Mr. Gu argued that the taxpayer dollars that Bank of America had received more than filled the hole, according to this person.

A Bank of America spokesman said that Mr. Gu and his management team discovered the problem and were not dismissive of it. The spokesman added that Mr. Gu had not made the comment about the taxpayer dollar. Mr. Gu declined to comment.

But Mr. Gu and Mr. Montag are coming under intense scrutiny. They and five other executives were subpoenaed on Wednesday by the attorney general of New York as part of his investigation into the merger and the bonuses paid to Merrill workers. Mr. Montag was paid a bonus of $39 million, while Mr. Gu's bonus was close to $15 million.

Even before the merger closed, several red flags arose at Merrill, mostly related to controls and procedures used to monitor and record trades. Some shareholders say Bank of America should have taken a closer look at Merrill. On Thursday, the CtW Investment Group, which represents unions, called for Mr. Lewis to be fired.

Questions also surround the way Merrill Lynch traders marked down trades on an index of credit-default swaps, instruments that have played a crucial role in the financial collapse. The index, which represented bets on 30 volatile corporate bonds, was marked down by several hundred million dollars at the end of the fourth quarter, according to two people familiar with Merrill's trading strategy.

While one Merrill insider said the brokerage had effectively hedged its position, others said the trade contributed to Merrill's fourth-quarter losses.

A former Merrill executive said executives discussed how to value such illiquid investments, but the discussion dragged on through late 2008. Merrill traders argued that the investments traded so infrequently that it was difficult to place an accurate value on them. Merrill risk managers pushed them to use the underlying corporate bonds as a benchmark. In any case, the losses were delayed until after shareholders approved the merger and bonuses were paid.

Even now, Merrill seems to be struggling to manage risk effectively in its trading operation, where some traders seem to flout the rules. In January, for instance, a Merrill mortgage trader set off alarms when he broke the bank's rules on bulk purchases for the second time. In February, Mr. Montag called traders in Europe to question them on the way they had hedged their trades.

"It would be a tragedy if Bank of America shuts down much of the institutional trading business of Merrill Lynch, but on the other hand, it was trading that brought Merrill down," Mr. Hintz said.

• 185 Corruption
• 201 Executive Compensation
• 208 Regulation