Merrill Lynch Chief Investment Office

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June 10, 1990




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As their limousines streamed toward Arizona’s CamelbacK Mountain on a Friday in February, en route to Merrill Lynch & Company’s junk bond conference, few of the 800 guests could have missed the various ironies surrounding the event. For one thing, there was the conspicuously lavish site of the conference, a 130-acre spread called the Phoenician Resort; it seemed strikingly at odds with an announcement just 12 days earlier that Merrill had taken a $470 million writedown during the fourth quarter of 1989. Then there was the curious fact that this flashy celebration of junk bonds was taking place just as the red-hot market for the high-yield securities was flaming out. And finally, there was a sense of deja vu, as Merrill’s C.E.O., William A. Schreyer, announced, ”We aim to become No. 1 in the high-yield market.” Not many months before, he had shut down businesses in New York and London for which he had once proclaimed a similiar goal.

For The Thundering Herd, it is not the best of times. Merrill lost money in 1989, the first such blot on its 105-year ledger. Since 1987, special charges, writedowns and one-time losses have totaled more than $1 billion, nearly a third of the firm’s current net worth. The public perception of the company is reflected in its stock price, which as of a month ago was trading at about $21 a 42 percent drop from its 52-week high of $36. Some indication of the industry’s attitude can be found in the decision by Moody’s Investors Service to downgrade Merrill’s long-term debt ratings and in the comments about top management by analysts like Lawrence W. Eckenfelder, of Prudential-Bache Securities: ”We know they’ve not been successful with this firm. The question is, do they have what it takes to turn it around?”

Merrill is far from being alone in its problems. Wall Street has been battered by the end of the seven-year bull market and the dramatic slow-down in investment banking. Kidder, Peabody & Company and Prudential-Bache joined Merrill in the red last year. Shearson Lehman Hutton, Merrill’s chief rival, announced a first quarter loss of $915 million. Drexel Burnham Lambert, whose junk-bond conferences could have been a model for Merrill’s extravaganza in Arizona, is bankrupt. As Schreyer suggests, his company has done well to emerge from the 80’s with its independence and its integrity intact. In Merrill’s 32d-floor executive offices at New York’s World Financial Center, ”We’re a survivor” is a frequent refrain.

Schreyer has battened down the hatches. With the end of his tenure approaching – he will be 65 in 1993 – he has taken to proclaiming that profitability should take precedence over market share. A tough cost-restructuring campaign – Schreyer calls it ”Merristroika” – has helped the firm to an 11 percent increase in first-quarter earnings over a year earlier. Strategies are in place for all of the dozens of pieces of this huge enterprise, whose 10,050 brokers and 700 investment bankers are No. 1 in so many segments of the industry, from selling stocks to underwriting. Beginning in 1991 or 1992, Schreyer says, ”we’ll have a return on equity of 15 percent, minimum; in better years, I can see 20 percent. It all boils down to execution, to people, to getting the results.” And yet . . . .

And yet the record of the six years since Bill Schreyer became chief executive is so uneven and so puzzling that many Wall Street analysts and industry leaders remain unconvinced that Merrill can achieve such results. During that time the stock market raged, the bond market surged, debt issuance exploded, corporate mergers soared – and Merrill’s revenues ballooned, from $5.7 billion in 1983 to $11.3 billion last year. But profits languished. As measured by several analysts, Merrill’s return on average equity between 1985 and 1989 lagged substantially behind its peers.

During those years, Merrill suffered through some remarkable blunders. Unanticipated expenses involving the firm’s new headquarters at the World Financial Center accounted for about $110 million of the $470 million writedown. Merrill lost $377 million while trading mortgage-backed securities. A grandly ambitious effort to establish an international presence proved costly. Veterans of the London campaign estimate that during 1987 and 1988, alone, Merrill’s operation there lost an estimated $100 million; the company’s estimate is $30 to $40 million.

