Here is One of the Cruel Ironies of the recent Wall Street crisis: Last October, former Merrill CEO Stan O'Neal was fired for initiating secret merger talks — with Wachovia. But O'Neal may have had the right idea after all; it's a pity he was on the wrong side of Charlotte, and some months too early. In September, just 11 months later, O'Neal's replacement, John Thain, was being hailed as a hero for pulling off a shocking shotgun sale to Wachovia's cross-town rival, Bank of America.
Indeed, at a town hall meeting on Tuesday, September 16, before Merrill Lynch's 60,000 employees, Thain received a standing ovation. Just two days earlier, after a weekend of furious negotiations, he had agreed to sell the very independent — and proud of it — Merrill Lynch to Bank of America in an all-stock deal, valued at about $50 billion. (One wonders, how much would O'Neal have gotten for Merrill last October? And did O'Neal foresee the crippling capital deficit that the rest of us didn't?) The very symbol of Wall Street brio, Merrill's snorting, stampeding bull had been humbled — but it was still standing, and, in time it may be stronger for the pain. What a contrast to Lehman Brothers, where many employees watched their entire retirements literally vanish, and were left to hoof it out of the firm's midtown Manhattan headquarters with boxes while the nation's media photographed the event. (Always on the prowl for money making opportunities, some employees put up Lehman t-shirts and pens for auction on eBay.)
Where Thain was decisive and analytical, able to pull the trigger and make a tough call (it may have helped that he was hired to fix the ailing firm), Lehman's CEO Richard Thuld was, apparently, too stubborn — or myopic — to see the handwriting on the wall: The jig was up — the old stand-alone securities firm model could no longer survive on funds from the short-term repo and secured lending markets. Fuld failed to cut a deal, failed to understand before it was too late and Lehman was out of business, the over-leveraged victim of a counterparty confidence run.
Most Merrill financial advisors say they are thrilled about the deal and plan to stay put — the rest are waiting to see if the retention package is right. (At press time, no details had been announced.) On a conference call the day after the deal was announced, BofA CEO Ken Lewis called Merrill's 17,000-member advisor force “the crown jewel of Merrill Lynch,” which one Merrill rep said implies that “we'll be well taken care of” — at least for now. Lewis also indicated that Merrill would keep its name and operate independently — which is exactly what Merrill reps want.
What's more, the merger will create a universal banking powerhouse that, analysts say, will dominate the market in deposits, commercial and consumer banking, retail brokerage and investment banking. BofA itself is a colossus, with $1.6 trillion in tangible assets and $163 billion in shareholder equity. That gives Merrill a strong capital backing, so it won't have to depend on the repo market to stay in business. BofA also wins revenue diversification, about 70 percent of which had been concentrated in consumer and small-business commercial banking. Cross selling opportunities abound: BofA has some eight million mass affluent clients with $100,000 to $3 million in liquid assets.
Imagine, as one top Merrill advisor did the other day, a combined BofA/Merrill branch network. “Someday a client will be able to go to a BofA branch and deposit money in his Merrill Lynch account,” as opposed to “having to take an elevator up to see me to drop off the check.” Not that there aren't lots of hurdles to making the integration work (which overlapping offices get eliminated? How to organize U.S. Trust and Merrill's private bank?), but you get the picture.
The New Model
O'Neal, the first Merrill CEO not to rise through the retail ranks, was the master architect of Merrill's ruin, since it was he who transformed Merrill from an un-sexy retail brokerage into a corporate finance (read: asset-backed securities) giant. Unfortunately, he — and the aggressive sales and trading desks he recruited — succeeded. By 2007, Merrill was one of the largest issuers of sub-prime asset-backed securities in the U.S.
But with Lehman kaput, Merrill in the arms of Bank of America, and now Morgan Stanley and Goldman Sachs converting themselves into bank holding companies, the independent brokerage/investment banking model is dead, and the era of Glass-Steagall will eventually fade into memory. Inside of their commercial banking shells, these institutions will be much more heavily regulated by the Federal Reserve and less able to take on huge amounts of leverage, which, in turn, will mean slimmer profit margins for the investment banking business.
That may be a good thing for retail brokerage and wealth management: With their steady recurring revenues, solid margins and their potential for growth in an era of baby boomer retirement, the wealth management divisions may become even dearer to the big banks, say analysts. One thing Merrill and other financial advisors won't be doing much more of is pushing derivatives and other complex products on their retail clients.
To Stay Or Go
What a difference a few weeks make. If Merrill and Bank of America had hooked up in, say, August, and certainly if the deal had been done back in, say, 2006, it would have infuriated most Merrill Lynch employees and maybe, most of all, its financial advisors. Merrill Lynch, in any case, has long been the reining king of the brokerage business, a claim born out by its thundering herd of financial advisors and their wealthy clients, its lead in revenues and assets per FA, its reputation for employee loyalty and a proud corporate culture.
