Friday, October 05, 2007

Growth, Risk Management, & Attendant Excesses in Financial Service Firms: The Merrill Lynch Case

As I read yesterday's Wall Street Journal, it occurred to me how Merrill Lynch's recent firings, sub-prime experience, and diversification are a textbook example of why large financial service firms almost never provide consistently superior total returns for shareholders.

In case you missed the piece, or other news stories about it, Merrill fired its global head of fixed income, his deputy, the co-head of fixed income for the Americas, and the former co-head of institutional securities. According to the article, an unnamed analyst estimated that Merrill will be writing off nearly $4B in losses from its sub-prime mortgage holdings.

While other firms, such as Bear Stearns and UBS, have also ejected senior executives, I want to examine the Merrill situation in more detail, because of its size and business scope.

Mr Kim, Merrill's recently-fired co-head of institutional securities, had led the team and area which bought First Franklin Corporation, a subprime mortgage originator, for $1.3B.

A dissenting executive, Jeff Kronthal, was fired as the team bought the sub-prime firm.

Once purchased, of course, First Franklin became a machine with which this fixed income team churned out lots of CDOs, becoming the #1 underwriter of the instruments since 2004.

According to the Journal article, the former global head of fixed income, Mr. Semerci,

"and Mr. Kim were known for putting a greater priority on expanding market share than on risk controls."

And there you have the crux of the phenomenon.

At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.

So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.

Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.

When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.

In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill,, seems to explode in fantastic losses every few years.

So long as these giants incent managers to get ahead by growing their businesses, which, in financial services, must, to sustain growth over time, lead to riskier business, this will be a permanent feature of the sector.

That's why my equity selections process never identifies a non-acquisitive diversified financial conglomerate as an investment. Sans acquisitions, which prop up revenue growth artificially for a time, these giants are continually prone to the sort of losses being recorded at Chase, Citi, Merrill, Bear Stearns, and UBS this year.

Merrill can axe three highly-ranked fixed income executives, but that won't stop this from happening to the firm again. The story is as old as Lehman's original fist fight in the partner's board room that saw Lew Glucksman, the firm's one-time trading titan, oust Pete Petersen, who went on to co-found the now-famous private equity BlackStone Group.

Glucksman went on to binge on trading and, subsequently, trading losses, in the next few years, leading the firm to fall into the lap of American Express.

Only the faces will change. The culture and internal climate of any diversified financial services firm will guarantee repetitions of the recent Merrill experience for years to come.

When financial service firms rely on one, or, at most, a very few businesses to fuel their value creation, and manage risk accordingly, only then will they avoid these recurring risk-management failures.

In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.

The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.

Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants.

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