What is Merrill’s problem? In conversations with dozens of present and former employees, the same answers emerged again and again. They pointed to Schreyer’s insistence that Merrill be the biggest factor in all of its markets – a go-for-broke mentality that tends to overwhelm cost controls and profits. They also talked of a hierarchy of like-minded executives who look out for each other, with the result that key assignments too often go to unqualified people. (”Merrill is like an orchestra made up of the best violinist, the best cellist, the best on every instrument,” says a former senior executive. ”You’ve got to make them play together. Merrill’s way is to get somebody who has never conducted before – or someone who’s tone deaf.”) Under Schreyer, Merrill has split its securities business into two sectors. Consumer Markets encompasses the brokerage business – where Merrill has for generations been the nation’s leader – and a host of financial products for the consumer, including cash management accounts, mutual funds and insurance. Capital Markets, a more recent Merrill business, covers a broad range of investment banking activities. But the company is run primarily by men whose ideas and attitudes toward business have been shaped by decades as brokers, thereby frustrating some of the bankers. Asked to explain why Schreyer and President Daniel P. Tully have not produced better bottom-line results, a former international banker at Merrill responds, ”The simple reasons are 1, 2, 3 – they don’t understand the business. They’re stock brokers.” Says Dean Eberling, an analyst at Shearson, ”Management has a way to go.”

Still, Bill Schreyer was all confidence as he faced some of his more vocal critics last April at the annual shareholders’ meeting. The setting was the sprawling headquarters and training center of the Consumer Markets sector in Plainsboro, N.J. Schreyer often works out of a wood-paneled office here, not far from his home in Princeton.

Balding, round-faced, a bit pudgy, Schreyer stood in the pit of the amphitheater, a pair of half-glasses perched on his nose. He had the master salesman’s engaging grin and gregarious, folksy manner, and he worked hard to win over his audience. At one point, a particularly pugnacious stockholder asked the chairman about a $160 million writedown of Merrill’s high-yield bond portfolio: ”The junk bond markets – shouldn’t you take a hard-nosed attitude toward these? Unless you like living where Mike Milken’s going to be living, which, judging from the country club surroundings here, I’d say you wouldn’t.”

Schreyer, deadpan, responded, ”I think you’re quite right about that,” stirring laughter throughout the auditorium. Then he went on to present a serious answer. It included his rationale for pursuing the junk bond market – the expectation that the high-yield instruments would eventually play an important role in the restructuring, the so-called ”re-equification,” of companies burdened with massive debt.

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”There is junk and there is garbage,” Schreyer said. ”The idea is to avoid the garbage. Our challenge is to work with companies to re-equify and rebuild.” And then he spoke the rallying cry that has echoed all through his reign at Merrill: ”We want to be the leader.”

Thomas H. Patrick stands framed in the 12-foot-tall window of his office in the World Financial Center. Last year, Schreyer called Patrick in from Merrill’s Chicago office to become the firm’s chief financial officer. On this day in March, the 46-year-old, barrel-chested C.F.O. is talking about his company’s struggle for profits: ”It’s a simple story – you’re standing in it. If we had stayed in the same building, we would be making more money than anybody on Wall Street.”

In 1984, Merrill’s New York-based operations were feeling growing pains. The staff worked in 11 offices scattered around lower Manhattan. The headquarters building at One Liberty Plaza was overcrowded, especially on the trading floor. ”We literally could not route another cable to the trading floor,” recalls Herbert M. Allison Jr., executive vice president for administration. What’s more, there were projections that the firm’s Manhattan head count would be increasing by 13 percent a year. But beyond such practical considerations, a senior Merrill executive says, the company longed for ”a focal point for a new global firm that has come of age. Those are hard things to get a bookkeeping hand on, but they are Schreyerlike concerns.”

A key figure in the search for a new home was Charles M. Manzella, a former branch manager with no background in commercial real estate, and he ended up talking with Olympia & York. The big Toronto-based developer was planning to construct an office complex of four towers in lower Manhattan to be called the World Financial Center. In August 1984, Merrill signed a 25-year lease on two of the towers, also receiving an option to buy a 49 percent equity interest in each. The rent would be $28.56 per square foot for the first 15 years and $40 per square foot for the next 10 years. The firm also agreed to sell One Liberty Plaza, which it had bought for about $100 million, to Olympia & York for some $375 million. In addition, Olympia & York agreed to take over a number of Merrill’s lease commitments at other locations. The sale of One Liberty enabled Merrill to book a pretax gain of $127 million. Without it, the firm would have had an operating loss of $57 million for the year.

