Merrill Lynch lost $280M on IO/PO mortgage trades — an early derivatives disaster

Merrill Lynch was one of Wall Street's most prestigious investment banks. In the mid-1980s, its mortgage desk built massive positions in interest-only (IO) and principal-only (PO) mortgage-backed securities — complex derivatives that split mortgage cash flows into separate bets on interest rate direction.

The mortgage desk was betting that interest rates would fall, which would make IO strips more valuable. Instead, rates rose unexpectedly in early 1987, and the highly leveraged IO positions collapsed. The desk's value-at-risk models had severely underestimated the potential losses from a rate move.

Merrill Lynch announced a $280 million loss from the mortgage trading — one of the largest single trading losses on Wall Street at the time. The loss shocked the financial world because Merrill was considered one of the most sophisticated mortgage traders.

The incident was a landmark early warning about the dangers of complex mortgage derivatives. It foreshadowed many of the dynamics that would later drive the 2008 financial crisis, including excessive leverage, model risk, and concentration in mortgage-backed securities.