Merrill Lynch's $50 billion feud

(Fortune) -- For Stan O'Neal, late August 2007 was a period of great anxiety. The chairman and CEO of Merrill Lynch was vacationing at his home on Martha's Vineyard and, as the world would later learn, playing a lot of golf. But he was also increasingly concerned about a $45 billion time bomb buried deep in Merrill's books. That bomb, of course, was the firm's liability from collateralized debt obligations (CDOs) -- an amount that had more than tripled just between December 2006 and April 2007.

The magnitude of the problem "hadn't been apparent in ways it should have," O'Neal tells Fortune in a recent conversation, his first on-the-record interview since he was forced to resign from Merrill in October 2007. As O'Neal dug into the issue from his vacation home off the coast of Massachusetts, he was flabbergasted by what he discovered. "A few things became clear," he says. "One is the complexity of it was far beyond what I would have imagined. Second, the number of people who actually understood the aggregated view of this -- not just in terms of size and scale but the potential complications associated with it -- were few and far between." When O'Neal finally came to grasp what the "aggregated view" meant, he realized his firm was facing an increasingly dire threat.

A little more than a year later, Merrill faced disaster and was forced to sell itself to Bank of America (BAC, Fortune 500) at the peak of the crisis in September 2008, when it appeared that the world's financial system just might unravel. O'Neal took his place in the pantheon of disgraced former Wall Street chieftains, his career reduced to a caricature among the many cartoonish goats of that tumultuous year. There was Bear Stearns's Jimmy Cayne (the CEO who flew off to bridge tournaments while his firm crashed) and Lehman Brothers' Dick Fuld (the CEO who seemed to hide in his bunker and trotted out other executives as sacrificial lambs when his firm faced its greatest peril).

O'Neal's distinguished career was reduced to its own tag line: the taciturn CEO who played golf alone while his firm struggled to survive. But that obscures the fact that O'Neal did recognize the gravity of the threat -- albeit well after he should have -- and did take action to save his firm more than a year before the financial tsunami swept it away.

Twice in 2007 O'Neal tried to negotiate deals to sell Merrill at premium prices, only to encounter crushing opposition from an unlikely source: Alberto Cribiore (pronounced Crihbe-OR-ee), a friend whom O'Neal had appointed to Merrill's board four years earlier. Given his extensive Wall Street experience, Cribiore, a former partner at private equity firm Clayton Dubilier & Rice, wielded outsize power. He argued vociferously that O'Neal was too negative and that Merrill could address its CDO problem without having to sell the firm at a moment of weakness.

This pitched battle between the CEO and the board member, largely unexplored until now, shows how a single person was able to thwart what may have been Merrill's salvation. And it suggests that O'Neal's failure consisted as much of his inability to persuade his board to take necessary action as it did in his earlier cluelessness about the risks posed by the mountains of CDOs, those bundles of debt securities, many of them tied to subprime mortgages.

Whatever you think, one conclusion is inescapable: This conflict cost Merrill shareholders dearly. In the aborted 2007 negotiation, O'Neal seemed close to a deal with Bank of America to sell for about $100 billion. When Merrill was finally unloaded a year later to the same buyer, it went for half that amount. In all, the failure to sell in 2007 would cost Merrill shareholders some $50 billion.

In the summer of 2007, the country's real estate bubble was finally beginning to pop. Two hedge funds at Bear Stearns, loaded with the same sort of CDOs that were lurking on Merrill's balance sheet, had exploded spectacularly in July, costing investors $1.5 billion. Credit markets the world over seized up. O'Neal concluded that the stuff on Merrill's balance sheet couldn't be sold. "There wasn't a buyer in the marketplace, and price didn't matter," he says. "You couldn't sell it and you couldn't hedge it and you couldn't finance it and you couldn't swap out the risk," he says. "It was too late."

The firm's vulnerability was agonizing for O'Neal. As CFO during the summer of 1998, he had lived through a liquidity nightmare brought on by both the Russian crisis and the near collapse of hedge fund Long-Term Capital Management. He knew how quickly things could spin out of control.

The CDO problem in 2007 left Merrill, as O'Neal puts it, like "a fighter in the middle of the ring with your hands tied behind you and an opponent, whenever he chose, could just whale away on you, punch you right in the face. And there was no referee, so he could kick you in the balls, give you an elbow to the chin and you could do nothing except stand there until he decided he was tired or finished or beneficent or whatever it was and turned away and walked out of the ring. That seemed to me to be unbearable. We had to have alternatives."

One alternative he considered was for Merrill to begin to write down the value of its CDOs, which would then require the firm to raise new equity. Once back in New York, O'Neal had a conversation with Cribiore, who was the most sophisticated financially among the outsiders on Merrill's board.