Before the deal could be completed, Merrill’s board of directors had to approve. According to a Merrill spokesman, the board received an estimate of $30 to $40 per square foot for ”fit-out” costs. These expenses included some of the basics: heating, ventilation and electrical systems as well as studs, walls and ceilings. The board approved the plan.

In 1985, an outside firm gave Merrill very different projections of the fit-out costs. The figure for the North Tower, where Merrill’s three deluxe trading floors are housed, was approximately $200 a square foot. Finishing the South Tower, it was estimated, would cost $137 a square foot. All told, by mid-1985, the fit-out of the two towers looked as though it might cost the firm more than $600 million. According to a Merrill spokesman, these projections included expenses that are not normally counted as fit-out.

In September of that year, an ad hoc group of Merrill executives, including some from the real estate finance department, made a presentation to the executive committee of the board. They proposed that Merrill could save money by simultaneously selling the South Tower lease back to Olympia & York and buying back and renovating One Liberty Plaza. An executive vice president responsible for facilities planning issued a memo authorizing new negotiations with Olympia & York, according to executives who received the document, but the idea died. A Merrill spokesman denies that new negotiations were authorized.

In 1986, Merrill had a change of heart and started looking for a tenant to sublet more than 1 million square feet, about half, of the unfinished South Tower. The area, scheduled to house back-office workers, had been judged too expensive. The search for a tenant did not end until September 1987, just as Merrill executives were moving into the North Tower. Olympia & York sublet 600,000 square feet of the space for 25 years and bought Merrill’s option on the 49 percent equity interest. The sale enabled Merrill to book a pretax $120.2 million gain for 1987, which came in handy. It offset nearly a third of a $377 million trading loss earlier in the year. But under the sublease, Merrill would have to continue leasing locations in Manhattan, including space in One Liberty Plaza – now owned by Olympia & York.

Merrill is still trying to sublet 420,000 square feet of the South Tower in a dismal market. Some $220 million of Merrill’s $470 million writedown last year was related to excess office space, most of it in lower Manhattan and overseas. About half of that is specifically tied to those nine floors still unrented. In addition, the managerial misjudgments involving the World Financial Center have steadily punished Merrill’s bottom line. Occupancy and depreciation costs for the firm as a whole have soared over the last five years from $325.8 million to $774.8 million.

In 1936, when Schreyer was 8 years old, his father, also named William, became manager of the Williamsport, Pa., office of one of Merrill’s predecessor firms. Eventually, the father’s 16-year career at Merrill enabled him to repay family debts accumulated during the Depression; the last debt was discharged just before his death of a heart attack at the age of 53. A deep affection tinges Schreyer’s voice as he remembers his father: ”I could talk about him for hours.” He commissioned a painting of his father that hangs in his New Jersey office; when Schreyer posed for a photograph for this article, he wore a brown suit to match the suit his father wears in the portrait.

For both generations of Schreyers, Merrill has been much more than a meal ticket. ”There was Mommy and Daddy and Merrill,” says Charles D. Peebler Jr., chief executive officer of Merrill’s advertising agency, Bozell, and a longtime friend. ”I don’t know what Bill Schreyer is without Merrill.”

While still in high school, Schreyer sometimes helped out in his father’s office – and wrote his senior class theme about the New York Stock Exchange. He graduated from Pennsylvania State University, with a B.A. in business administration, and joined Merrill in 1948 at the age of 20.

The firm was still fresh from the blueprint that Charles E. Merrill and Winthrop H. Smith had drawn up eight years earlier when they merged Merrill Lynch & Company with E. A. Pierce & Company. Chief among their goals was to establish a reputation for scrupulous honesty. Nothing less, they felt, would gain the confidence of Main Street investors in the wake of the 1929 stock market crash and the Depression.

The firm’s business guidelines, dubbed ”The Ten Commandments,” led off with: ”The interests of our customers MUST come first.” And that included all customers, big and small. Schreyer remembers having the commandments drilled into his head, and today’s recruits are still expected to learn them. Bill Schreyer was ready for the discipline, ready to be part of the team. Merrill was the kind of place with which bright, hard-working young men were proud to identify. Says Schreyer: ”If you took a group of I.B.M. salesmen and Merrill Lynch brokers and mixed them up, you couldn’t tell one from the other. Their principles were so similiar. When people came with Merrill Lynch in those days, they never thought about going anywhere else.”

