Business & Professional Ethics 6th Edition by Leonard Brooks

Exercise 36

In December 2002, Stan O'Neal became CEO of Merrill Lynch Co Inc, the world's largest brokerage house. Known as "Mother Merrill" to insiders, the firm had a nurturing environment that accepted lower profit margins so that veteran employees could remain with the firm. O'Neal changed that culture. He laid off one-third of the workforce-24,000 employees-and fired nineteen senior executives while eliminating senior management perks. He put in a new young management team, expanded the firm's overseas activities, and made Merrill a more aggressive, risk friendly organization. In 2006, for example, the firm made $7 billion in trading securities, compared with $2.2 billion in 2002. Under O'Neal's leadership Merrill became the most profitable investment bank in America, making more money per broker than any of its competitors. O'Neal was rewarded well-in 2007 he became one of Wall Street's bestpaid executives, earning $48 million in salary and bonuses.
He pushed the company into new lines of business, including investing in collateralized debt obligations (CDOs). Merrill led the industry in its exposure to CDOs. Over an eighteen-month period, to the summer of 2007, its investment in these subprime mortgage-backed CDO pools rose from $1 billion to more than $40 billion. Then the subprime mortgage bubble burst.
The term "subprime" does not refer to the interest rate changed on the mortgage but, rather, to the risk associated with the borrower. Subprime mortgages are given to high-risk customers who are charged an interest rate that is greater than prime. These mortgages are typically given to people who would not normally qualify for a mortgage from a conventional lender such as a bank. From the lender's point of view, as long as house prices increase, the risk of a loss on the mortgage is low. As such, the mortgages became low-risk, high-yield investments. The lenders of these sub-prime mortgages would then package these mortgages as bundles of asset-backed synthetic securities, such as CDOs, which were sold to third parties, including individuals, corporations, pension funds, banks, insurance companies, and brokerage houses.
The subprime mortgage bubble bust when house prices in the United States began to fall. People could no longer refinance their homes nor pay off their mortgages by selling their homes. By late 2006, one in eight subprime mortgages was in default. Throughout 2007, nearly 1.5 million American homeowners lost their homes. As the housing market imploded, mortgage payment defaults increased and the value of subprime mortgages fell as did the value of the subprime mortgage-backed CDOs. By the summer of 2007, subprime-related losses were being reported by all the major financial institutions.
In the third quarter of 2007, Merrill announced a loss of $2.3 billion, compared with a profit of $3.05 billion for the third quarter in 2006. It also announced a $7.9 billion provision for losses on mort gagerelated investments, larger than the warning of a possible $5 billion write-down that it had made a month earlier. Within a week of reporting the largest quarterly loss in the company's ninety-three-year history, O'Neal resigned as Chairman and Chief Executive Officer of Merrill Lynch. Although he did not receive any severance, O'Neal did receive $161 million in stock and retirement benefits.
O'Neal transformed Merrill Lynch from a conservative bank into an aggressive risk-taking institution. Risk-taking means that there is the potential for high rewards as well as large losses. From 2002, when O'Neal became CEO, Merrill's share rose 53 percent. Should the investors now be upset that, as a result of the subprime mortgage meltdown, Merrill's stock price fell by about 30 percent in 2007?