Illusions and reality – the world of Merrill Lynch
by Andrew ThomasNational Industrial Officer
The Australian Rail, Tram and Bus Industry Union
In September 2008, Merrill Lynch, a large, well known US investment and finance firm, disappeared from the face of the planet, forced to merge with the Bank of America. Nothing unusual about that you may say – mergers and acquisitions are a common feature of contemporary capitalism. But in this case the merger was forced on Merrill Lynch as it raced towards bankruptcy – again nothing out of the ordinary your may say. But, this was a firm that 2 years earlier posted a record-breaking performance and its demise coincided with, indeed played its part in creating, what has been described as the “global financial crisis” (later expanded to the “global economic crisis”). It is in this context that the Merrill Lynch experience is worthy of consideration.
According to the New York Times, Merrill Lynch's performance in 2006 was “breathtaking, revenue and earnings has soared and its shares were up 40% for the year”. Its decision to invest in the mortgage industry appeared to be rewarding it handsomely. Had they found the goose that laid the golden egg? Certainly, it appeared that the executives at Merrill Lynch thought so.
The manipulation of mortgages was the way to go. The leading mortgage player on Wall St. at the time – Lehman Brothers - was doing extremely well. Merrill Lynch was keen to join them. And it did, in more ways than one.
Merrill Lynch began with the gathering together of mortgages. Between 2005-07, it purchased 12 major players on the residential or commercial mortgage market. This gave it the mortgages; the base upon which to make more money.
Having assembled a mortgage machine, the next step was to parcel them (and other types of loans) into exotic financial derivatives such as collaterised debt obligations and its big brother, synthetic collaterised debt obligations. This latter arcane financial instrument has been described as “an amalgamation of collaterised debt obligations (the pools of loans that it bundled for investors) and credit-default swaps (which essentially are insurance that bondholders buy to protect themselves against possible default).” Clearly, this wasn't a game for the uninitiated or the unimaginative! Added to this concoction was a failure to adequately assess the risks inherent in these types of financial instruments. Prudence was put to one side. Quick and significant profits, whether by parcelling and selling the instruments and/or underwriting, was both overpowering and addictive. In 2005, Wall Street finance firms issued $US178 billion in mortgage and other asset based collateralised debt obligation instruments. Twelve months later the figure reached $US316 billion.
To add to the addiction of quick and easy profit came the payment of bonuses to employees. The bonus system in Merrill Lynch has been described as one that “encouraged employees to act like gamblers at a casino – and let them collect their winnings while the roulette wheel was still spinning.” In 2006, its chief executive, E. Stanley O'Neal received a bonus of $US46 million. More than 100 employees received bonuses in excess of $US1 million.
The payment of bonuses was tied to short-term profits. Profit was all that mattered. That the underlying earnings base was weak and ultimately illusory was not on the computer screens of its analysts – it was hidden behind a screensaver of dollar signs. Various warning signs were ignored. For example, the insurance company, AIG stopped issuing insurance against the risk of the highest portions of the collateralised debt obligation issued by Merrill Lynch defaulting . Never mind, Merrill Lynch carried on regardless. Nobody urged caution; nobody wanted it to stop whilst the money kept rolling in. Regulators and Ratings Agencies either sat idly by or supported the use of such financial instruments. The truism that the greater the reward the higher the risk may well have applied here but the notion of risk was inadequately considered.
Financial derivatives, by definition, derive their value from other assets – in this case overwhelmingly mortgages. Mortgages in turn depend for stability on maintaining or increasing the real value of the asset. This becomes even more important in circumstances where the risk profile of the mortgage is high, as was the case in the sub-prime mortgage market. When the housing market in the US collapsed it was only a matter of time before it hit Merrill Lynch's precious derivatives.