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While Schreyer worked his way up through the branch system, Donald T. Regan, with Harvard and the Marine Corps behind him, was ascending Merrill’s management ranks. He became C.E.O. in 1971, in time to prepare Merrill for the consequences of May Day, 1975, when the Government abolished fixed commissions on stock sales, sparking cut-throat competition in the brokerage business. The changes wrought by the iron-willed chairman are still felt at Merrill and through the industry.

Regan fathered the Cash Management Account, or C.M.A., which combined the characteristics of a debit card, money market checking account and brokerage account. He also led Merrill on its first major diversification drive. He envisioned the company as a ”three-legged stool” supported by businesses in the securities, insurance and real estate industries. Merrill would offer customers one-stop shopping for all their financial needs, and relieve the company’s dependence on the cyclical brokerage business. To establish the investment banking division, Regan tapped Schreyer, who had run the Government securities business and the New York branches, a very visible post. The division, later to be Capital Markets, encompassed underwriting, mergers and acquisition services and institutional sales, trading and research; it did not achieve critical mass until 1978 when Merrill acquired the old-line investment banking firm of White, Weld & Company.

Still, retail commissions continued to provide the lion’s share of Merrill’s revenues, and the brokers’ expansive outlook prevailed: As long as the commissions kept rolling in, financial controls could take a back seat.

A few months ago, in the chairman’s private dining room, which has a flawless view of the Statue of Liberty, Daniel P. Tully, Merrill’s president, and Schreyer shared a hearty laugh, as they recalled what it was like in the old days.

Tully, a 58-year-old salesman’s salesman, tall and amiable, sets the scene: the managers of Merrill’s business units sitting around the boardroom table. ”The question would be, ‘Well, Bill, how’s your business doing?’ And Bill would say, ‘Great, we’re going to make $10 million.’ And then the next guy would say his business was doing great, too; it was going to make $12 million. Well, guess what? By the time we finished going around the table the numbers weren’t anywhere near what the firm was actually making.”

In 1981, Roger E. Birk, who had come up through the operations side of the business, succeeded Regan, who became Secretary of the Treasury. Schreyer was named C.E.O. three years later. By that time, the costs of Merrill’s expansion into real estate, capital markets and insurance had mounted dramatically.

Don Regan had eased Merrill’s brokers into the brave new world of financial services; Bill Schreyer accelerated the process. The time had passed when a broker could spend his day simply dispensing market wisdom (mostly provided by his research department) and booking buy-and-sell orders. Brokers were to be known as ”financial consultants,” and they were expected to learn how to sell the new products, including life insurance and mutual funds, into which Schreyer was pouring Merrill’s money.

Like the Cash Management Account, these products were intended to lure the customer into putting all his money under Merrill’s care, enabling the brokerage to obtain a steady stream of fees. Individually, the fees were small, compared to the commissions a bull market could generate, but discount brokers had cut commission margins to the bone. And when a firm has $334 billion of its customers’ money under its roof – nearly double that of its nearest competitor – the fees add up.

The old-fashioned customer’s man had trouble adapting to the asset-management strategy, and Merrill is still developing approaches to cope with this problem. The selling skills and knowledge a broker needs in daily contact with customers are very different from those called on to book a single order for a life insurance policy or to persuade a customer to set up a trust. ”I think it’s very difficult to be good at all these areas at once,” says Ronald E. Vioni, a veteran Merrill broker. The company has adjusted its hiring and training policies to develop a cadre of new-look brokers, and has dispatched 200 so-called ”specialists” to the branches to help sell the non-securities products.

Today, with the investment banking business in the doldrums, Schreyer and Tully are counting on Consumer Markets chieftain John L. (”Launny”) Steffens to help them make good on their profitability promises. Steffens, a 48-year-old Dartmouth grad, has spent 27 years at Merrill. An excitable leader, he has more than once had heated disagreements with Merrill investment bankers over how his people will distribute products crafted by Capital Markets. And he flushes at the suggestion that Merrill’s retail sector has not been as profitable as its investment banking sector in recent years. ”Our return on equity is very good, and would compare quite favorably to Capital Markets,” he says.

