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Merrill Lynch: What Went Wrong with Risk Management in 2008

Merrill Lynch: What Went Wrong with Risk Management in 2008?

Abstract

This paper examines the factors that drove the 2008 financial crisis at Merrill Lynch. The collateralization of mortgages showed that no institution was too big to fail. While the Fed had a role in averting the crisis, aggressive risk practices as seen in the subprime sector exposed the institutions to market risk leading to crashes, bail-outs, and mergers (Labonte, 2014). In this regard, the paper apportions blame to Merrill Lynch itself by showing that the Federal Reserve Bank was not responsible for liquidity problems at individual financial institutions. One, the paper finds evidence for the global financial crisis that affected Merrill Lynch. Second, the paper builds on the global crisis to identify factors that exposed Merrill Lynch to the crisis. The discussion suggests that poor management and high appetite for risk occasioned the liquidity crisis at Merrill Lynch.

Merrill Lynch: What Went Wrong with Risk Management in 2008?

Introduction

One of the most phenomenal failures in the 2008 crisis was the credit shortfall in Merrill Lynch characterized by liquidity issues. Consequently, this essay absolves the Fed by portraying Merrill Lynch’s poor risk management strategies as the enabling factors for the 2008 crisis. The study reviews the literature on the financial crisis and relies on qualitative research as evidenced by content analysis on economic studies to evaluate and synthesize existing literature. As this paper shows the evolution of the 2008 financial crisis, it argues that Merrill Lynch’s history of poor management heightened its risk appetite leading to its demise before eventual absorption by the Bank of America.

Background

An understanding of the liquidity crisis at Merrill Lynch requires a discussion of the factors leading to the 2008 credit crisis. Although the credit crisis began in the United States housing and mortgage markets, the Federal Reserve cannot be blamed for not intervening in time as the financial meltdown was becoming apparent. Instead, banks and credit institutions should take responsibility on the grounds of poor and imprudent risk management strategies that led to risky lending and resulting credit crunch. Regarding the discussion topic, the management at Merrill Lynch embraced risky practices such as non-secure mortgages which exposed the financial institution to the 2008 crisis.

After affecting the real estate and mortgage markets, the credit crisis spread to the rest of the US economy and the rest of the world. The financial chaos led to the freezing up of the interbank dollar funding market whereby banks could not lend to each other (Noeth and Rajdeep, 2012). The US mortgage market suffered such extensive losses that market participants did not have faith in the others’ creditworthiness. Therefore, the market that provided liquidity to the banks and other financial institutions also became illiquid (Kensil & Margraf, 2012). According to Palma (2009), the most affected were participants in the housing sector with mortgages taking a huge hit. In this regard, lenders to commercial banks were also affected because they had already invested in the real estate industry. According to Palma (2009), the most affected were participants in the housing sector with mortgages taking a huge hit. In this regard, lenders to commercial banks were also affected because they had already invested in the real estate industry.

Critics blamed the Federal Reserve for the catastrophe and called for the curtailment of its autonomy. Limiting its independence would affect its capacity to regulate and supervise national banks and commercial banks as well as protect consumers (Rogoff, 2018, para. 2-3). According to this study, it is evident that more profound challenges were on the regulatory mechanisms and the Federal Reserve was not responsible for the global financial crisis. In this light, the management decisions and investment options at Merrill Lynch led to the liquidity crisis at the institution.

Discussion

Risk Management at Merrill Lynch

Key events that highlighted Merrill Lynch’s financial problems included the failure to auction bonds valued at $850 million and its 2007 $5.5 billion losses on subprime investments (Deventer, 2011). In the same year, Deventer (2011, p. 3) quotes BBC News to show that the losses on subprime investments rose to around 7.8 billion. These losses arose from the writing down on subprime mortgages (Deventer, 2011). According to Deventer (2011), Merrill Lynch not only failed to collect its debts but also achieved little success in selling seized assets. The effect of this was the worsening liquidity at Merrill Lynch.

