LYNCHING OF MERRILL LYNCH
June 28 - July 04, 2010
The Wall Street frenzy shook the US and most of the leading world economies in a stunningly short period of time just around six years. During all those years, the mesmerized CEOs of investment banks, hedge funds, brokerage houses and insurance companies kept on accumulating strangely-structured mortgage-backed-securities and proudly presenting them on the assets side of their balance sheets. They enjoyed huge compensations and perks for raising corporate income to unprecedented heights.
The financial conservatism of nineties and before gave way to the limitless risk-taking and perilously-high leveraging. The Wall Street had become the exclusive and jealously guarded domain of the high-risk-takers like Chuck Prince (CEO Citigroup), Jimmy Cayne (CEO Bear Sterns), Dick Fuld (CEO Lehman Brothers), and Stan O'Neal (CEO Merrill Lynch). With these people at the helm, the US economy started to go through a tectonic shift, as David Faber puts it in his book And Then The Roof Caved In:
"Medical doctors became hedge fund managers and investment bankers, and Engineers chose not to build or invent "physical things," but to devise complex securities such as CDOs. Computer scientists eschewed entrepreneurship for the chance to launch algorithms that would fuel winning investment strategies."
When David Komansky, the Merrill Lynch CEO till 2002 - the year when Stan O'Neal took over - started his career at Wall Street as a stockbroker, in 1968, Merrill Lynch used to be a partnership firm. The partnership firms in sharp contrast to limited companies are prudent and conservative operators for the obvious reason that all loss-making misadventures deliver a direct hit to their investment capital. The corporate CEOs manage to pass on the losses resulting from their insatiable appetite for risk to their investors, creditors and shareholders with their stellar compensations hardly showing any signs of diminution. Merrill Lynch, under David Komansky, kept on showing excellent financial results. David Komansky was succeeded in 2002 by Stan O'Neal, a man of humble origin and a Harvard Business School MBA. David Faber writes:
"Ask people who know Stan O'Neal to describe him and the two adjectives they come up with are smart and mean. Those two characteristics are usually a good combination for running a financial services company."
O'Neal started by doing away with the people who were close to Komansky. His mantra was 'boost corporate earnings through cost cuts'. And Merrill Lynch earnings started going up in leaps and bounds and so did the compensations of the company's top five executives. In 1996, the company paid its top five executives a total compensation, cash and stock, of $32 million. This compensation went up in 2006 to $172 million - a 437 percent hike. The cumulative US inflation during those ten years happened to be less than 30 percent. The high leveraged position of the company gave an illusive view of high corporate earnings in absolute terms. Merrill Lynch earned $7.6 billion in 2006 recording a 49 percent increase against the previous year. The ROE (Return on Equity) in 2006 was 21.3 percent, by all means an excellent performance and that too in an economy where central bank interest rate was less than 6 percent. But then Merrill Lynch under Komansky too did not produce less impressive results. In 1996, company's ROE was 26.8 percent with its net earnings up 47.5 percent over comparable period. What was the difference then?
The difference sure was the loads of substandard and risky mortgages that now formed a major portion of company's assets. The difference was the unmanageable degree of leverage that threatened the very existence of the company. O'Neal somehow managed to underplay - or even totally omit the mention of - the incidence of mortgage business on overall company operations. The camouflage not only formed part of mid-term financial reports and earning press briefings but also got place in company's annual reports. Nobody cared to know about the real structure of company's assets and the degree of severity of the disease those assets had contracted. And that was quite understandable in a frantic economic environment where there was ample demand for such spurious financial products as synthetic collateralized debts obligations - synthetic CDOs; where the top rating agencies like Moody's and S&P were blindfold awarding triple-A status to junk securities; and where the leading Asian and European economies were lining up with shiploads of dollars. Dollar-denominated was the key word. After all, who was going to doubt the credentials of the ruling currency?
By the end of 2006, Merrill's assets had grown to $841 billion, with its equity standing at $42 billion. What did that mean? A leverage ratio of 20! A mere 5 percent decrease in its assets values was going to wipe off its entire equity. In a mortgage market where home prices were increasing in the range of 6-8 percent, the thought of market reversal should have sent shivers down the spines of company's executives, but it didn't. Kyle Bass, one of the only few who doubted the genuineness of the mortgage boom and who did a lot of research work to bet against the boom sounded a number of warnings but nobody took him seriously. A hedge fund manager and an ex-employee of Merrill Lynch, Bass addressed a meeting attended by his colleagues and Merrill executives. Their response was: "we are managing our investment risks, you manage yours." He further tried to convince the Fed people who argued: "with the jobs still being created and incomes still growing, we don't see the things the way you do." By shorting on mortgage market Bass earned 600 percent profits for his Fund.
During 2007, Merrill assets crossed the much-coveted one trillion dollar mark. The earnings and its share prices too touched the historic highs. But, by the end of 2007, Merrill's tangible equity shrank to just $31.6 billion after it reported a net pre-tax loss of $12.8 billion ñ first in its recent history. The net tangible equity reflected a leverage level of 32 times. A slight more than 3 percent decline in assets' value was enough to make the equity vanish into thin air. The inevitable mortgage market collapse did that. Stan O'Neal lost his job. The new CEO John Thain tried to do a bit of revamping job by raising $13 billion through issuance of common and preferred stock. But the year-2008-losses of $41.2 billion dealt the coup de grace to Merrill Lynch - lynching it in the presence of its thousands of shareholders, creditors, and domestic and international investors.