Merrill’s investment bankers tend to be skeptical. ”Even if we have a home-run year,” one says, ”if the brokerage business continues to lose money, we can’t make any money.” But many analysts believe the retail side of Merrill was very profitable last year. Commission revenue was $1.8 billion, below its peak of $2.4 billion in 1987. From 1987 to 1989, asset management and custodial fees, the hope of the future, grew 22 percent to $598 million.

Merrill’s target customer has at least $50,000 in household income. By the year 2000, with the baby boomers at their top earning capacity, the number of households above the $50,000 level is expected to double, as is the total of their assets. Something to shoot for, but will the asset-management strategy carry Merrill to its profit goals? Shearson’s Dean Eberling, among other analysts, has his doubts. ”Retail will produce earnings,” he says, ”but it won’t, on a sustainable basis, push them into the return they want.”

One afternoon in 1979, while Donald Regan still held sway at Merrill, Bill Schreyer shared a Manhattan taxicab ride uptown with John C. Whitehead, then co-chairman of the management committee of Goldman, Sachs & Company, a powerhouse of investment banking. At one point, Schreyer recalls, Whitehead observed that Merrill was ”coming along” with its fledgling investment banking activities. Then the Goldman executive asked, ”Why don’t you just be satisfied with being the largest co-manager of securities offerings?” That would have meant having the Merrill name forever in the place of an also-ran on the tombstones, the newspaper ads that bankers place to trumpet their underwriting coups. As Schreyer recalls, ”I said, ‘First of all, that wouldn’t be any fun. Second, that’s not what we want to be.’ ”

What Schreyer and Merrill wanted to be was No. 1. In the brokerage business, that argument had much to recommend it: larger volume generates more commission income. But the investment banking business was different. The richest margins went to firms that had long-standing relationships with the nation’s major corporations. How could the giant broker break into the club?

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Merrill’s answer: sheer financial muscle. ”It has always been that profitability follows market share,” says Tully. ”We did not have the school ties; we did not have 200 years of experience. We therefore had to show municipalities and governments and institutions around the world that we were a factor.”

From a standing start in 1976, Merrill has bolted to the top of the debt and stock underwriting tables, winning first place in 8 of the 11 underwriting categories tracked by IDD Information Services in 1988. It has been the No. 1 underwriter of all securities, worldwide, for two years in a row.

Underwriting is the traditional bread-and-butter of investment banking, and Merrill, with its massive distribution system, has an advantage. But competition has trimmed underwriting profits over the years, and the immediate prospects for richer margins are limited. When the volume of all stocks and bonds underwritten last year fell by 15 percent, fee revenues declined 21 percent.

Capital Markets also fought for a piece of what is potentially the most profitable corner of investment banking, mergers and acquisitions. Corporations traditionally give such plum advisory assignments to their longtime banking friends. But in the takeover frenzy of the past decade, many companies were willing to join hands with any trustworthy stranger who could rescue them – Merrill Lynch, for example.

The company became a pioneer in 1980’s-style merchant banking, putting up its own capital to facilitate takeovers. These temporary ”bridge loans” would eventually be replaced with junk bonds and other debt, also provided by Merrill. Sometimes the firm made equity investments as well. Merrill’s huge capital base provided a potent competitive weapon. Merrill became a player in some of the largest and most lucrative leveraged buyouts, from the $4.23 billionBorg-Warner deal to the $25 billion RJR Nabisco bonanza. Investment banking revenues soared from $720 million in 1985 to $1.1 billion last year.

The firm’s strongest relationships are with financial engineers and buyout groups, such as Kohlberg, Kravis, Roberts & Company. Unhappily for Merrill, their activities have markedly dwindled of late. What Capital Markets still lacks are the close ties to many C.E.O.’s of major corporations. ”The only reason we got any M. & A. business is because we bought it with our capital,” says a Merrill banker.

Investment banking managers are generally accustomed to conducting their businesses without much oversight. ”Your average senior banker doesn’t know what expenses look like,” says a former Merrill banker. ”He knows what revenues look like. Bonuses are based on revenues.” But if Schreyer’s profit goals are to be achieved, the bankers will have to learn new habits.

