With Stan O’Neal stepping down from the top spot at Merrill Lynch, many industry insiders are left wondering just what the future holds for the investment firm, as losses mount and company outsider John Thain, NYSE Euronext’s CEO, is set to take the helm on December 1. The newly tapped Thain may be a Merrill Lynch outsider, but he is a well-known industry insider and player. Prior to his current and very visible spot at the NYSE Euronext, Thain served as the president and chief operating officer of Goldman Sachs Group. Thain is credited with taking the NYSE public during his tenure on the exchange.

The new guard at Merrill and the pedigree of Thain may signal a new day for the beleaguered firm. On October 30, O’Neal announced his retirement from his post as Merrill Lynch CEO and chairman, after an announcement of a write-down of $7.9 billion related to their exposure in the credit market, specifically through Merrill Lynch’s fixed income, currencies and commodities (FICC) business in CDOs (collateralized debt obligations) and U.S. sub-prime mortgages. (CDOs are bonds made up of pools of debt securities and loans.) The news of the change in the numbers came as a shock, as Merrill originally stated its write-downs on October 5 attributed to this portion of their business at $4.5 billion.

A press release from Merrill, issued on the day of O’Neal’s retirement, noted, “Mr. O'Neal and the board of directors both agreed that a change in leadership would best enable Merrill Lynch to move forward and focus on maintaining the strong operating performance of its businesses, which the company last week reported were performing well, apart from sub-prime mortgages and CDOs.”

The news of O’Neal’s departure may not have come as a big surprise, given the revised write-downs and Merrill board’s rejection of his decision to acquire Wachovia. Peter Demerjian, an assistant professor of accounting at Emory University’s Goizueta Business School, notes, “It is not immediately or intuitively clear why O’Neal approached Wachovia. Merrill Lynch is considered a “bulge bracket” investment bank, while Wachovia has only recently become a national player in banking.” Of course, he notes that one rationale may have been to acquire Wachovia’s brokerage operations.

Wachovia recently acquired broker A.G. Edwards, and combining operations would have made Merrill a more prominent player in their core brokerage business. Demerjian adds, “This also may have been a signal to the market that Merrill was moving away from risky investments and back to their less risky course. Another reason may have been that O’Neal, fearing for his job, wanted to make one final attempt at a splashy acquisition.” O’Neal did have success in his acquisition strategy in the past, particularly in adding BlackRock Inc., the private equity firm, to the Merrill Lynch fold in September 2006.

Following the Market Trends

The next step for Merrill could be a critical one, as it faces up to past problems and moves ahead to seek a place among bigger competition, including other larger bulge bracket firms and banks. Of course, following trends, as Merrill did, isn’t anything new, says T. Clifton Green, a finance professor at Goizueta Business School. Green notes, “Investment banks have a history of transforming themselves in ways that emphasize profitable aspects of their business. In the 1980s, junk bonds were king and bond traders were influential people within investment banks.” By the 1990s, the stock market was hot, so investment banks emphasized underwriting and equity research, he adds. Consequently, these individuals took on larger roles within banking and investment firms.

After the debt markets heated up again, collateralized debt obligations became very profitable. For now, says Green, the investment world has turned to commodities that are producing an increasing share of the profits, with oil and energy specialists taking on larger roles. But Green adds, “From a bank’s perspective, it can be risky not to enter a new profitable space when other banks are doing it profitably. They worry about getting passed up by their peers.” This is how leaders at the also-ran organization may end up following the pack.

But following trends can also be a death knell for a firm’s leader, and possibly for the institution, if the gamble doesn’t pay off. Ray Hill, an adjunct senior lecturer of finance at Goizueta, notes, “All investment banks need to follow trends to be successful, and influence within the bank does shift to the people whose line of business lines up with whatever the profitable trend is at the moment.” Management skills come into play, notes Hill, when the firm’s leader learns to exploit the trend without losing control of the entire firm. Essentially, the trend of the moment cannot have too much influence over the entire shop. Adds Hill, “An investment bank is full of deal making, transaction-oriented bankers. When their business line is “hot,” they think that they should run the show. Richard Fuld of Lehman Brothers, who has had the longest CEO tenure in the industry, rose to the top and stayed there by making it clear that he would run the show and that Lehman’s strategy would always be tied to a long-run view of the value of their particular franchise. Goldman’s culture plays the same role for that firm.”
 
