Mother Merrill and You

My girlfriend who works at one of the big Wall Street firms asked, “Do you think people who are not in this industry really care about the Merrill Lynch story?” I thought the same thing after appearing as a guest on the new Fox Business Network last week.

The hosts, Liz Claman, formerly of CNBC and David Asman, who moved to FBN from Fox News Channel, started the conversation with a discussion of Merrill Lynch’s impending (now already-announced) firing of Chairman and CEO E. Stanley O’Neal. While the chatter focused on the ins and outs of why the board let him go (tops on the list of reasons was the $8.4 billion write-down due to losses associated with the sub-prime debacle), I could not help thinking: what can the rest of us take away from this situation?

Unfortunately, I did not think about this during the interview, so I have saved it for an article. I think the most interesting part of the story is that O’Neal and his Board fell for the oldest trap in the investment book: they piled into a strategy long after it had seen its heyday and ignored the risks that were associated with big gains.

O’Neal sought ways to improve the earnings of the somewhat stogy firm, which led him to enter the murky subprime/collateralized debt obligation (CDO) market. The board liked the results when the trades were winners--it’s like the guy who bragged to me about the money he made after purchasing technology stocks in the beginning of 1999. The whole year I had to hear from him on the radio show. By the spring of 2000, the tech bubble started to collapse and all of the sudden the calls stopped.

Liz Claman noted that since O’Neal took the helm of Merrill, the stock had increased 60%. But investors and boards have very narrow time horizons when it comes to accepting the pain of losing. Since the beginning of 2006 through October 30, Merrill’s stock price had declined just under 1%. Obviously the broader market was up during the same time and some of Merrill’s rivals, including Goldman Sachs, Morgan Stanley and JP Morgan Chase have enjoyed returns of 91%, 43.5% and 24.7% respectively over the almost two-year period.

When the news of the losses exceeded $8 billion, O’Neal stood up and delivered the grim details. In fact, he is one of the few Wall Street CEOs who took personal responsibility for losing money. There was no blaming a rogue trader or a flawed computer model, just one man, saying publicly, “I’m responsible”.

I’m less impressed with Merrill’s board. Sure, they held O’Neal accountable and fired him (his exit compensation is valued at about $161.5 million), but only when the strategy went awry did they not like the risks that had been assumed. In my mind, the questioning should have taken place not after the losses had occurred, but when the firm was earning record profits in the exotic debt market. A board member might have asked O’Neal and his team to quantify the risks inherent in the strategies, because as every investor knows, rarely do we get the rewards without risks.
So what can you learn from Merrill? Beware the temptations that draw you into a new strategy and of course, mind the risks that may deliver outsized returns and losses at any given time.