The two had known each other for more than a decade, ever since Merrill, with O'Neal then head of its high-yield bond department, had underwritten a groundbreaking high-yield financing for Van Kampen Merritt, a large asset-management firm that Clayton Dubilier had bought in 1993. Cribiore had been especially impressed by O'Neal's creativity. Cribiore later hired Merrill to sell Van Kampen (which was bought by Morgan Stanley (MS, Fortune 500)).

The deal was a huge success, and Cribiore and O'Neal remained friendly over the years. Cribiore, a major opera buff -- he is an advisory director of the board of the Metropolitan Opera -- invited O'Neal and his wife to go with him and his wife to the opera a few times. The two couples also dined together occasionally in New York City. When O'Neal became Merrill's CEO in December 2002, Cribiore sent him an expensive case of Baron d'L wine from the Loire Valley in France. "I suggested that the way to take care of the stress is open a bottle," Cribiore says. In 2003, O'Neal asked Cribiore to join Merrill's board of directors.

A more unlikely pair than O'Neal, 58, and Cribiore, 64, would be difficult to find. O'Neal is intense, reserved, and, some say, aloof; Cribiore, jovial, outgoing, and loquacious. O'Neal speaks in a quiet monotone with just a hint of a Southern drawl. Cribiore gushes in a strong Italian accent that has barely thinned despite decades in the U.S.

O'Neal's hardscrabble upbringing has become well known, especially since he became the first black CEO of a major Wall Street firm. He grew up in the rural Alabama town of Wedowee, population 800. His big break came from the General Motors Institute, which awarded him a work/study scholarship to study engineering and industrial management and then hired him as a foreman at an Atlanta plant. Later, on a GM scholarship, O'Neal attended Harvard Business School, which led him to deal work for GM and then to Merrill Lynch.

At Merrill, O'Neal rose into a series of increasingly important jobs. (Disclosure: When I was an investment banker at Merrill from 1995 to 1997, I worked tangentially with O'Neal on a deal or two.) As CEO, O'Neal was known for -- depending on your point of view -- rationalizing the company's cost structure or laying off thousands, including rivals, and toughening up the firm's vaunted "Mother Merrill" culture.

Cribiore, who grew up in Milan, faced few of the hardships that O'Neal did, but he still keeps a postcard of his family's modest home. "It's a good reminder of where we started," he says. His father worked his way up from a clerk at Banco Popolare di Milano, the largest commercial bank in Milan, to become one of its senior executives. When Cribiore graduated from college, he got a prestigious job working for the private investment company that managed the fortune of the Agnellis, who controlled Fiat, the Italian car company.

Cribiore later moved to New York after the Agnellis opened an investment office there. But some years later, he decided to work for an American company instead. "To stay in the United States and work for an Italian company is half a loaf of bread," he says. By this time, he had met Steve Ross, the powerful CEO of Warner Communications, and Ross asked Cribiore to become his M&A guy. The two men became close, and Cribiore advised Ross on a raft of deals. Cribiore single-handedly reconstructed Warner's damaged balance sheet by selling 14 companies in six months. And he was in the middle of a maelstrom created when Rupert Murdoch bought a chunk of Warner stock and briefly threatened a takeover. It was all heady stuff.

But after he and Ross disagreed about selling MTV to Viacom (VIAB, Fortune 500), Cribiore left in disgust. He saw -- correctly -- that MTV should have been kept. Cribiore then spent 11 years at Clayton Dubilier, helping make it one of the most successful private equity shops around before going on to form his own firm, Brera Capital Partners, in 1997.

There Cribiore's hot streak ended. Staked to $650 million, Brera invested in high-growth businesses like upstart telecommunications companies. (Disclosure: As a Merrill banker, I was one of the people who pitched deal ideas to Brera.) But the competition for investments was fierce, and prices escalated. Many deals went sour. Take, for instance, Brera's $100 million investment in Classic Communications, a rural cable operator. Six months after Brera bought in, in 1999, Classic went public at $25 a share. Less than two years later, Classic's stock fell below $1. Eventually the company filed for bankruptcy.

Cribiore's timing was poor, and his investments may have been worse. "It was a great lesson in humility," he says. "With full hindsight, I did not spend enough time evaluating what was my competitive advantage." The firm is "in runoff mode," he says, a phrase he prefers to "liquidation." Cribiore hopes Brera will eventually return investors' original investment. "It has been less than stellar," he admits.

