In Peril at Merrill

Like sailors trying to appease the angry god of credit, investment banks have been tossing top executives overboard. Citigroup, the largest bank firm, said on Oct. 1 it would take write-downs of $5.9 billion because of troubled loans. Several days later, Tommy Maheras, the co-head of investment banking, was let go (subscription required). Merrill Lynch, the largest brokerage firm, performed a two-step pratfall. Three weeks after noting it would take a $4.5 billion charge to write down the value of structured financial products like collateralized debt obligations, the firm on Wednesday announced that, after further review, the charges would instead amount to $7.9 billion. Even in today's new Gilded Age, that's real money. And so Osman Semerci and Dale Lattanzio, the two senior executives who ran the fixed-income unit responsible for the problems, were fired.

While the bucks have stopped flowing in at places like Citigroup and Merrill Lynch, the buck seems to have stopped short of the CEO's desk—at least until this week. Today, the positions of Citigroup CEO Chuck Prince and Merrill Lynch CEO Stanley O'Neal seem to be tenuous—in large part because these managers brought in to clean up the post-1990s-bubble mess succumbed too readily to the siren call of this decade's credit bubble.

Prince and O'Neal, both in their mid-50s, came from outside Wall Street and made their bones as managers, not traders. In the 1980s, Prince, a lawyer at Commercial Credit Co., hitched his wagon to Sandy Weill and held on for dear life as Weill transformed Citigroup into the financial equivalent of the Mall of America. Prince was promoted to CEO in 2003 to clean up after the 1990s bender. Among his tasks: settle a raft-load of regulatory issues and rationalize far-flung operations. O'Neal, a child of the segregated South, worked at General Motors and obtained a Harvard MBA before joining Merrill Lynch in the 1980s. After rising through the management ranks, he was named CEO of Merrill Lynch in December 2002, becoming the first African-American to head a major Wall Street brokerage. Among his tasks: settling regulatory issues and rationalizing far-flung operations.

The assumption was that Prince and O'Neal, creatures of the conference room rather than the trading floor, would be effective leaders for a new era of sobriety and careful management of risk. That era lasted for about 12 months. Merrill Lynch, intent on building market share in the hot new area of securitized mortgages, built a massive business in CDOs and other structured financial products. To ensure itself a steady supply of raw material—mortgages to package into debt instruments—Merrill bought subprime lender First Franklin Financial Corp. for $1.3 billion in December 2006, long after the housing market had crested. Citigroup under Prince similarly rushed into the erogenous zone of private-equity lending, even after it was clear things had gone a bit too far. Last summer, Prince famously said: "As long as the music is playing, you've got to get up and dance. We're still dancing."

For Masters of the Universe, these guys proved to be remarkably fatalistic. As long as the market was demanding it, they believed they had no other choice put to keep dancing—to keep making loan commitments and to keep buying up mortgages to package into securities. In both instances, partisans note, getting stuck with a lot of bum inventory is just the price of playing the game. Write-downs happen. Everyone was doing it. Richard Bove, an analyst at Punk, Ziegel, agrees that "horrendous errors" were made by both CEOs, "and they did so because basically they didn't understand risk management." But, like most analysts, he doesn't believe their jobs should be in jeopardy. "I just think both these guys have demonstrated the ability to manage huge companies. There aren't a whole bunch of people running around who can manage a company of that size." (Wall Street CEOs benefit from something akin to a blue wall of silence. Analysts who work at investment banks are generally reluctant to ask for the scalps of CEOs of other investment banks.)

But, of course, not everybody was doing it. Goldman Sachs and J.P. Morgan Chase thus far have managed to emerge from the crisis with comparatively minor nicks. And besides, CEOs get paid not simply to ride the wave but to make tough calls—to decide which loans not to make, which companies not to buy. (O'Neal's total compensation in 2006 was $48 million, and Prince's was about $26 million.) They're supposed to control the brake and the clutch, rather than simply step on the gas. And as they continually tell shareholders, they're supposed to focus on long-term performance and not simply hustle to meet expectations for quarterly results. On this count, both O'Neal and the executive formerly known as Prince are struggling. Battered by the write-downs, Merrill's stock this morning sat almost exactly where it was in November 2003. Citigroup's stands at about where it was in June 2003.

Today, Merrill's stock rallied on CNBC's reporting that O'Neal may be gone from Merrill as soon as this weekend. And as the credit bubble unwinds, shareholders and boards of directors at some of America's largest financial institutions are looking for a new sober-minded executive to clean up the mess. As analysts like to note, Wall Street is a cyclical business.

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