What Was Merrill Lynch Thinking?

According to an October 25, 2007 Wall Street Journal article

(Pioneer Helped Merrill Move Into CDOs - subscription required)

Merrill Lynch underwrote $160 billion of CDOs from 2000 through 2007 year-to-date. Assuming Merrill earned an average underwriting spread of 1.25% on this business, they booked $2.0 billion in underwriting fees over these 7 1/2 years. Those are some pretty good numbers even by investment banking standards. And with investment banking compensation at 45-50% of revenue, you can assume Merrill's CDO desk took home some pretty handsome paychecks over the years.

Now Merrill is taking a nearly $8 billion writedown on CDO inventory that they warehoused and couldn't sell. Some think the number will go even higher in the current quarter ending December. At the moment, it would appear that Merrill's approach to CDO underwriting was driven more by league table bragging rights, quarterly profit targets and perhaps a compensation system that ultimately failed to tax the CDO underwriting group with an appropriate capital charge for the risks they took with the firm's money. Ultimately, Merrill was buying the securities it packaged. This looks less like a failure of risk-management systems than a complete lack of one.

To be fair, the development of CDO's helped provide the abundant liquidity that enabled private-equity firms to buy out companies, which in turn, has helped prop up the equity markets. And Merrill seems to have done quite well in its M&A advisory, brokerage and other underwriting activities. So the CDO underwriting business may have contributed directly and indirectly to Merrill's success in other lines of business, mitigating the pain somewhat. Ironically, Merrill seems to have managed its exposure to leveraged finance commitments remarkably well, making the CDO debacle even more puzzling.

More to come on this one.