Merrill Lynch cuts its losses, and its CEO

NEW YORK -- The Stanley O'Neal era is officially over at Merrill Lynch. mer But the $2 trillion question — namely, whether Merrill Lynch can regain its footing as the firm trusted by mom-and-pop investors on Main Street as well as investment bankers on Wall Street — is very much up in the air.

As expected, O'Neal resigned Tuesday, less than a week after admitting that he had underestimated the firm's losses in the subprime mortgage market.

But what might have come as a surprise is that rather than name a successor, Merrill's board of directors elected Alberto Cribiore as interim non-executive chairman and asked him to form a search committee to identify the firm's next CEO. Meanwhile, two of O'Neal's key lieutenants — Ahmass Fakahany and Gregory Fleming — will continue to run the company on a day-to-day basis as co-presidents.

So Merrill is searching for a new leader while its future as the nation's premier stock-brokerage firm is at stake. It is arguably at its most important crossroads in a generation, as losses from the imploding subprime mortgage market blew a hole in its earnings, eroded faith in a firm that until recently was a shining success and sent its stock price to a two-year low.

A good part of the shine came off Merrill's reputation last week when it announced the largest quarterly loss in its history. The primary cause was a write-down of $7.9 billion in the area of collateralized debt obligations (CDOs) and subprime mortgages. To make matters worse, just weeks earlier, Merrill had announced the write-down would be $4.5 billion. The sudden increase in the write-off suggested that Merrill, which still has $20 billion in exposure to the subprime mortgage sector, didn't have a handle on the depth of its financial problems.

When it comes to write-downs and special charges, investors prefer to see companies digest their problems at once and move on. That's why Merrill's double-clutch this month spooked investors — and why there is so much concern about who will lead the firm out of this crisis.

"That's as high a number I've seen," says Eric Fitzwater, analyst at SNL Financial. "It's still a distinct possibility that Merrill may have to take additional write-downs."

The fluctuating write-down was a sign that the problems at Merrill went beyond the factors that have been hurting the investment banking industry, says Mark Lane, analyst at William Blair. "In most people's eyes, this is a management issue, a risk-management issue, and a large enough number, looking at past history, to prompt a lot of management change," he says.

O'Neal's fall

O'Neal's resignation, following several days of wrangling with the board of directors, ends an almost five-year reign that until a few months ago was noteworthy for its success.

Starting in 2002, O'Neal took a bloated, overextended firm and slashed costs mercilessly, firing more than 20,000 people and shutting down offices around the world. He de-emphasized Merrill's traditional role as stockbroker to the average Main Street investor and refocused its business on high-net-worth clients, investment banking and global capital markets.

As a result, Merrill morphed into a much more efficient and profitable firm. Its stock price hit an all-time high of $98.68 early this year.

But O'Neal's single-minded pursuit of profits came at a price. His predecessors, including David Komansky and Dan Tully, liked to talk about the strong corporate culture at Merrill, which emphasized collegiality along with performance.

Under O'Neal's watch, people skills didn't matter anymore. Within months of his ascension to the top job, he fired an array of senior executives, some of whom had been his rivals and some of whom had been his biggest supporters. The message: Making it at the new Merrill would be all about performance and whether you followed O'Neal in lockstep.

Ultimately, it would be O'Neal himself who would be judged on performance. In 2006, after watching other Wall Street banks turbocharge their earnings with investments in CDOs based on subprime mortgages, O'Neal invested heavily in the area.

When the subprime market caved in this summer, Merrill held a disproportionate share of assets tied to that sector, putting the firm at risk of a big third-quarter loss. How he handled that risk, and Merrill's inability to manage it properly, ultimately did O'Neal in, say those who have followed his career.

"He blew it," says Richard Bove of Punk Ziegel. "He was aggressive and didn't understand the signs of when to pull back."

"He was so enthusiastic about the returns in subprime that he missed the high risks," says Jeff Sonnenfeld of the Yale School of Management.

Over the past few years — which were an ideal environment for investment banks due to low interest rates, global growth and liquidity — all the major Wall Street firms were able to "mint money," says Matthew Albrecht, stock analyst at Standard & Poor's.