When O'Neal asked him to join the Merrill board in 2003, Cribiore was eager to do so. A number of people close to former Merrill executives recall that Cribiore also not so secretly hoped that O'Neal would find a job for him at Merrill, to help him ease out of his predicament at Brera. Out of deference, these people say, the CEO allowed Cribiore to speak to Merrill executives. But O'Neal recused himself from their decision-making, and no job materialized. "Stan rightly refused to give Alberto a job," says one former Merrill insider. O'Neal declined to comment on this subject, and Cribiore denies he sought a Merrill job.

When O'Neal got back to New York from Martha's Vineyard in September 2007, he spoke to Cribiore about his growing concerns. "This is a serious and deep problem," O'Neal says he told Cribiore. "Well, just take as big a write-off as you can imagine," Cribiore told him. "The problem, Alberto, is I don't know how deep the hole is," O'Neal remembers explaining. "I can't sit here and tell you that if I decide to take a $5 billion or $10 billion write-down, I can't tell that that's the right number. I can't tell you if there's $15 billion or $20 billion more, and the reason I can't tell you that is because I don't know how the market will evolve, and there is no market today for these securities. Whatever value we come up with is highly theoretical." O'Neal felt uncomfortable telling Merrill's employees and shareholders that a big write-off would solve the problem when he wasn't sure it would.

O'Neal had a better idea: Sell Merrill. The company's stock was then trading around $70 a share but had been as high as $87 during the quarter, so O'Neal figured initially that any deal would be for at least $90 a share. O'Neal had a keen sense of who the most likely buyers might be. High on the list were big banks with small investment-banking groups, such as Bank of America and Wachovia, both based in Charlotte, and Barclays, in London, which was looking to expand its investment-banking franchise in the U.S.

There was no question in his mind that Bank of America's size made it by far the best partner for Merrill -- and that it could afford the premium he was seeking. On Sunday, Sept. 30, O'Neal drove from his weekend home in Waccabuc, N.Y., to meet with Ken Lewis, Bank of America's CEO, and Greg Curl, the bank's chief dealmaker, at Bank of America's corporate apartment at the Time Warner Center in Manhattan. At one point, O'Neal remembers telling Lewis, "I know we talked $90 a share initially. I thought about it more. I think the number is probably more like $100." According to O'Neal, Lewis responded: "I know. That has been related to me. I'm not saying no, but that just requires X amount more dollars of cost-cutting," or, as O'Neal recalls, something like another $2 billion of cuts on top of the initial $6 billion or so. (Lawrence DeRita, a spokesman for Bank of America, confirms the meeting took place but declines to comment on what was said.)

The next day O'Neal went to see Cribiore at Brera and described his meeting with Lewis. "I know that BofA wants to do this deal," O'Neal says he told Cribiore. "It might be an alternative to taking the big write-offs. We ought to cultivate this alternative, because in the absence of that, I'm not sure what we do." They also spoke about writing down the value of the CDOs and how Merrill would then have to raise more equity capital after the write-down.

Still, it was clear to O'Neal that Cribiore did not like the idea of selling Merrill one bit. "But Stan, Ken Lewis is an asshole," O'Neal remembers Cribiore saying. He says he doesn't think Cribiore knows Lewis personally. "It was shorthand for a perception that Bank of America is like the dark empire," O'Neal says.

That was it. For O'Neal, Cribiore's comment spelled the end of any chance he had of selling Merrill to BofA. O'Neal never called Lewis back, despite the allure of a $100-a-share deal.

How could O'Neal, a powerful CEO, have wilted that easily -- and not even taken the idea to the full board? O'Neal responds: "Alberto was the most knowledgeable person on the board by far about investment banking and about all the issues that we were talking about. If Alberto didn't buy the argument, there was no way I was going to be able to sell the argument to anybody else. And this was a very low-key discussion in his office with no pressure, nobody else listening."

Curiously, Cribiore maintains he has no recollection of discussing the possible sale. "I was not aware that Stan had any conversation with Ken Lewis," Cribiore says. "That was something that occurred between Stan O'Neal and Ken Lewis." Cribiore says he didn't find out about O'Neal's September 2007 conversation with Lewis until a year later, when Bank of America was negotiating to acquire Merrill during the same weekend that Lehman Brothers filed for bankruptcy. By that time, Cribiore had left Merrill's board -- he had departed on Sept. 3, after deciding to take a job as a vice chairman in investment banking at Citigroup (C, Fortune 500), where he remains today. (He was negotiating for the Citi job while he was Merrill's lead independent director, a fact that has irked some Merrill executives and former board members.)

But former Merrill insiders confirm O'Neal's account of the meeting with Cribiore. "Yeah, it was Cribiore who nixed it," one says. "Full stop." Adds another: "Cribiore told him, 'You're not going to sell it with me on the board.'"

