Merril Lynch's Microwave Ovens

The focus on Merrill Lynch these days is on its tattered balance sheet, namely the more than $30 billion in mortgage-related assets it wrote down last week for some 22 cents on the dollar. Given that Merrill valued these toxic assets at 36 cents on the dollar just weeks ago underscores the severity of the mess Wall Street has created. Even a veteran executive like Merrill CEO John Thain has absolutely no clue how to value the assets on his company’s books.

But Mr. Thain has another formidable problem. It is the mind-boggling allegations outlined in the administrative complaint Massachusetts regulators filed Thursday outlining with impressive clarity how Merrill Lynch deceived its clients into believing that auction rate securities were safe cash equivalent investments when in fact they were inherently quite risky. If a significant portion of Merrill’s brokers and retail customers take the time to actually read the complaint, they will be outraged by how badly Merrill's management betrayed them.

The Massachusetts complaint, impressively written in language that a layman can easily understand, makes clear that Merrill was badly conflicted when selling auction rate securities to its retail customers, some of whom I represent. The firm reaped a hefty $90 million in profits in 2006 and 2007 underwriting these securities for their corporate customers and priced them at interest rates ultimately advantageous to them.

The interest rates on these securities reset at weekly or monthly auctions and were typically slightly higher than an investor could receive from a money-market fund. The little understood risk was that Merrill was artificially propping up the auction rate market and that if an auction ever failed, investors would get stuck holding essentially illiquid long-term bonds carrying relatively low rates of interest. Merrill’s mortgage-related problems eventually prevented the firm from propping up the auction rate market; almost overnight its retail clients were stuck holding low-interest bonds with long-term maturity dates.

“Time after time, when confronted with conflicts of interest, Merrill Lynch was consistent in that it placed its own interests ahead of its investor clients (emphasis mine),” the administrative complaint charges.

With more than three decades of experience representing individual investors who have been wronged by their brokers, it comes as no surprise to me that Merrill put its interests ahead of those of its clients. And to be fair, other brokerage firms also have been accused of deceptively selling auction rate securities to their clients. But the Massachusetts complaint against Merrill also reveals the firm’s lack of regard for both the letter and spirit of previous regulatory agreements it has entered into and provides yet another appalling example of conflicted research.

According to the complaint, Frances Constable, a manager director responsible for overseeing Merrill’s auction rate securities desk, was allowed to compromise the integrity of Merrill’s fixed-income research by demanding that a less-than-sanguine report about auction rate securities be retracted. Merrill’s research department acquiesced and issued a new report positively characterizing auction rate securities as “a buying opportunity.” Merrill cannot claim that Ms. Constable was acting without the complicit approval of her superiors; Ms. Constable sent an email to her bosses written entirely in capital letters outlining her planned course of action.

Another damaging email was sent by Ms. Constable to an associate on November 26 when the firm was clearly worried about the firm’s increasing inability to peddle auction rate securities to its unsuspecting clients: “The gloves are off and we are not concerned about issuer perception of [Merrill Lynch’s] abilities and the competition. Gotta Move these microwave ovens!!”

Conflicted research is nothing new at Merrill. In 2001 the firm was party to a global $1.4 billion settlement after former New York Attorney General Eliot Spitzer uncovered emails showing that then Merrill analyst Henry Blodget was touting stocks he privately believed were “pieces of crap.” As part of the settlement, Merrill agreed to ensure the independence of its equity research department from its investment banking operations. Shockingly, a Merrill spokesman defended Ms. Constable’s actions by saying the Spitzer settlement didn’t preclude communications between Merrill’s sales and fixed-income research analysts.

Artificially propping up its auction rate securities also underscores the disregard Merrill has for regulators. On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms, including Merrill Lynch for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. The penalty: a paltry fine totaling $13 million, of which Merrill’s piece was an insignificant $1.5 million.

To the credit of Massachusetts regulators, they are seeking to force Merrill to make their retail clients whole on the auction rate securities they were duped into buying. But if the Commonwealth’s regulators are truly bent on forcing Merrill to reform, they will insist that any settlement require Merrill to admit wrongdoing, thereby making it considerably easier for their clients to seek redress in securities arbitration for additional losses they sustained because of the unexpected illiquidity of their investments.

The fallout for Merrill's brokers could also be significant. The complaint alleges that brokers who questioned the safety of auction rate securities were stifled and there is strong evidence that they may not have known or understand the inherent risks of the securities they were selling to clients. Merrill's brokers could suffer considerable reputation damage if a significant number of clients file claims against them.

Perhaps most damaging of all is that Merrill's brokers must now accept the hard reality that management ultimately regards them as nothing more than microwave oven salesman.

The Subjective Nature of Wall Street Write-Downs

Fourteen billion. That's the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren't under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill's and Citi's write downs is how it exemplifies the subjective nature of Wall Street's accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now "retired" CEOs Stan O'Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O'Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe "uncertain market conditions" are to be blamed?

The point is, strategy shouldn't influence when and how much to write down losses. What Wall Street's earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street's books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the "Big Four" accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman's sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, "This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years' numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC's overall compensation."

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O'Neil has some explaining to do because investors should not accept that Merrill Lynch couldn't have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street's favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you're on a wing and a prayer.