The Investment Banking Industry Comparison

According to Hill, having a consistent and delineated path often can be the key in leading an investment bank. He notes, “If we compare Merrill to Goldman Sachs, Lehman Brothers, and Morgan Stanley over the past fifteen years, I think we would say that these other three investment banks have had a much clearer idea about their strategies.” For Goldman Sachs and Lehman Brothers, having a “strong continuity of leadership” and very focused businesses has contributed to their overall success, he notes.

For Morgan Stanley, the waters have been a little rougher, but things seem to be calming down for the company now, says Hill. “Morgan Stanley became much more focused after the ouster of CEO Phillip Purcell and the return of control to the old Morgan Stanley veterans.” After months of a very public conflict with the board of the firm, Purcell finally announced his retirement on July 15. His predecessor John Mack returned to the top spot.

The tried and the true can sometimes be the right path, but in the investment business, growth doesn’t come without some level of risk. Weighing the risks accordingly is the key, says Hill. He adds, “Merrill had a reputation as a great brokerage franchise, but it was not in the same investment banking league as these other three firms. Stan O’Neal seems to have tried to enhance Merrill’s status by expanding their capital market presence. This, inevitably, involved taking on new risks.”

Hill notes that the more interesting question to consider about risk is assessing whether or not O’Neal simply made a bet that could have paid off well, but instead went sour, or did he poorly understand the risk/return profile of the business Merrill was taking on in the collateralized loan market. He adds, “If the answer is he simply made a bet that went sour, then this is just a story about a strategy that might have paid off, but didn't. CEOs are often fired for this. If the answer is a poor understanding of the collateralized loan market, then it helps explain some of the events of the past few weeks, including O’Neal's poor performance in explaining what was going on at Merrill and the board's relatively precipitous action in firing him.”

For now, says Hill, Merrill’s total write-down of $8.4 billion (mostly made up of the $7.9 billion from the sub-prime and CDO portion, plus other unrelated write-downs) is the equivalent of a couple of year’s of profits, so while that is a sizeable number, there is no fundamental risk to Merrill as an on-going concern. Additionally, he adds that the problems, while considerable, certainly haven’t tarnished the “Merrill brand.” The addition of Thain, considering his resume, also comes at a much-needed time.

While the default rates on the portfolios of sub-prime mortgages that created the losses at Merrill Lynch were much larger than expected, Hill still believes that “this source of economic damage is relatively small.” The remaining problem for Merrill, and for other banks and investment firms, is the illiquid nature of these financial instruments. Notes Hill, “Without a liquid market, Merrill must record these assets on its books at a lower value than they could be worth in the long run. It is a much more subtle point to say that O’Neal was fired for failing to anticipate that these assets could become illiquid than to say that O’Neal was fired for allowing the firm to invest mortgages with higher default rates than expected.”

Roy T. Black, a professor in the practice of finance at Goizueta Business School, adds that O’Neal’s rise to power by taking greater risks in the pursuit of higher returns was a bad move, especially in light of placing such a large bet on an asset class whose true risks were unknown. “If O’Neal's play had worked, of course he would have been hailed as a genius, but once again, the market ignored economic fundamentals,” he says. “O’Neal was certainly not the only culprit, just one of the most visible.” Black worries that the industry’s “sheep herding mentality, poor risk assessment, and the moral hazard created by compensating people just to do deals, and not necessarily good deals,” may play into a future crisis.

Understanding the Accounting

The sub-prime meltdown isn’t the only bad news facing the investment industry. Financial institutions must comply with Level 3 accounting (from Financial Accounting Standards Board’s Statement No. 157), and put some sort of price on more difficult to value financial assets. The rule goes into effect for fiscal years after November 15, 2007, though some firms are already reporting to this new standard. Industry analysts are waiting to see the final shakeout, as firms begin to write-down these hard to quantify items on the books.

In late August and early September, several large banks, including Goldman Sachs, Bear Stearns, Morgan Stanley, and Lehman Brothers, all announced write-downs associated with sub-prime mortgage positions. According to Demerjian, the bulk of Merrill Lynch’s losses, as described in their earnings announcement, were related to Level 3 securities and specifically to asset-backed securities CDO positions and sub-prime mortgage securities and derivatives.