A key date for Merrill Lynch’s poor credit rating was July 29, 2008. On this date, the investment bank sold “$30.6 billion in CDOs for 22% of par value” (Deventer, 2011, p. 4). In the same year, the Bank of America made public its acquisition of Merrill Lynch with the merger occurring in January of 2009 (Deventer, 2011, p. 5). After the merger, the Bank of America took over the operations of Merrill Lynch including Merill Lynch’s debts.

2008 Financial Crisis and Merrill Lynch’s Risk Management

In the years leading to the credit crunch, financial institutions exhibited a high appetite for risks. As the then biggest mortgage lender, Merrill Lynch embraced riskier decisions. Merrill Lynch wanted to protect itself from competition from other lenders who had embraced practices that encouraged risky lending. Here, some of the risky lending practices included unsecured mortgages extended to lower-income households. Further, the lax regulation of the financial sector acted as an incentive that increased the likelihood of banks to embrace high risk decisions (Crotty, 2009, p. 563). At the same time, financial institutions did not suffer punishment for any losses incurred during investment. For instance, hedge funds and equity investment firms are involved in high risk investments whose losses do not require them to make refunds to investors (Crotty, 2009, p. 564; (Krishnamurthy, Nagel & Orlov, 2014). Investment banks offered large bonuses to their executives and employees thus increasing the probability of the banks in participating in risky investments that yield a lot of returns (Crotty, 2009, p. 564). Here, management was inclined to promote an aggressive approach to risky practices because the bonuses and rewards served as an incentive.

Regarding the credit crisis, investment banks actively engaged in the real estate market by servicing mortgages and acquiring a lot of property. Not wanting to miss out on the profits in the real estate market, investment banks including Merrill Lynch increased their involvement in the issuance of mortgages (Krishnamurthy et al., 2014). However, most of these mortgages were unsecured, and they were sold aggressively even to low-income households. As a result of the vibrant commercial activity of the banks, the housing sector and overall market experienced a high flow of money. The excess money increased inflation and affected the value of properties. Further, inflation affected the capacity of people to meet their financial obligations. Put differently; inflation caused debts to become more expensive. One of the debts that became more expensive was the mortgage facility.

The participation of Merrill Lynch among other investment banks in the real estate and mortgage market led to an increase in the volume and flow of debts in the housing market. At first, there was a great supply for mortgage debts which went hand in hand with an increase in the costs of mortgages. The increase in the value of mortgages led to a situation where Merrill Lynch debtors could not service their mortgages on time. Therefore, the debts remained unpaid because amounts lent in the property market pushed up both the housing prices and personal debt levels (Krishnamurthy et al., 2014). Borrowers had to pay money with increased interest rates to the banks. The debts rose higher than incomes at quicker rates making many people unable to cope with their loans and mortgages. In particular, the increase in the rate of inflation increased the defaulting on unsecured mortgages. Most people stopped paying back their loans causing banks to go bankrupt (Krishnamurthy et al., 2014). It is at this point that Merrill Lynch suffered a liquidity crisis because it could not recoup its mortgage debts. Further, the investment bank’s efforts to auction security did not yield success. The costs of houses continued dropping, banks cut lending further, contributing to a downturn and commencement of recession. After the crisis, banks limited their credit to high-income households.

The banking collapse resulted from a high rate in the subprime mortgage sector because of the low-interest-rate in lending of mortgages. Availability of lax regulation permitted predatory lending prompting the federal government to enact laws to curb anti-predatory practices. The Community Reinvestment Act (CRA) includes a federal law that helped both moderate and low-income earners to acquire mortgage loans, and continue to encourage banks to give mortgages to single families. Many people received a guarantee of mortgages as subprime loans remained bundled and sold out. The US federal government guaranteed mortgages as an incentive to increase homeownership among lower and middle-income households. By assuring mortgages and directing banks to offer unsecured mortgages, the government contributed to risky lending practices. Second, there was securitization whereby many mortgages combined to form new mortgage-backed securities. The bundles sold contained securities of lower risks because of available insurance of default credit swaps. Hence, the securitization of mortgages caused the banking sector to issue more unsecured mortgages.

