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BUSINESS NEWS

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Financial Glossary

PERSONAL FINANCE AT WALLETPOP

SMALL BUSINESS

A Costly Cleanup for Merrill's Mess

By Steve Rosenbush,

BusinessWeek

Posted: 2007-10-30 17:56:26

The problems at Merrill Lynch won't end with Stanley O'Neal's tenure. The company's board said on Oct. 30 that O'Neal would retire and give up his chief executive and chairman posts, in the wake of Merrill's announcement last week that it would take an $8.4 billion writedown. The board also elected director Alberto Cribiore as interim chairman and said he would lead the search for the firm's next CEO. The candidates to succeed O'Neal include Laurence Fink, chief executive of investment manager BlackRock, and John Thain, chief executive of NYSE Euronext.

But the challenges his successor will face are imposing. At the top of the list are issues with strategy and execution that led to staggering losses under O'Neal. In particular, the firm will have to sort out how willingand able it is to engage in high-risk, high-reward proprietary trading, a very different business from the brokerage operation that's long been the core of Merrill. It will also have to fix the problems with its risk-management approach, which contributed to losses. "Just because a new executive comes in at the top, investors shouldn't expect problems to go away overnight," says Kathleen Shanley, a credit analyst who follows Merrill for researcher Gimme Credit.

Trading Places

Since taking over five years ago, O'Neal pushed hard into proprietary trading, a business that has helped propel profits at rival firms including Goldman Sachs (GS) and Morgan Stanley (MS). That helped boost net income at Merrill to $7.5 billion in 2006, from $1.7 billion in 2002. "They were trying to duplicate Goldman and Morgan Stanley. It worked for a while, until it didn't," says Adam Compton, director of financial-services research at RCM Capital Management, which manages $130 billion and owned 800,000 shares of Merrill as of the end of June.

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Trading would be plenty tough to give up. It has driven not just profits, but revenue growth too. Revenues for the second quarter of 2007, before the credit crunch hit the bottom line, were $9.7 billion, up from $8.2 billion in the second quarter of 2006. Compton notes that the principal transactions business, which includes the troubled asset-backed securities sector, soared from $1.2 billion to $3.5 billion over the same period, accounting for more than 100% of the revenue increase.

Nevertheless, investors such as Compton think it's time to reverse course on O'Neal's trading strategy. Merrill doesn't necessarily have to stop trading for its own account altogether, or even in the treacherous fixed-income business, he says, adding that it shouldn't be driving the company's growth or taking up so much capital. "It's not in their DNA," Compton says.

The alternative would be a safer, and duller, Merrill. It probably would never be able to match the returns of a Goldman Sachs, with its extensive proprietary trading. But concentrating on the retail brokerage business, where it is the largest in the U.S., would likely allow the company to expand in the low double digits over the long term, a respectable rate. It's also a business based on Merrill's traditional culture. "Maybe they should focus on something they are good at," says Compton.

Breaking Down Risk

Regardless of how it resets its strategic course, Merrill must address its problems with risk management. That may be easier said than done, according to Leslie Bright, a senior director at Fitch Ratings. On the face of it, Merrill appears to have many standard precautions in place. The company has a risk oversight committee, which includes the chief financial officer, and senior business and control officers. The committee makes sure that investments conform to risk limits established by the management's executive committee. The company board creates the risk committee's charter and oversees credit market and liquidity risks and processes.

The breakdown in risk management in the latest quarter seems to have been a matter of execution, according to Bright, who said communication through Merrill's ranks appears to have been insufficient. When the market value of Merrill's asset-backed debt fell, the information may not have moved through the corporate hierarchy, impairing the firm's ability to respond quickly. Bright downgraded Merrill on Friday to A-plus, from AA-minus.

Learning from Mistakes

Indeed, even more charges may be ahead. On Oct. 28, Michael Mayo, an analyst with Deutsche Bank (DB), put out a research note saying he expects the firm to take another $4 billion in writedowns once new management is in place and it conducts a conservative valuation of its portfolio. Fitch's Bright said the company remains on credit watch with a negative outlook. "The size of trading losses and unrealized losses unexpectedly overwhelmed the performance of the consolidated firm," she said in her downgrade.

Last week, when O'Neal announced $7.9 billion in credit losses and $500 million in loan losses, investors asked him to explain how the securities firm could find itself in such a position. O'Neal offered a mea culpa: "We made a mistake." He explained that Merrill bet too big on subprime mortgages and moved too slowly after realizing its error. "We hedgedbut not aggressively or fast enough." The question now is whether his successor will learn from those mistakes.

2007-10-26 07:09:24

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78 comments

lcd982 05:58:54 PM Nov 06 2007

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in my opinion and its humble at best there are proceedures in place to measure your risk..but my guess is that to many people were getting paid big bonuses off of the marked up inventory...and they were the ruling party at merrill...now stan will walk away with millions...did he really try to shop merrill around ? and if so..why should he get anything ? you cant award him anything for doing that ! sharehoiders better speak up now !! let me make this very clear..stan isnt the only one that should be shown the door...pleanty of blame to go around here !!....lets keep an eye on the board now.

lcd982 05:58:44 PM Nov 06 2007

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jagr1850 04:53:19 PM Nov 01 2007

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i am ready to replace o'neal as ceo..................i can make a lot less mistakes than he did.
let me know when to start.................

alex54016 04:06:34 PM Nov 01 2007

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THERE ALL CROOKS

alex54016 04:06:34 PM Nov 01 2007

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THERE ALL CROOKS

barlott 09:27:53 AM Nov 01 2007

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ANOTHER RIDICULOUS SITUATION... I AM A SMALL BUSINESS OWNER,WITH 10 EMPLOYEES AND 5 MILLION IN REVENUE...IF I RAN MY BUSINESS LIKE ONEAL DID,I WOULD NOT HAVE LASTED 3 MONTHS....IT ONLY PROVES HOW FRAGILE AND FULL OF BULLSHIT THE WHOLE MARKET IS....WHERE ARE THE COMPANIES WHO OPERATE ON THE REAL LEVEL.....PROFITS ARE REAL,NOT PUMPED UP BY PHONEY BOOKS AND HYPER STOCK TRADING.....ITS ONLY A MATTER OF TIME BEFORE WE WILL SEE A MAJOR MELTDOWN OF THE WHOLE MARKET... PEOPLE WILL FINALLY SAY STOP THE BULLSHIT....LETS GET REAL.

barlott 09:27:11 AM Nov 01 2007

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CARNEYVA 07:48:00 AM Oct 31 2007

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Postscript: Al Sharpton will NOT be taking his calls.

CARNEYVA 07:39:00 AM Oct 31 2007

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I just happen to be black, and it should be made clear that I have yet to meet a single other black person who gives a flaming rat's ass about Stan O'Neal's denouement. Here is a cold-blooded, self-seeker who never extended a helping hand to anyone, black, white or other. He refused to engage himself in the struggle of his people, claiming to be totally "self-made" - a claim which can only be made if you changed your own diapers. But for the sacrifices of numerous nameless, faceless black pioneers, Stan O'Neal wouldn't have been allowed to sweep the floors at Merrill Lynch.

wilhite 06:17:41 AM Oct 31 2007

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The only race that matters here is the one for the gold. Some of us are barely in that race - we're more like spectators - while others can barely run because they are already so heavily weighed down with gold. When the race is over and the victors are separated from the losers, it would be nice if the gold-handlers could be as devastated as everyone else. Break their piggy banks and watch the piggies cry.

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