According to Demerjian, the writing up or upward valuation of assets on the balance sheet was commonplace in the pre-SEC era. However, he says that following the Crash of 1929 and the depression that followed, upward valuation was effectively banned. “The reasoning was that many investors had been fooled into investing by robust valuations with little basis in economic reality,” he adds.

This leads to several important questions, he notes, particularly for Merrill Lynch. “First, were the collateralized debt obligations and sub-prime positions on Merrill’s books from that point overvalued? Second, how legitimate were their write-offs? That is, are the write-offs a function of the true economic environment, or are they attempting to clean up their balance sheet for [Thain, O’Neal’s successor]?”

And, for the investment and banking industry, in general, Demerjian wonders if the availability, and requirement, of fair value accounting for these difficult to value assets contributed in any way to the current credit crisis. For now, investors are also wondering what may be the next bad news that will arise, as credit terms tighten, foreclosures rise, and home sales decline. He adds, “While the write-offs are clearly not solely responsible, it is plausible that they have played a role in the overall destabilization of the credit market.”

A Big Miss

While current market conditions played a role in the write-down at Merrill and other firms, just how did Merrill miss estimates by so much that they needed to revise the earlier number? Demerjian notes that this write-down was three times the size of the next largest, Goldman’s, and portended the seriousness of the crisis, especially considering Goldman Sach’s behemoth size against that of also-ran Merrill Lynch.

Understanding the change in the write-down may be difficult to assess, given that the basis for the write-down is private information and generally calculated by the help of modeling. Demerjian notes, “The use of Level 3 fair value estimates makes answering this question difficult. To start with, there is no market in these types of investments, or even a market for similar instruments. Companies therefore use “unobservable” inputs to produce the value they report on the balance sheet. Changes in these unobservable inputs result in changes in the value of the assets, which are in turn reported as part of net income.”

However, he notes that Merrill may have used modeling to recalculate the numbers. With investments based on mortgages, the value is generally driven by the expected receipt of cash (principal and interest from individual mortgage payments). Demerjian states, “It is plausible that credit conditions deteriorated sufficiently over the next three weeks that the fair value under Level 3 justified a much larger write-down.”

The second possibility is that Merrill used a “conservatism” scenario. Says Demerjian, “Defined generally, conservatism is the tendency to recognize losses immediately but defer the recognition of gains. Some examples of conservative accounting include accelerated depreciation for fixed assets (which recognizes more expense early in an assets life) and the lower-of-cost-or-market rule for valuing inventory (inventory appears on the balance sheet at the purchase price or current market value, whichever is lower).” The theoretical rationale for conservative reporting is that managers have incentives to report gains but not losses, making gains less verifiable and harder to rely upon, he notes. Of course, this doesn’t explain away the recalculation of the write-down.

In a third scenario, says Demerjian, the board used the ouster of O’Neal as an opportunity for Merrill to increase the write-down. This will give the new CEO Thain a “fresh start,” and the write-down can be attributed entirely to O’Neal. Adds Demerjian, “While this is perhaps a cynical view, everyone ends up happy (even O’Neal, who left with out a severance package, but did make $48 million last year).  In fact, based on the amount of write-downs they recognized, analysts are suggesting that Merrill is going to be relatively healthy compared to other big banks in the coming quarters.”

On October 15, three of the larger banks, all exposed to sub-prime risk, including Citigroup, Bank of America, and JPMorgan Chase Bank, and several other financial institutions, announced the start-up of a Master Liquidity Enhancement Conduit (M-LEC) of up to $100 billion to prop up their balance sheets against bad loans. The consortium will issue new short-term credit instruments to finance its purchase of these eligible assets from participating sellers, but the actual impact of the effort remains to be seen. Interestingly, Citigroup CEO and chairman Charles “Chuck” Prince was forced out in early November, after their announcement of write-downs of $10 billion related to the mortgage crisis. Says Demerjian, “The incentives all point to the banks wanting the crisis to end as soon as possible—but it is a crisis of their own making.” Given the realization, he notes, the write-downs at Merrill and across the industry make sense. He adds, “By writing the value of the asset down, and as early as possible, they put the crisis behind them. This should in turn increase investor’s confidence in these firms.”