Stan O'Neal's legacy will be cemented as the $8 billion man. That's about the size of the massive writedown that Merrill Lynch & Co. had to take during its just-ended quarter, which has ruined the reputation of the investment bank's CEO.
Only months ago, he was being lauded for leading the nation's largest brokerage firm to its most profitable year ever, thanks to broad cost-cutting and expansions in Merrill's investment banking and trading operations.
Now, Merrill has added some unwelcome firsts to its list, by reporting the biggest quarterly loss in the company's 93-year history and by taking the largest quarterly writedown ever by a financial institution, due to the plunging value of its mortgage-related assets.
All this has stripped O'Neal, who grew up in rural Alabama and rose to become the highest-ranking black executive on Wall Street, of his star power. His good standing in corporate America is gone, as is his job. He is surely getting a quick lesson in how today's financial world works — the focus is on "what have you done for me lately," not what you've done before.
First as Merrill's president and chief operating officer, and then when he stepped into the CEO slot in late 2002, O'Neal was charged with reviving a company that was struggling to find its footing after the dot-com bubble burst and the financial fallout following the Sept. 11 terrorist attacks.
Merrill's brokerage trading activity had fallen off sharply earlier this decade just as it was experiencing weakness in its investment bank and asset management businesses. The company's costs had been soaring, while the nature of its business had been changing amid globalization of financial markets.
One of his primary focuses became cost control, and Merrill managed to pare down expenses significantly. In 2000, it cost $21 billion to run Merrill Lynch. By 2003, that was slashed to $14.9 billion, in part from major layoffs, according to analyst Richard Bove of Punk Ziegel & Co.
O'Neal also moved aggressively to expand the company's product base by increasing its appetite for risk. The business was pushed farther into potentially higher-returning avenues, like the fast-growing emerging markets and complex debt instruments like derivatives and mortgage-backed securities.
In particular, Merrill became heavily involved in the underwriting and trading of volatile assets known as collateralized debt obligations, or CDOs, which are pools of mortgage securities that are sliced up based on risk levels. That business skyrocketed in recent years, as seen by the soaring gains in the Merrill's fixed-income revenues that jumped 31 percent to $8.1 billion from 2005 to 2006.
O'Neal's efforts seemed to pay off handsomely — Merrill was raking in the underwriting fees and using its own capital to make money in risky credit products. Merrill earned $7.5 billion after tax in 2006, almost 10 times its 2001 profit and almost twice its previous record profit in 2000, which had been viewed as the high-water year for anyone in the banking or brokerage business, Bove said.
Even for the first half of this year, things looked good. Earnings more than doubled to $4.3 billion from a year earlier and revenues jumped 21 percent to $19.6 billion. But O'Neal's party at Merrill was quickly coming to a halt, spoiled by the global credit crunch.
It now seems that O'Neal and his management team embraced the idea of risk without really understanding how to manage it. While the housing market was soaring, Merrill — like plenty of other Wall Street firms — believed they had limited exposure because home prices kept rising and mortgage defaults were low. At the same time, the buyers of such investments were also seduced by the siren song of higher yields, without weighing the consequences.
That scenario has deteriorated significantly since early August. Parts of the debt market have been paralyzed by investors' refusal to own risky assets, and the housing market's collapse has exceeded even the most pessimistic estimates.
Those investments that helped Merrill earn billions of dollars just months ago are turning out to be a huge liability for the company — bigger than even Merrill's top brass thought they would be when they warned investors about them just weeks ago.
Merrill announced on Oct. 24 that it took an $8.4 billion writedown, $7.9 billion of which was related to the revaluation of its mortgage assets tied to borrowers with risky credit profiles. Merrill had intended to sell those securities but the credit market's meltdown trapped those suddenly less valuable investments on its books.
Such figures shocked Wall Street, which had expected a writedown totaling around $4.5 billion, based on the guidance that Merrill's executives had given on Oct. 5.
Investors also had to digest losses that far outweighed their expectations. The world's largest brokerage firm reported a $2.24 billion, or $2.82 per share, third-quarter loss — its first loss in six years and far larger than the 45 cents a share loss that analysts had forecast.
Wall Street research analysts now expect more trouble ahead — maybe as much as $4 billion in additional mortgage-related writedowns to come, and they are slashing their earnings estimates to reflect another big loss in the fourth quarter.
No wonder investors and Merrill's board of directors are rebelling. The stock has tumbled more than 20 percent since July to trade around $65 a share, with much of the hit coming last week after the weak earnings news. The company announced Tuesday that O'Neal would be retiring.
The denouement of O'Neal's five-year tenure is a good reminder that risk sometimes doesn't come with rewards.