Merrill Lynch (MER)/Bank of America (BAC)

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Merrill Lynch (NYSE: MER) was acquired by Bank of America (BAC) for $50B on January 1, 2009.[1] On September 15, 2008, Merrill Lynch agreed to a deal with Bank of America in which BAC swapped 0.8595 share of its stock for each share of Merrill Lynch. This price was 1.8 times Merrill's stated tangible book value.[2]

Under former CEO E. Stanley O'Neal, Merrill began to shoulder more risk by investing its own assets directly in the market, a strategy pursued successfully by Goldman Sachs Group (GS) for years. For a time, this strategy helped Merrill grow earnings. However, by the company's own admission,[3] risk was poorly handled, and Merrill invested aggressively in collateralized debt obligations based on subprime mortgages. Merrill was forced to write down and write off nearly $8 billion in assets in the third quarter of 2007 and $16.7 billion in the fourth quarter, more than any other investment bank. On May 23, 2008, Merrill set up a group to figure out how to get rid of CDOs and other risky assets,[4] which led to the July 28th sale of $30.6 billion of CDOs for 22¢ on the dollar.[5] However, despite its attempts, Merrill Lynch was unable to sustain its losses and was acquired by Bank of America on January 1, 2009.


Trends and Forces: Profit drivers and risks

Business Cycles

Merrill Lynch is highly impacted by both global and US economic conditions. During periods of rapid economic growth, companies typically borrow more money and offer more IPOs , leading to greater demand for Merrill's investment banking services. Also, the stock markets typically move in the same direction as the overall economy. If the market is up, then demand for trading and other capital markets services will likely increase as well. Conversely, if the economy is depressed, demand for Merrill's banking services decreases substantially.

Interest Rates

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Interest Rates can be thought of as the cost of borrowing money. Though the impact of interest rates spans across the economy, businesses and lenders are particularly sensitive to fluctuations in interest rates. As interest rates increase, businesses are less likely to issue debt or equity given that the price of borrowing has increased. Interest rates have, however, been fairly low since 2004, which has played a significant role in driving business activities. Merrill has benefited from high levels of mergers and acquisitions, underwriting, and IPO activities over the last three years.

Subprime Lending

Subprime lending lending refers to the practice of extending credit or loans to borrowers to who fail qualify for prime or market rates due to their less than optimal credit scores. For the past decade, the interest rates associated with subprime mortgages have been about 2% higher than those associated with prime loans; the rationale is that borrowers with lower credit scores carry a higher risk of default and must therefore pay a considerable risk premium. Subprime borrowers can be extremely sensitive to interest rates. As rates rise, these borrowers, many of whom have adjustable-rate mortgages, find themselves unable to meet their debt obligations.

In 2006, Merrill Lynch purchased subprime mortgage originator First Franklin, with the expectation that Merrill would be able to package and resell First Franklin's subprime loans in the form of mortgage-backed securities. Rising numbers of defaults in the subprime mortgage market have had a significantly negative impact on Merrill's First Franklin business. Also, demand for securities backed by subprime mortgages has dwindled, limiting Merrill's ability to repackage and sell First Franklin's loans. On top of all of this, Merrill paid $1.3 billion for First Franklin, which many say was a grossly overinflated price, considering the current state of the subprime market. See the Merrill Lynch Bears article for more information on its subprime exposure.

Litigation

As a leading private wealth manager, Merrill is extremely vulnerable to litigation. Disgruntled clients with both real and imagined complaints often file lawsuits against the company on the bases of poor performance or mismanagement. This litigation can be extremely costly in terms of legal fees and settlements, not to mention the negative publicity that lawsuits entail.

Merrill Lynch's Global Market and Investment Banking unit is also vulnerable to lawsuits by regulatory authorities such as the Securities and Exchange Commission (SEC). These lawsuits can not only result in legal defense expenses and fines in the millions of dollars but can also damage the firm's reputation.

Competition

Merrill Lynch ranked 6th in M&A volume for the first nine months of 2007. It is important to note that Merrill's strategy with regards to both underwriting and M&A advisory focuses on profitability rather than volume. In other words, Merrill Lynch does not seek to be the number one underwriter but instead seeks the most profitable deals, regardless of size.

Recently, Bank of America announced its plans of purchasing Merrill Lynch for approximately $39 billion in stock.

2007 metrics Goldman Sachs Group (GS) Morgan Stanley Merrill Lynch Lehman Brothers Bear Stearns
Gross earnings ($B) 45.6 23.1 -6.119.32.2
Pre-tax income ($M) 17,604 3,441 -12,831 6,013 193
1-yr revenue growth (%) 23 -9.7 N/A9.5-52
Equity origination revenue ($B) 1,382 1,570 1,6291,015N/A
M&A advisory revenue ($B) 4,222 2,541 1,740 1,337 828
Debt underwriting revenue ($B) 1,951 1,427 1,550 1,551 N/A
Note: Bear Stearns Companies (BSC) reported $529 million in revenue for all its underwriting activities but did not provide a breakdown of debt vs. equity underwriting in its Form 10-K.


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Global M&A market share for the first nine months of 2007[6]
2007 Metrics Citigroup Morgan Stanley Merrill Lynch
Revenue per adviser $742,000 $853,000 $860,000
Total advisers 14,858 8,429 16,740
Total assets (bn) $2,182 $1,045 $1,020
Fee-based assets as % of total 28.8% 27% 37.4%
Total client assets (bn) $1,548 $758 $1,751

Merrill Lynch is the dominant player in the private wealth management business. It has the largest sales force and is known for providing best-in-industry training to its financial advisers. Its revenue per adviser is among the highest in the industry, at an average of $860,000 annually. This is partly due to Merrill's effective client segmentation strategy, which emphasizes higher-net-worth clients. Under Merrill's policies, each FA is only allowed to serve a limited number of clients; it, therefore, makes sense for them to concentrate their energy on wealthier clients who generate more income. To encourage this practice, the firm instituted a policy of not paying FAs on relationships under $100K. Merrill lags behind its competitors, however, in terms of its annuitized assets to total assets ratio. Financial advisers generate revenue from annuitized assets by charging a fee equal to a percentage of the client's total assets under management, typically 1% to 3%. The arrangement produces a more stable revenue stream since advisers are paid the same amount regardless of the number of transactions requested by their clients.





References

  1. The Wall Street Journal "Bank of America-Merrill Lynch: A $50 Billion Deal From Hell" 22 Jan 2009
  2. Marketwatch.com
  3. http://www.nytimes.com/2007/10/25/business/25merrill.html
  4. Merrill Lynch sets up group to shed bad assets | Reuters
  5. Thain's Housekeeping Spiffs Up Merrill - WSJ.com
  6. M&A Bubble Bursts - WSJ.com
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