Back in 2003, Stan O’Neal’s strategic objective was clear. In a rare interview, the chief executive of Merrill Lynch told the Financial Times he wanted to increase the group’s profits coming from retail businesses from one third of the total to half.
Merrill’s large brokerage and asset management arms have always been seen by investors as its strength, producing high-quality earnings with less volatility than capital markets businesses. As a result, the market gave Merrill’s shares a higher rating than rivals such as Goldman Sachs. So it was not surprising Mr O’Neal would want to weight the group towards retail.
It has not worked out that way. Faced with booming capital markets driven by very low interest rates, Mr O’Neal turned opportunistic, investing in Merrill’s trading operations, encouraging the organisation to take more risks and ultimately cutting the relative importance of retail operations.
At first, the tactic appeared to work better than anyone could have expected. Merrill’s trading profits boomed as it expanded into areas where it had been weak, such as commodities, structured products and private equity.
Last year, the bank’s overall earnings jumped by nearly half to a record $7.5bn, with the proportion from retail having fallen below a quarter.
But last week came the shock news that Merrill would have to write off $5bn in the third quarter after being wrong-footed by the credit squeeze. The hit was the worst so far for any bank and, in spite of an initial bounce, its shares have since fallen by 4 per cent. The $4.5bn of writedowns in its collateralised debt obligations business – which packages subprime mortgages for sale to investors – were particularly brutal.
Critics say the losses raise questions about Mr O’Neal’s strategy and management style and about Merrill’s ability to compete head-on in trading with the likes of Goldman Sachs.
Observers were stunned by the writedowns. Brad Hintz, an analyst at Sanford Bernstein, says they represent “a significant breakdown of the firm’s risk management process”.
Merrill’s public statements in the run-up to the writedowns have also come in for scrutiny. In July, following the sharp downturn in the subprime mortgage market, the bank reassured investors its subprime exposure was “limited, contained and appropriate”.
Janet Tavakoli, a structured finance consultant, says the problem was that, as management was denying there could be huge potential losses, they could hardly make the case for hedging the positions.
She points out that Merrill was one of the lenders to the Bear Stearns mortgage-backed securities hedge funds that collapsed in August. In April, lenders to the funds were challenging Bear’s mark-to-market valuations of the funds’ holdings, she says. “Merrill was not so finicky when it came to marking its own books.”
One former Merrill trader says that, in spite of warnings from senior executives, expansion into CDOs got out of control. Executives kept buying and packaging subprime loans long after investor appetite had dried up. “They were addicted to the fees,” he says.
According to former executives, concerns were expressed as early as last year by Jeff Kronthal, who was a co-head of fixed income until July last year when he was removed to make way for Osman Semerci. Mr Semerci was sacked last week along with his deputy Dale Lattanzio.
Greg Fleming, then co-head of Merrill’s markets and banking business, raised concerns with Mr O’Neal about Mr Kronthal’s replacement by Mr Semerci, insiders say. Mr O’Neal subsequently promoted Mr Fleming to co-president.
One former executive claims that Mr O’Neal places too high a value on personal loyality and that this sometimes means he puts the wrong people in key jobs.
Merrill declined to comment but one executive close to Mr O’Neal said he did not micromanage personnel moves like the replacement of Mr Kronthal. That had been a decision of Dow Kim, then co-head of Merrill’s markets business, who in May announced plans to leave to set up a hedge fund and was granted an office until the end of the year. Last week, Mr O’Neal told him to leave immediately.
People close to Mr O’Neal insist that Merrill has suffered one, admittedly serious, problem in one asset class – due to the CDO market “totally shutting down” – but that its risk management process has worked well elsewhere, not least in leveraged finance. Given the transformation of Merrill over the past five years, Mr O’Neal should be “entitled to hit one pothole”, said one executive.
Mr O’Neal backed the ill-timed $1.3bn purchase of First Franklin, a subprime mortgage lender, last year and was at the helm when $5bn of writedowns plunged Merrill to a quarterly loss. Previous Merrill chief executives have been sacked for less. But there is no sign that his position is under threat. He should still be able to present his board with healthy profits this year which analysts expect to be the second-best ever.
But the dent to Mr O’Neal’s reputation and Merrill’s premium share may take some time to repair.