Approval of mortgages gave rise to many home-buyers and increased the prices of houses. The houses appreciated attracting many homeowners to obtain loans against their homes. The mortgages on single-family residential housing peaked by 2008. The high rates of delinquency caused a devaluation of financial instruments such as bundled loan portfolios, credit default swaps, and derivatives. The value of assets dropped as security buyers in the markets evaporated, making banks face a crisis in liquidity. There was a widespread failure in the regulation of finances and their supervision. Inability to manage risks and inadequacy in transparency among financial institutions led to the 2008 collapse of the banking sector. The 1999 repeal of the Glass-Steagall Act removed the existing separation between depository banks and investment banks in the United States (Korotana, 2012). The credit rating agencies, together with investors, did not price the risk involved with mortgages accurately. Also, the government failed to adjust regulatory practices that address markets in the twenty-first century.

Arguably, the Federal Reserve Bank is responsible for maintaining liquidity and buoyancy of the economy. Thus, it fell within the mandate of the Fed to take remedial policy measures to avert the crisis because the Fed is obliged to foster liquidity in the banking sector. In this case, the Fed did not implement adequate measures to prevent the housing bubble that led to the credit crunch. However, it is important to note that the government’s move to encourage the issuance of mortgages is what fueled the 2008 housing bubble. In particular, the government created an environment that drove banks’ appetite for risk through policy directives that enabled banks to finance unsecured mortgages.

However, the crisis had multiple causes including investment and credit in the European market. The financiers led to a flood of irrational mortgage lending as evidenced by unsecured loans. To enhance financial inclusion, Gilreath (2017) observes that loans were given to borrowers with poor credit histories who struggled to pay them back. The risky mortgages were then passed on to the big banks that consolidated the unsecured mortgages hence turning them into low-risk securities by pooling them together (Gilreath, 2017). The banks including Merrill Lynch used the pooled mortgages to back securities termed as collateralized debt obligations (CDOs) which seemed safer to investors and were recommended by various trusted agencies such as Standard & Poor (The Economist, 2018, para.4). The investors were attracted to the securitized products since they seemed reasonably safe and offered higher returns in a field of low-interest rates. These rates generated an incentive for financiers, hedge funds, and investors to pursue risky assets with high yields. In other words, there was an increase in the risk appetite of credit institutions and investment institutions.

The increase in profit margins increased borrowing habits among investors and encouraged investment banks to increase the volume of mortgages. This was based on the notion that the returns would be more than the cost of borrowing (Gilreath, 2017). The rates appeared stable which made investors confident in buying long-term, high-yield securities (The Economist, 2018, para.5-6). However, the housing market shook, and fragilities in the financial system were exposed. Pooling mortgages and securities no longer protected the investors, and the mortgage-backed securities became worthless (The Economist, 2018, para.7). The whole system was disclosed as built on weak foundations and fraudulent practices whereby some investment banks misreported their balance-sheets leaving them with insufficient capital to absorb the losses associated with the housing bubble.

Research conducted by Hyun Song Shin implicates European banks for voraciously borrowing in the American money market and using the funds to buy questionable securities (Shin, 2012, p. 6). The creation of the Euro led to an unexpected growth of an economic zone within the Euro area and adjacent banking areas. Additionally, Europe was suffering through internal economics and trade imbalances similar to those in America. The southern European economies were plagued with high current-account deficits while Northern Europe had counterbalancing surpluses. The European banks turned to the American market with higher gross capital flows (Shin, 2012, p. 44). Therefore, the Euro crisis had resulted from the weakness of the Europeans Banks that were filled with bad debts from property busts.

