With Stan O’Neal out the door, whither the board which supported all of his
decisions? Peter Eavis has a good point today: Merrill
Lynch’s board is arguably just as culpable for the firm’s atrocious results
as the erstwhile CEO was.
For a long time before [its] April meeting, the board should have spotted
that Merrill was becoming overexposed to CDOs. This summer, as the credit
crunch began to bite, Merrill’s exposure to CDOs was $40 billion, up massively
from just over $1 billion 18 months earlier.
That growth should have been an immediate red flag to the audit and finance
committees, because it had the power to severely damage Merrill’s balance
Because CDOs never traded in liquid markets, there was always a danger that
a bank would be stuck with them if it couldn’t find sufficient buyers in a
market downturn. To guard against this risk, a bank would try to avoid ever
having too many CDOs on its books or it would take out insurance against losses
on CDOs with financial instruments called derivatives.
If Merrill’s audit and finance committees judged that the overall net increase
in CDO exposure was not a big risk, they would have been reaching a very unorthodox
conclusion, from a risk management point of view.
To increase CDO exposure from $1 billion to $40 billion in 18 months is insane,
and is prima facie evidence that the board was asleep at the wheel:
$40 billion is more than Merrill’s entire book value. It’s perfectly reasonable
for a bank like Merrill to want to become a leader in CDOs. But becoming a leader
in CDOs means being able to sell the bloody things; in reality, Merrill
seems to have kept a large unhedged chunk of every CDO it underwrote. If it
couldn’t even offload this stuff to hedge funds, it was clearly out of its depth
in the CDO market, and the board had both the ability and the obligation to
force the firm to scale back.