In 1987, a lapse in managerial control in the trading of mortgage-backed securities left Merrill with a $377 million loss, an event Schreyer once referred to as ”my Chernobyl.” As Daniel Tully explains it, Howard A. Rubin, a senior trader whom Merrill had lured away from Salomon by tripling his salary, took a risky position with an exotic derivative of a mortgage-backed security. The firm knew about the position, says Tully, and deemed it ”tolerable.” Then Rubin increased his bet, according to Tully, but failed to disclose the new position immediately.

When Rubin’s action was learned, traders and salesmen started trying to unwind the firm’s position discreetly by selling the securities to customers. But very quickly, a group of executives led by Jerry Kenney, head of the Capital Markets group, and Tully, took control of the situation. First they tried to hedge the firm’s position, with little success. Then they began canvassing other dealers in the securities for possible buyers. Kenney called Alan C. Greenberg, the chairman of Bear Stearns & Company, who agreed to buy a big chunk at a bargain-basement price. Kenney says the price was ”fair.”

Merrill dismissed Rubin; Bear, Stearns hired him. Last March, the Securities and Exchange Commission suspended Rubin from working on Wall Street for 9 months. When asked about its $377 million loss, Merrill blames most of it on Rubin. On the other hand, Martin A. Kuperberg, associate regional manager of the S.E.C.’s New York office, says, ”It’s our opinion that Merrill’s loss related to the unauthorized trading was $85 million.”

Merrill’s push for market share extended abroad as well. Along with dozens of American investment bankers, Merrill wanted to be on hand in force for Big Bang – the deregulation of London’s financial markets in October 1986. But few spent so grandly as Merrill. And when the invaders began to suffer – because they were unfamiliar with the operations of the local markets and because of the intense competition – few hurt more than Merrill.

Merrill has now withdrawn completely from the European commercial paper and gilts markets, and cut its trading in European equities. In addition, the company has been consolidating its facilities in London and Zurich.

And the London office has a new strategy. It is focusing on debt and equity underwriting and advisory work, particularly on so-called cross-border transactions – mergers and acquisitions, for example, that involve companies in different countries. Merrill wants to be ready for the economic integration of Europe in 1992.

During the six years since Bill Schreyer took over the reins, he has repeatedly talked of his determination to control costs. Yet total expenses, 92.3 percent of net revenues in 1985, actually increased to 94.6 percent for 1989 – and that figure does not allow for the special $470 million charge. Still, there are signs that Merrill is in fact taking a harder line on costs. One of those signs was the arrival last year of Tom Patrick as C.F.O. Patrick jokes that he was a noisy in-house critic for so long that Schreyer finally invited him to come to New York to try his hand at fixing Merrill’s problems. He is thought to be an important force behind Schreyer’s decision to focus on profitability.

Schreyer’s Merristroika restructuring is basically a hard-nosed review of each business unit and its budget. The units are placed in one of three categories: ”special situations,” which need to be nurtured; ”core businesses” and ”burden of proof” businesses with poor returns. Merrill says that it can now confidently calculate each unit’s return on equity. Says Tully, ”It gives us the ability to manage other than by the seat of our pants and gut reaction.”

Merrill has sold off a portion of Broadcort Capital Corporation, a securities clearance operation, thus trimming 300 employees from Merrill’s books. Its Canadian brokerage operation, with 800 people, has also been sold. In fact, since 1987 Merrill has reduced its head count by 8,000.

Schreyer’s focus on profitability, and his decision to subject his company to a $470 million writedown, are signs that Merrill may be changing. What remains to be seen is whether a man so shaped by the old culture can fully embrace the rigors of the new.

Last March, looking to the years ahead, Schreyer told of meeting an East bloc official. The visitor asked how one of his nation’s companies might get listed on the New York Stock Exchange. The prospect of yet another world for Merrill to conquer brought a delighted grin to Schreyer’s face as he told the story. Around the world, he still expects Merrill to be No. 1: ”I think the biggest problem for my successors – and I’m going to enjoy reading about it – will be an antitrust problem.”

Merrill Lynch Chief Investment Office


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