Bond Bombshell

It started as a mistake, by all signs an honest one, but it grew into a Wall Street disaster. A 36-year-old senior bond trader at Merrill Lynch apparently lost his cool last month when rising interest rates started rapidly eroding the value of his $900 million portfolio. Instead of liquidating the securities and taking the loss, as most of his colleagues on Wall Street were doing, the Merrill Lynch trader seemingly gambled on a go-for-broke strategy. Without his employer's permission, he plunged in deeper, buying up $800 million more of the securities in the hope that an interest-rate turnaround would bring enough profits to bail out all his losses. His wager failed spectacularly. When Merrill Lynch announced the episode last week, the firm estimated its losses at $250 million, possibly the largest single trading deficit in Wall Street history.

The financial community was stunned at not only the immensity of the loss but also the identity of the trader: Howard Rubin, the head of Merrill Lynch's trading desk for mortgage-backed securities. Rubin, who has been fired but not charged with any criminal wrongdoing, was a respected trader and is a Harvard Business School graduate. Said Stephen Joseph, a senior trader at Drexel Burnham Lambert: "It's really strange. He has a great reputation."

But Rubin was apparently dealing in one of the tricky, relatively untested new types of securities. The bonds that tripped up Merrill Lynch are interest-only/principal-only securities, known as IOPOs. Investment houses create them by buying mortgage-backed bonds -- typically those issued by the Government National Mortgage Association, or Ginnie Mae -- and then splitting the securities into two parts, one that pays interest and another whose price rises or falls with the resale value of the bond. Rubin was selling the interest-paying bonds and hanging on to the principal securities, which lost value rapidly as interest rates rose.

The incident prompted questions about Merrill Lynch's internal supervision. The firm claimed it had put a closer watch on Rubin at least a year earlier, after assessing him as talented but riskprone. Last week the company began an in-house probe and fired a second trader, who had allegedly failed to disclose investments and lost $10 million. Meanwhile, colleagues began looking for hints in Rubin's background about why he took such a plunge. According to one account, the trader had been a devoted blackjack player before his business-school days.