Further exacerbating the situation at Merrill Lynch was the government’s reluctance to bail our organizations as well as the Fed’s failure to exercise appropriate oversight on financial institutions. In 2008, the Fed made a step to lower their interest rates to stimulate the economy (Gilreath, 2017). The bank's efforts meant it had to abandon traditional monetary policy practices and respond to the crisis as a financial institution. As a result, it changed the procedure and terms of providing credit to the financial system, and to whom (Gilreath, 2017). It took the role of a direct lender to a broad range of financial institutions in the US which also meant assuming the management of the global credit and liquidity risks of the US ((Gilreath, 2017; Rude, 2010, p. 130). However, this was not enough for Merrill because the lowering of interest rates did not address the bad loans lost in the housing bubble because of the devaluation of homes (Engel & McCoy, 2016). Despite taking on new responsibilities and changing its interaction economically with the US financial system, the global crisis could not be averted because the economic system was already weak. Thus, Merrill was still vulnerable to the financial crisis irrespective of the Federal Reserve’s resolution to salvage the markets.

Leadership and Risk Management

The leadership at Merrill Lynch also contributed to the crisis at the lender. According to Hardy, Ondracek, and Bertsch (2015), the 2002 decision by Merrill Lynch to use risky financial instruments exposed the investment bank to the credit crunch. In a bid to boost short term profits, Merrill Lynch engaged in the derivatives where it offered unregulated financial services (Hardy et al., 2015). One of these was the use of synthetic collateralized debt obligations (CDOs). Quoting Cresci, Hardy et al. (2015) observe that Merrill Lynch’s “business consisted of the most popular cash CDOs that were made up of commercial and residential mortgage-backed securities, including home equity loans and mortgage loans to individuals with questionable credit histories” (31). While this boosted profits, it set Merrill Lynch on a path of making imprudent decisions. One of these decisions was the aggressive collateralization of mortgages (Gilreath, 2017; Hardy et al., 2015). Previously, Merrill as an investment bank used to outsource mortgages by financing or partnering with other commercial banks offering mortgages. However, the profits from CDOs persuaded Merrill Lynch to package the mortgages as CDOs. Packaging them as CDOs was a ploy to avoid outsourcing mortgages as a way of increasing sales and profits.

At the time of rolling out the CDOs, Merrill Lynch had insured them with AIG. However, Merrill Lynch adopted an aggressive marketing approach in its CDOs which caused AIG to worry. Despite the insistence of AIG that the CDOs were risky and highly likely to suffer from defaults, Merrill Lynch increased its investment in CDOs. Alarmed by this high and reckless risk appetite, AIG ceased insuring some of the CDOs. The withdrawal of insurance exposed Merrill Lynch to unsustainable market risks. Therefore, the uninsured CDOs coupled with aggressive spending on CDOs set Merrill Lynch on a path for a liquidity crisis.

Even before rolling out the risky CDOs, O’Neal as the CEO of Merrill Lynch had conducted a staff reorganization that exposed Merrill Lynch to systemic risks. Upon taking over operations at Merrill Lynch, O’Neal overhauled the investment back operations. Quoting Thornton, Hardy et al. (2015) observe that the reorganization of investment operations was designed to position the investment giant as a competitive firm. At the same time, O’Neal embarked on an unpopular staff cutting scheme (Hardy et al., 2015). In this staff reorganization, he not only laid off 10, 000 employees but also arbitrarily fired experienced management in favor of a handpicked team (Hardy et al., 2015). The loss of the experienced management team and employees meant that O’Neal could manipulate his handpicked team to focus on investment options that interested him. O’Neal embarked on an aggressive expansion of Merrill Lynch’s investment portfolio (Hardy et al., 2015). The bulk of the resources were directed at reducing operating costs and maximizing profits in the space of two years. It is this unbridled pursuit of profits that saw Merrill Lynch offer uninsured CDOs and unsecured mortgages in total disregard of professional advice.

Conclusion

Arguably, no event highlights the importance of the robustness of the financial system as the 2008 credit crisis. According to Palma (2009), the most affected actors in the financial crisis were participants in the housing sector with mortgages taking a huge hit. In this respect, the combination of poor risk management and government directives to offer unsecured mortgages increased risk for appetite in the housing sector thus causing the housing bubble. When the banks were unable to recover the unsecured mortgages, the banking sector experienced grave liquidity problems leading to the credit crisis.

