The Merrill Lynch story

The weekend of Sept. 13 and 14, 2008 was one of the worst ever on Wall Street. And when Lehman Brothers went bankrupt on Sept. 15, it triggered a global financial panic.

Also over that weekend, Bank of America and Merrill Lynch hammered out one of the biggest deals in Wall Street history in less than 36 hours. The feds pushed for a deal to prevent Merrill from becoming the next domino to fall. With Lehman preparing to file for bankruptcy after failing to find a buyer, executives at both Bank of America and Merrill knew they needed to act quickly as Merrill’s liquidity was evaporating.

Merrill Lynch was founded in 1914 by Charles Merrill and his friend Edmund Lynch. During the next 30 years, it grew by a series of mergers and acquisitions into the nation’s largest and best-known retail brokerage firm. Just as Lehman Brothers had epitomized the “aristocratic German-Jewish culture” in the financial industry, Merrill Lynch became a symbol of “working-class Irish Catholic culture” (like New York City’s police and fire departments). Not that it mattered much when push came to shove in September 2008.

In 1971, Merrill Lynch became a publicly traded corporation. And in 1978, it acquired the small but prestigious investment bank White Weld & Company to expand its underwriting activities and take advantage of the ability of its huge retail brokerage arm to place new common stock issues with investors directly rather than through syndicates composed of other firms.

But by 2000, Merrill (like Lehman and Bear Stearns) was becoming increasingly dependent on its collaterized mortgage obligations business to grow profits. By goosing this growth by more than doubling its 2003 leverage ratio of 19-1 to 39 to 1 in 2007, Merrill was able to provide its common stock holders with a 13 percent increase in investment returns during this period.

By 2006, Merrill had leaped to the top spot in the nation’s collateriized mortgage obligations business, underwriting $35 billion in these securities, 40 percent of which were backed by sub-prime mortgages. To help secure its position, Merrill spent $1.3 billion to acquire First Franklin, one of the nation’s largest originators of sub-prime residential mortgages. This gave it a major in-house mortgage originator and reduced its dependence on buying mortgages from numerous banks and home loan firms to back new underwritings of collateralized mortgage obligations.

Concerns about Merrill’s viability increased during the summer of 2007, when two Bear Stearns hedge funds defaulted. As a short-term lender to these funds, Merrill seized $800 million of Bear’s mortgage assets and proceeded to auction them off in the secondary markets. But the auctions failed to generate reasonable bids for the sub-prime mortgages and highlighted Merrill’s exposure to these “toxic waste securities”. For the last quarter of 2007 and the first three quarters of 2008 combined, Merrill wrote down more than $46 billion to bad bets on real estate and other mortgage-related instruments.

These write downs had severe consequences for Merrill: the firm’s stock price fell significantly, Moody’s Investors Service placed Merrill’s long-term debt “on review for a possible downgrade”, traders in other firms lost confidence in the firm’s ability to meet its trading obligations, and the firm had to increase its equity capital by selling off assets such as its 20 percent stake in Bloomberg for a much-needed $4.4 billion.

Additionally, between May 2007 and September 2008, Merrill laid off over 7 percent of its employees. Its board ousted CEO Stan O’Neil in October 2007, though he retained $30 million in retirement benefits and $129 million in stocks and options.

Merrill’s continued write downs of toxic mortgage assets, increasing operating losses, difficulty refinancing its short-term borrowings made it clear that its days as an independent firm were numbered. On Sept. 14, 2008 Merrill agreed to sell itself to the Bank of America.

Financial markets are prone to instability. But when paired with excessive financial leverage, the result can be severe economic pain.

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