Merrill’s Board: Asleep at the Wheel

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.

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