But there are new realities, and Thain is to be congratulated for understanding that despite $46 billion in write-downs, a deal had to be done. How would have Merrill FAs regarded the BofA transaction two years ago, we asked a Merrill rep? “Two years ago? Jesus,” he replies, “Would I have been happy Merrill is owned by BofA, by any bank, for that matter, anyone? Listen, the world changed. And I'm willing to bet Morgan Stanley is inside a bank by the end of the week. They've already met with three of them.” (On September 22, Morgan Stanley announced plans to sell a 20-percent stake in itself to Mitsubishi UFJ Financial Group, the largest Japanese bank.)
That's not to say there aren't plenty of disgruntled Merrill advisors out there who don't want to work for a bank and worry that their clients will be bombarded with marketing for BofA products, or that their highest-net-worth clients will be spirited away to be served by BofA's trust division, U.S. Trust. Many of these advisors are waiting to hear what kind of retention package BofA will offer them; most are expecting that the top two quintiles will get 100 percent of trailing 12-months production in cash and stock over nine years — that's what Bear Stearns advisors got. Still, when you are talking about 17,000 advisors with average production of $600,000 to $800,000 — depending on who you ask, and depending on how you calculate it — that will certainly add up. Bank of America CEO Ken Lewis is known as a cost-cutter, and he has promised $7 billion in cost savings from the deal by 2012. (Some analysts think that's quite ambitious.)
Some Merrill complex directors (who report to divisional directors) say they are angry, because they've heard they are not getting a cent. They also claim that a lot of the smaller producers at Merrill — those producing $400,000 or less — are preparing to leave because they, too, expect to get little transition money from Lewis.
The fear is that Merrill wealth management head Bob McCann and his number two guy, Dan Sontag — who are rumored to remain in place at the new combined firm — will not make the best decisions on transition packages. “The conflict here is that they now have to participate in a beauty pageant for their new bosses; they will have to prove how shrewd and economical they will be,” says one producer in the Northeast. “It's the number one conversation around here. Well, it's the number two conversation, behind how this is going to affect our relationships with our clients, our autonomy, our ability to continue to have input into the direction of our clients' portfolios.”
Still, most of the top Merrill producers interviewed by Registered Rep. say the BofA deal is the best thing that could have happened to them, not just under the circumstances, but, perhaps, in the long run. “I love Merrill Lynch,” says one top producer in California. “The deal is going to be awesome — it's incredible — and the retention packages will just be incremental for me. My clients work with me. They could not care less about what platform I'm on, as long as we're stable.”
Enhancing Indie Appeal
And, anyway, where would unhappy Merrill advisors go? “Do they want to work for a brokerage, or drive a taxi?” asks Dick Bove, a research analyst at Ladenburg Thalmann. He has a point. All of the big Wall Street brokerage firms have troubled balance sheets, the old model hobbled by a bad case of liquidity anorexia.
Of course, there is always independence — and not just for Merrill advisors, but for wirehouse guys from all over. “I think that any time you really shake it up as much as you are right now, you will definitely have more people looking for alternatives to the wirehouses,” says Danny Sarch, a recruiter with Leitner Sarch Consultants. “The law of numbers dictates that there will be wirehouse guys who are interested in all of the above: RIAs, regionals and independent b/ds. It's a tremendous opportunity for people looking to hire.”
Sarch and other analysts concede that only a small percentage of those considering leaving wirehouses will seek an RIA solution, because so few wirehouse advisors have all-fee books of business. But, on the other hand, “Two years ago, you never?heard about mainstream brokers of substance moving to RIAs. Now you do. I think most Merrill people are open to seeing what is out there, while taking?a wait-and-see attitude about the retention package.”
According to Fidelity Investments, 55 “breakaway brokers” — financial advisors who have left one of the five wirehouse firms — with $7 billion in client assets joined the firm's growing RIA empire (Fidelity Institutional Wealth Services) in the first six months of 2008. That's more than double the assets breakaway brokers brought over to Fidelity in all of 2007. Meanwhile, Schwab's RIA custodian, Schwab Institutional, is also having a banner year. The firm says net new client assets for the first half of 2008 were $9.4 billion, eclipsing the sum gained in all of 2007 ($9.2 billion).
In fact, Charles Schwab says it saw a 200-percent increase in incoming calls from advisors who want to learn more about independence during September.?“Given the sheer number of advisors who are undergoing, or are about to undergo, some kind of change, it's certainly reasonable to assume that we'll see an increase in?advisors deciding?that the change they really want is to own their own practice,” says Schwab spokesperson Lindsay Tiles. “But it's still early to make specific predictions.?Also you likely won't see most of the real effects until 2009, because these transitions do not happen overnight.?Plus, many advisors right now are focused on addressing questions and concerns from their clients.”