Despite Cribiore's claims that he was unaware of the potential sale to BofA, his assessment of what Merrill needed to do makes it clear that he opposed such a sale. "Let's address the problem," he says, arguing that Merrill should have focused on writing down the value of its CDOs in 2007. "Let's solve the problem without having to sell the company. Merrill at that point, and still now, is a great franchise. It's a great brand, a great franchise. And I can tell you that was the way in which the board came out: There is a problem. Let's fix the problem rather than sell the company. Let's save the franchise."

The Bank of America/Merrill deal, version 1.0, was dead. But O'Neal continued to pursue mergers into October 2007. "He had a sense that we were not in a great spot and we weren't going to come out of this independent anyway," says one former Merrill executive, "so let's try to get ahead of the curve."

If there were any doubts of Cribiore's steadfast opposition and his ability to influence others on the Merrill board, it became crystal clear in the third week of October 2007, after O'Neal asked Greg Fleming, Merrill's co-president, to contact Ken Thompson, then CEO of Wachovia, to see if he would be interested in a merger with Merrill. When O'Neal reported his preliminary discussion with Thompson, Cribiore was furious. According to O'Neal, "the quote from Alberto in that meeting was, 'But we don't want to move to Charlotte.'" The headquarters of the potential combined firm had not even been discussed. But, according to O'Neal, Cribiore continued to repeat his point: "Why should we want to move to Charlotte and become Wachovia?"

Cribiore was determined, O'Neal says, and he persuaded other directors to resist a possible sale. In particular, Cribiore seemed to have considerable influence over Armando Codina, a Florida real estate developer who had joined Merrill's board in 2005. The two called each other "Don Alberto" and "Don Armando," according to O'Neal. In the October board meeting, Codina pursued Cribiore's argument against a merger: "Why would we sell from weakness?" he wondered. (Codina did not return calls seeking comment.)

O'Neal says the board told him, "We don't understand why we can't just think about raising capital, taking whatever write-down is necessary and moving on from there." He told Cribiore and the board that he didn't know when, but he thought a serious financial crisis could be looming. "By the time we figure out what we can do," he says he told them, "we won't have options, and that, to me, is a mistake." (Cribiore declines to comment on what was said at this meeting.)

But it was O'Neal himself who soon ran out of options. On Oct. 24, 2007, the firm released disastrous third-quarter earnings, including write-downs of $7.9 billion on Merrill's inventory of CDOs and subprime-related mortgages. That was 75% higher than what Merrill had predicted earlier in the month. One week later O'Neal resigned under pressure and walked away with a severance package of around $161.5 million. The board had lost confidence that O'Neal was willing to consider alternatives other than a merger. With O'Neal gone, Cribiore was named interim chairman. He would take charge of the search for a new CEO.

Stan O'Neal's instinct that the time had come to sell Merrill has proved prescient. But that wasn't enough. "I was not the most persuasive," he says. "If Cribiore had gone the other way, it was a deal that would have gotten done, and I thought it was a deal that should have gotten done."

In March 2008, when rumors were swirling about the viability of Bear Stearns, O'Neal -- then a private citizen with no formal ties to Merrill -- sent Cribiore and other directors an e-mail to the effect that what seemed to be unfolding at Bear Stearns was exactly what he had been worried might happen to Merrill. "It's not hard to conceive that the sequence after this is Lehman and then either Merrill or Morgan Stanley (MS, Fortune 500), more likely Merrill, and once it starts the progression is easy to see unfold," he says he wrote. "You ought to think about doing something." Cribiore thanked O'Neal and forwarded his e-mail to John Thain, who succeeded O'Neal as Merrill's CEO in December 2007. (Cribiore favored Thain over Larry Fink, the CEO of investment management giant BlackRock, in part because Thain had little interest in selling the firm and agreed with Cribiore that write-offs could be taken.) Thain invited O'Neal to visit and further share his views, but O'Neal declined, saying he had said all he could in his e-mail.

O'Neal sent another e-mail in early September 2008, shortly before Cribiore left Merrill's board and Lehman Brothers imploded. Again, O'Neal says he warned that Merrill would be next. Cribiore responded that he had again passed the message on to Thain and added, "He's in the market fighting dragons every day." O'Neal remembers thinking, "That sounds slightly too heroic."

Finally, after the announcement of the sale to Bank of America for stock worth $29 per Merrill share, O'Neal sent Cribiore one last e-mail: "My former friend, you should have helped me sell this business when we had the chance."

O'Neal says Cribiore never responded.