4 questions for Stan O'Neal

stan_oneal.gi.top.jpgInterview by William D. Cohan, contributor

(Fortune) -- How did Merrill Lynch end up with so much exposure to the CDOs that ultimately sank it?

It was never my intent that we would take risk other than the intermediation risk in the mortgage business. If you package, structure, and sell what you buy, or if you originate it yourself, presumably you can control the quality of the credit a little bit better. But if you do that, you're going to have warehousing risk and inventory risk. ... It should have been more like $10 billion for us and probably was around $10 billion at the end of '06, but by April of '07 they'd run to $45 billion. It didn't grow much from that point, but it was too late.

In retrospect, did you delegate too much -- including the CDOs -- to your lieutenants? Shouldn't you have had Merrill's risk managers report directly to you?

Did I delegate risk management too much? I can't really say. Bear, Citi (C, Fortune 500), Lehman, AIG (AIG, Fortune 500), Fannie Mae (FNM, Fortune 500), and many others all got it wrong. Even Morgan Stanley (MS, Fortune 500) got it wrong to a degree. In each case the structure of risk management was different. So it's not clear it would have made the decisive difference. Also, I never stopped looking at the risk reports. It turns out they didn't properly capture the nature of the risk. I now understand why, but it obviously doesn't matter. A second point: In August 2007, there was no sense of crisis generally within the firm, and I wanted, insofar as possible, to keep it that way. Nevertheless we were working on ideas for selling, hedging, or mitigating the risk of the CDOs and making sure liquidity was strong. We were successful in assuring liquidity but could find no options for the CDOs. I was never far away from these efforts. I knew where we were every day.

Tell me about your discussions in spring 2007 with Rodgin Cohen, your lawyer at Sullivan & Cromwell, and Tim Geithner, then president of the New York Federal Reserve Bank, about the possibility of Merrill becoming a bank holding company.

Having a larger consumer base as part of the financing base, and beginning to change the character of not only the balance sheet, but also the composition of business at Merrill was something I would have liked to have done strategically. It turns out it's much more complicated to do. ... Rog was initially confused. He asked, "Why would you want to do this?" and "Here's some of the negatives that come along with it." But ultimately we began to have conversations about it. He had some exploratory conversations, I believe, in Washington, and there were also -- to the degree I understood it -- there were some politics behind all this as well, like, who was going to regulate it? In the end, it didn't happen, obviously.

You have been criticized for taking your annual two-week vacation in August 2007 as Merrill's CDO problems escalated. What's your reaction to that criticism?

People say to me, "You went away on vacation." Well, there wasn't a lot I could do on-site, and I didn't want to start to raise alarm bells by flying back to New York. I wanted to give some time and quiet after the shock of the [Aug. 9 news that French bank BNP Paribas had blocked investors from withdrawing money from three funds because of the "complete evaporation of liquidity" in some segments]. That was seminal -- it scared the bejesus out of me. Henry Paulson called up after that and said, "How do you feel about things?" I said, "If you had called me a couple of days ago, I would have been more sanguine. I'm not anymore." He said, "Why?" And I said, "Because you had overnight secured lending fail between rated banks. I think it means there are potential risks in what we think we see going on."

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