The Road Ahead
Of course, there are still risks for Bank of America now that it is saddled with Merrill Lynch's liabilities as well as assets. For one, there are questions about whether it has enough capital to cover future liability surprises on Merrill's balance sheet — it might have to cut its dividend or take other drastic measures, says Bove, the Ladenburg analyst. After all, Lewis is, in effect, betting that the worst of the mortgage crisis is behind us and that Merrill's asset-backed securities are currently being conservatively accounted for.
It's a big bet. According to Brad Hintz, of Sanford C. Bernstein, Merrill had $8.8 billion of gross exposure to CDOs ($1.2 billion net exposure), $22.9 billion of commercial real estate net exposure and $54.1 billion of residential mortgage net exposure ($33.6 billion of it is U.S. prime mortgages) when the BofA deal was done. That comes out to about 270 percent of Merrill's tangible equity base. And that's after Merrill had already written down $46 billion in troubled securities.
Some analysts even have doubts about the wisdom behind combining investment banking and commercial banking divisions under one roof. “When it comes to fighting for capital, it will be a question of whether Merrill's investment bank will get the capital, or the commercial bank will get the capital,” says Geoffrey Bobroff, President of Bobroff Consulting in East Greenwich, R.I.
There are plenty of questions left about the U.S. financial system, how it will shake out, and how it will fare from here on out. The big positive is that the wealth management units are making money despite the turbulence in the markets. And that means management will want to keep financial advisors — especially the most productive of them — happy.
A DECADE OF DEALS
Broker/Dealer acquisitions by banks and thrifts
|Year||Number of Transactions||Aggregate Deal Value ($M)|
Note: Grouped by announcement date *As of September 17, 2008
Source: SNL Financial LC
A selective timeline of financial history reveals that good times seed the bad times.
1887 — Lehman Brothers joins NYSE as member.
1913 — Federal Reserve established.
1914 — Merrill Lynch founded.
1920 — Prohibition; New Era bull market.
1923 — Bear Stearns founded.
1929 — Black Tuesday. Stock values lose 89 percent from peak to bottom in 1932.
1930 — The Great Depression. The Bank of the United States fails.
1933-1938 — New Deal creates the Federal Housing Authority, Fannie Mae, the FDIC and Social Security; Congress creates the SEC.
1971 — Merrill goes public.
1973-1974 — Second-worst bear market in history; stocks plunge over 50 percent.
1974 — Merrill Lynch's “bull” is introduced.
1975 — May Day; SEC creates “net capital” rule.
1977 — Community Reinvestment Act requires banks to lend to low- and moderate-income customers.
1984 — American Express acquires Lehman, merges firm with Shearson.
1987 — Black Monday. DJIA drops more than 22 percent in one day.
1989-1995 — Resolution Trust Company resolves savings and loan crisis of the 1980s; 747 banks fail, ultimately costing $160 billion.
1994 — Lehman Brothers goes public.
1994 — Sub-prime loans account for 5 percent ($35 billion) of outstanding mortgages.
1997 — First sub-prime loans securitized by First Union.
1999 — Glass-Steagall Act of 1933 repealed. Sub-prime loans represent 13 percent ($160 billion) of outstanding mortgages.
2000 — NASDAQ peaks at 5132.
2000-2001 — Fed cuts Fed Funds rate 11 consecutive times to 1.75 percent.
2003 — Lehman Brothers acquires Neuberger Berman.
2004 — SEC loosens leverage requirements for Lehman, Merrill, Bear, Goldman and Morgan Stanley.
2006 — Sub-prime loans represent 20 percent ($600 billion) of outstanding mortgages.
2007 — Lehman Brothers ranks #1 “Most Admired Securities Firm” by Fortune.
February-March, 2007 — 25 sub-prime lenders declare bankruptcy, announce massive losses or put themselves up for sale.
July 2007 — Two sub-prime-heavy Bear Stearns hedge funds collapse.
August 16, 2007 — Countrywide Financial narrowly misses bankruptcy, takes $11 billion in emergency loans from several banks.
January 11, 2008 — BofA agrees to buy Countrywide.
March 15, 2008 — Bear Stearns sold to JP Morgan Chase.
July 11, 2008 — FDIC takes over IndyMac.
September 7, 2008 — Fannie Mae and Freddie Mac nationalized, effectively doubling the national debt.
September 15, 2008 — Lehman files for bankruptcy. BofA buys Merrill.
September 16, 2008 — Fed takes over 80 percent of AIG. Barclays buys Lehman assets.
September 21, 2008 — Goldman Sachs and Morgan Stanley approved to become bank holding companies.
September 22 — Morgan Stanley says it will sell a stake to the Mitsubishi UJF Financial Group, of Japan, for up to $9 billion.
September 23-Warren Buffet invests $5 billion in Goldman Sachs.