But when the credit markets were strained, the firms that didn't manage their risks got burned, Albrecht says. "It appears that Merrill Lynch was one of the big firms with the worst risk-management policies," he says. The massive size of the loss begged for change at the top, Albrecht says.

O'Neal paid for his mistakes with his job, but financially, he'll walk away flush. Merrill said O'Neal would not get any severance, or a bonus for 2007, and that his salary stopped Tuesday. But because of his long service to the company, O'Neal will be able to keep all of his stock-option grants and restricted stock accumulated over the years, a sum that approaches $160 million.

Nell Minow, editor at The Corporate Library, which rates companies on the basis of corporate governance, says Merrill's board has a habit of rewarding failure. "Their CEOs are going to get paid very, very well, whether they perform or not," she says.

Yale's Sonnenfeld says the board should not have been surprised by the developments of recent weeks, but the lack of financial experts among directors could have added to O'Neal's problems.

At the same time, Sonnenfeld notes that one board member, Armando Codina, has had a ringside seat at several corporate governance disasters: He was on Winn-Dixie's board when it sought bankruptcy protection two years ago, and served on Home Depot's board last year when it allowed Bob Nardelli to walk away with several hundred million dollars following a poor performance as CEO. "Armando has seen an awful lot of disasters," he says. "He probably has a low threshold for surprises."

The swift action by Merrill's board to boot O'Neal is a clear sign of tougher corporate governance and shareholders' pressure on companies, says Shirley Westcott, managing director at the Proxy Governance consulting firm.

"Boards will not hesitate to dismiss a CEO if they feel that they and shareholders have lost confidence in his abilities," Westcott says. "Home Depot, Hewlett-Packard and other companies have dismissed CEOs under very public circumstances."

To buy or to sell?

Some Wall Street investors are looking at Merrill's recent woes as more of a buying opportunity than a reason to sell. The stock closed Tuesday at $65.56, down 34% from its 52-week high.

Arguing that Merrill's franchise — which boasts an army of roughly 16,000 financial advisers — is still intact, the stock is currently undervalued by roughly 12% to 15%, says Ryan Lentell, analyst at Morningstar. Lentell values Merrill at $76 per share. "Except for fixed income (the division that holds the subprime paper), the company is in pretty good shape," he says.

Merrill's other major business lines have fared well in 2007. Equity markets revenue, says Lentell, is up 23%, investment banking revenue is up 38% and global private bank revenue is up 16%. And Merrill's nearly 50% stake in money management firm BlackRock has also been profitable.

But not everyone buys that rosy outlook. "It's a question of risk," says Bill Fitzpatrick, analyst at Johnson Asset Management, who rates the stock a "sell."

Two big risks remain. Merrill is expected to write down further losses on bad bets tied to mortgages gone bad in the fourth quarter. Also, the firm's investment banking division, a big revenue producer, may fall victim to a talent drain as competitors seek to capitalize on Merrill's woes by luring away their top producers.

"The bonuses at Merrill are going to be smaller, and coveted investment bankers might jump ship," Fitzpatrick says.

The temporary pop in the stock over the past week — driven by speculation that O'Neal would be ousted — is not sustainable, Fitzpatrick says. "It's just short-term traders pouncing on a distressed stock to make some quick money," he says. "You don't have long-term buyers in there yet." The stock could languish until the full losses are known, he says.

Bove says O'Neal should not have been pushed out, since it puts Merrill back where it was five years ago, re-creating its business without the benefit of time-tested veterans. Bove's biggest criticism of O'Neal is he fired so many experienced people that there was no one to warn him about overexposure to credit risk in the subprime market. Bove placed a "sell" on the stock this week, saying he did not have "faith that this board understands the need to build a long-term business plan or the capability to execute it."

Win Smith, the son of one of the firm's founders, says the fundamentals at Merrill remain strong. Like Bove, he says the key problem under O'Neal's reign was the loss of top managers who'd been through hard times before. "When you get rid of institutional memory, it's very difficult to deal with a crisis," he says. "You can't tinker with successful cultures."

Contributing: Edward Iwata in San Francisco and Matt Krantz in Los Angeles