“Can you say what happened to Stan O’Neal at Merrill Lynch?” we were asked on the phone yesterday by a reporter. “Sure,” we replied.
Our reply turned out to be too meandering for use in a sound bite. So we’ll use it here in the Markets and Money!
O’Neal, in case you missed it, was more or less fired from his CEO/President job at Merrill Lynch (NYSE:MER) earlier this week. This came after the firm reported the largest loss in its 93-year history and the largest ever loss on Wall Street. Thanks to Merrill’s exposure to subprime backed collateralised debt obligations, the firm wrote down nearly US$8.4 billion.
To put that in perspective, Merrill’s subprime losses are the equivalent of a company the size of Santos or Zinifex or Origin Energy ceasing to exist overnight. The write down cost shareholder’s 20% of the firm’s equity. So it wasn’t just embarrassing. It destroyed value.
The worst of it is that the worst may not be over for Merrill. O’Neal was punished for first suggesting the loss would only be around US$4.5 billion. When it was nearly double that, the market was not only surprised but seriously concerned. The bad news is that Merrill still has some US$15 billion in subprime exposure—and that it was one of the biggest players on Wall Street in underwriting and trading mortgage-backed securities and CDOs.
O’Neal does not deserve to be the Ken Lay of the subprime crisis. True, his decision to turn Merrill into the largest underwriter of CDOs with subprime assets made the firm especially vulnerable to the inevitable (when high-risk American borrowers realised their loss-making potential). But his risk-taking behaviour, though heavy handed according to published reports, wasn’t all that different than a lot of folks in the financial industry. It was dreadfully poor and short-sighted.
Lest O’Neal’s critics forget, he did deliver the firm from the dark days of the dot.com bubble. Under O’Neal’s ruthless hand, Merrill fired 20,000 people. The slimmer company delivered higher returns on equity to shareholders. And O’Neal made another important decision.
Until recently, Merrill has been known as the leading retail brokerage firm in America. It is—or was before e-Trade and Ameritrade—the broker to main street America. It was also justly famous for the depth and quality of its investment research. But the Internet boom was a double bogey for Merrill Lynch.
The first bogey is that the Internet bust wiped out US$7 trillion in the net worth of American investors. That was surely bad news for Merrill. Stock market crashes are always bad for commissions.
The second bogey is more ironic, while Internet stocks crashed and Merrill lost credibility (Merrill’s star Internet analyst Henry Blodgett would later be ridiculed for his baseleslly bullish research reports), the actual Internet revolution in hardware and software eroded Merrill’s business margins.
It wasn’t until after the dot.com bust that the Internet truly delivered on its business promise, especially in the financial sector. The Internet delivered retail investors more and better information and analysis at ever cheaper prices. Yes, there is still a lot of junk analysis on the Web. But for plugged-in and cashed up investors, the Web struck directly at the heart of Merrill’s core business proposition—superior and hard-to-get research on investments.
So O’Neal tried to turn Merrill into Goldman Sachs (NYSE:GS). He moved the firm away from the retail brokerage business and into higher-margin businesses like private wealth management, investment baking, and proprietary trading in the bond and commodity markets. Those moves—before the bear market in credit—delivered bumper profits for the firm.
Merrill did what so many firms have done in response to Alan Greenspan’s long march toward negative real interest rates—it turned itself into a business built on speculating and profiting from cheap credit and credit-related instruments.
This is yet another example of the distorting power of monetary policy. When there is no free market in money, the resulting distortions don’t just end up in misallocated capital. They result in people losing their jobs and Merrill getting sued by shareholders.
You can’t blame Stan O’Neal for doing anything illegal. He just went along with the temper of the times, trading a time-tested business model for short-term trading profits. It was a good trade while it lasted.
Markets and Money