Current Economic Crisis Made Simple by Merrill Lynch

I think few people understand how we got in the mess we’re in. We’ve heard about complex derivatives, synthetic collateralized debt obligations, and credit-default swaps, all apparently stemming from the sub-prime mortgage debacle. As reported in the New York Times, the story of Merrill Lynch’s role in this crisis simplifies the catastrophe for normal people.

We remember Merrill Lynch as America’s most famous brokerage house with its powerful corporate logo of a hard-charging bull. Though registering huge profits, Merrill was jealous of Lehman Brothers for its massive mortgage profits. Merrill decided that though late to the mortgage market game, it could make up for lost time. It went on a buying binge, making 12 major purchases of residential or commercial mortgage-related companies or assets in just two years.

The synthetic collaterlized debt obligations had been invented by J.P. Morgan bankers in the late 1990′s as a means of protecting investors from investments carrying high risks. Once Merrill began using the device to concentrate increasingly dangerous risks instead of insulating against them, J.P. Morgan backed off, while Merrill charged ahead with breathtaking profits. We now know that Merrill was building a mere house of cards, but there are two simple things — in addition to the sheer greed – that stand out as Merrill marched over the cliff.

First, Merrill’s risk management unit had always prided itself in accurately measuring the firm’s risk and reining in activity that was too risky. Merrill’s executives presiding over this new money machine forced risk management to back off. One of risk management’s simple ways of controlling risk was to have employees who “walked the floor,” talking with traders to figure out first hand what kinds of risks were being taken on. The floor walk was stopped.

Second, as Merrill’s profits skyrocketed and the proponents of mortgage-based investment products gained power, “there was no dissent,” even though long-term employees were deeply concerned about the direction the firm had taken. Consequently, Merrill became the world’s biggest underwriter of these products.

It’s simple. Any business must have people in management constantly walking the floor, talking with employees, understanding what they’re doing, asking their advice, giving them advice, grasping the current state of the business. If that doesn’t happen, you won’t have any idea what’s going on.

Any business should also require dissent. Some businesses talk a good game, but employees soon figure out that it’s just talk when they do dissent only to be sat in the corner. Every employee should understand that dissent is his duty, and every executive should thank her lucky stars each time an employee raises a hand to ask a tough question or criticize a policy.

As for the greed, well, I’m not sure that we humans are capable of handling it once it catches fire and everybody around is raking in the money. As one person whose business was acquired by Merrill said: “[Merrill Lynch] had found this huge profit potential . . . . But they were pigs about it.”

1. 

   Cultural Offering says:

   November 15, 2008 at 11:32 pm

   Thanks for posting. One of the best pieces you have written.
2. 

   John Phillips says:

   November 16, 2008 at 3:58 pm

   CO,

   Thanks so much.

   John