Given that the Fed had expressed its worry and cautioned against the subprime mortgages, there is a need for management to seek advice before implementing decisions. The pressure to maximize profits in both recession and normal economic times may cause the management of a firm to engage in risky behaviors. Because of the demand and pressure to post positive records, the management at Merrill Lynch disregarded advice from their insurer AIG who cautioned against their high appetite for high risk. While this comes close to greed, management should make ethical decisions supported by sound financial advice. If Merrill Lynch had acted on AIG’s advice, the bank could have maintained its liquidity and insured its CDOs. In line with this assertion, management should not encourage risky credit behaviors that could affect liquidity. Considered that financial markets may tolerate low margin of profits but not an uncontrolled risk, the management of an organization should not engage in risky behaviors that endanger the earnings and life of firms.

References

Crotty, J. (2009). Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’. Cambridge journal of economics33(4), 563-580.

Deventer, D. R. (2011). Case Studies in Liquidity Risk: Merrill Lynch.

Engel, K. C., & McCoy, P. A. (2016). The Subprime Virus: Reckless Credit, Regulatory Failure, And Next Steps. Oxford University Press.

Gilreath, Z. S. (2017). The Culprit of the Great Recession: A Detailed Explanation of Mortgage-Backed Securities, their Impact on the 2008 Financial Crisis, and the Legal Aftermath. J. Bus. & Tech. L.13, 319.

Hardy, K., Ondracek, J., & Bertsch, A. (2015). Analyzing Leadership Decisions: Stan O'Neal and Merrill Lynch. In Business and Social Science Research Conference. Paris, France.

Kensil, S., & Margraf, K. (2012). The Advantage of Failing First: Bear Stearns v. Lehman Brothers. Journal of Applied Finance22(2), 60-76.

Korotana, M. S. (2012). The Impact of The Repeal Of Glass-Steagall Act Of 1933 in the Context of the Current Financial Crisis. The Journal of World Investment & Trade13(4), 618-644.

Krishnamurthy, A., Nagel, S., & Orlov, D. (2014). Sizing up Repo. The Journal of Finance69(6), 2381-2417.

Labonte, M. (2014). Systemically Important or “Too Big to Fail” Financial Institutions.

Noeth, B., & Sengupta, R. (2012). Global European Banks and The Financial Crisis. Federal Reserve Bank of St. Louis Review94(6), 457-79.

Palma, J. G. (2009). The Revenge of The Market On The Rentiers. Why Neo-Liberal Reports Of The End Of History Turned Out To Be Premature. Cambridge Journal of Economics33(4), 829-869.

Rogoff, K. (2013). Don't Blame The Federal Reserve For Not Predicting The Financial Crisis. The Guardian. Retrieved from https://www.theguardian.com/business/2013/feb/11/federal-reserve-blame-financial-crisis 

Rude, C. (2010). The World Economic Crisis and the Federal Reserve’s Response to It: August 2007-December 2008. Studies in Political Economy85(1), 125-148.

Shin, H. S. (2012). Global Banking Glut and Loan Risk Premium. IMF Economic Review60(2), 155-192.

The Economist. (2013). The Origins of the Financial Crisis: Crash course. The Economist. Retrieved from https://www.economist.com/schools-brief/2013/09/07/crash-course 

Dennis Kariuki is an individual who has built a career in a variety of roles and industries, both in private and public sector.I am constantly in the quest for a challenging, rewarding and learning career opportunity that encourages creativity and decision making in a progressive organization.

I come from a strong mixed practitioner and academic background having worked in various diverse institutions including law firms, Non-Governmental Organisations as well as an academic think-tank.

Specialties: I specialise in policy and legislation and its analysis in research as well as in its practical analysis and application within the context of negotiations with revenue authorities and before tribunals and the judiciary in Africa.

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