And when it hit, it hit with a vengeance. In October 2007, it announced a write down of $US7.9 billion related to its mortgage collateralised debt obligations. This translated into a loss of $US2.3 billion. And things did not improve. In the first 9 months of 2008, Merrill Lynch recorded nets losses of $US14.7 billion from its collateralised debt obligations. Its new chief executive arranged for the sale of $US31 billion of collateralised debt obligations for 22 cents in the dollar. The end was nigh. In September 2008 it closed its doors through a merger with the Bank of America.
In the choice between illusion and reality, Merrill Lynch chose the former. It was much more convenient than the latter. Illusion is, of course, the world of magic; the realm of magicians with sleight of hand and wires and mirrors. Spellbound as we may be by magic, only the naïve believe its real. And its motive is pure entertainment. When the show finishes, it's inevitably back to the real world. Not for Merrill Lynch though where illusion and reality became one and the same, at least for a brief period. When, as it must, the real world took over it was a very ugly world awaiting them.
Had the damage been confined to its creators it would be one thing. But it wasn't and was never going to be. Indeed, it seems that the key executives escaped any damage. For example, Merrill Lynch's CEO, E Stanley O'Neil received $US161 million exit package. As Prime Minister Rudd said of the gang at Merrill Lynch: “They literally laughed all the way to the bank”. On the other hand, the real victims are those that have/will lose their jobs, who can't meet their bills, or sit innocently on the sideline as their superannuation savings head south at a rate of knots.
The Merrill Lynch experience is one more example of what happens when a “market” is “free” to do as it pleases. It shows who suffers and who is left to clean up the mess. It is the inevitable outcome of the practical application of a neo-liberal ideology foisted on a largely unsuspecting public by successive governments, right wing think tanks and an accommodating mainstream media. Warnings of its dangers were roundly and loudly ridiculed or conversely, ignored. However, as they say, the chooks have come home to roost.
It is simplistic in the extreme to suggest, as Prime Minister Rudd does, that the problem was one of “extreme capitalism”. This rationalisation is akin to the “few bad apples” thesis, where a few greedy mavericks corrupt an otherwise effective system. Even if it was the case, any system that permits a few mavericks to create this extent of mischief and destruction is a system that it inherently unstable. British Prime Minister Gordon Brown, on the other hand, believes that the markets simply need a good dose of morals; a position also taken by the British Tory leader, David Cameron. This is the “if only everybody was nice” thesis; a contradiction in terms in an industry where the zero sum game rules. In the world of Wall Street (and its counterparts in the world's financial capitals) where the only thing that counts is how much money you make, there is little likelihood that philosophical notions such as morals will figure prominently any time soon.
Thus far in the so-called global economic crisis, we have seen governments of all persuasions reach into their coffers to bail out a self-destructing financial system. Literally billions of dollars, pounds, euros etc. have gone towards “fixing” the mess created by the Merrill Lynch's of this world. But, to date, we have seen little to ensure that a repeat performance is not a possibility somewhere down the track. There is an unfortunate list of crises in the finance industry in the last 30 years or so, particularly in the home of capitalism, the United States. The Savings and Loans Crisis, the Junk Bonds Crisis and the Long Term Capital Management Inc. Crisis spring to mind. The global economic crisis is another, albeit on a much larger scale. But the lesson of past crises is that the lesson was not learnt. Will this be a repeat performance?
Prime Minister Rudd has made a moral virtue out of taking the “tough” decisions or, at least talking about taking the tough decisions. Here lies his opportunity to put the captains of the finance industry in their place; to build a system that operates in the public interest and not for the private interests of the few and backed by the state (the classic case of “privatise the profits and socialise the losses”); to erect a system that is based on reality and not illusion; to build a system that forestalls the madness that engulfed Merrill Lynch and others in recent years and will do so again if the finance industry is left to its own devices. The behaviour at Merrill Lynch and elsewhere happened simply because it could; because poorly regulated and poorly monitored finance markets combined with the incessant need of capital to expand contain the seeds of their own destruction. As experience shows, we ignore this lesson at our peril.
Source: Australian Options, Issue 56, Autumn 2009, pp. 15-6.