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Merrill Lynch and the Subprime Debacle: Five Mistakes or None or One? Merrill Lynch will have to write off 7.9 billion dollars because of losses in the subprime market. According to the New York Times, when asked how Merrill could lose so much money, E. Stanley O'Neal, Merrill Lynch's Chief Executive, said, "We made a mistake." Mr. O'Neal is probably using language loosely here. He may have made four or five or more mistakes. He may have made none. Oddly, I hope he didn't make a single mistake, which might well be the worst situation of all. I am not privy to the inner workings of Merrill, so, I do not know how deep the rot goes. But if newspaper accounts can be trusted, it goes deep.
First, Merrill misjudged the direction of the subprime market. In itself, this is nothing to be ashamed of. Misjudging the direction of a market is roughly equivalent to losing a trade. Happens to all of us all of the time.
Second, if the reports I have read about Merrill can be trusted, Merrill did not have a stop loss in place. Merrill has a risk management department, of course, but I have seen no mention of a business rule that says that when cumulative losses reach a certain point, the business line must be closed. It does not follow that because something is not mentioned in print or on the web it does not exist, of course. On the other hand, in my experience, upper management wants to keep their hands on this kind of decision, not relegate it to rules. Not having a stop loss, if, indeed, they did not have a stop loss, is a beginner's mistake.
Third, Merrill eventually discovered it was losing and found there was no one to sell to. This usually means that given the logic of an investor's approach, his position is too large for the market. This is not a beginner's mistake, but it is not a mistake an intermediate trader would make either.
Fourth, Merrill eventually found that its losses were considerably larger than it expected, larger than it could stomach. This usually means that the investor took too large a position. Position sizing is a difficult, technical area. Merrill clearly made mistakes here, but from the outside it is hard to tell if the mistakes were reasonable or criminally stupid.
Depending on how you read the available evidence, Merrill might have made five mistakes or one or none. It is possible, of course, that Merrill had all of the right risk control systems in place and a one in a billion event caused their loss. Possible, but I don't believe it. Paul Krugman and others saw this debacle coming years ago, when the market was still strong enough for Merrill to unload all of its positions. Not only did Mr. Krugman make the right call, he made the call for the right reasons.
Thirty years ago, the kind of knowledge necessary to avoid the mistakes above would have cost you two or three years of your life and at least one fortune. These days, you can learn this by trading on a small scale for a year or two and then studying the literature, especially my books and articles on the subject. But Merrill had experienced traders, not to mention a risk management department. If Merrill didn't put all of the necessary systems in place, then management was incompetent in one way or another. That incompetence, whatever its form, would be a fifth mistake.
But it is possible that Merrill made only one real mistake. Taking a risk that can kill you sometimes makes sense. Suppose you had a heart disease that you knew would kill you within the week. Suppose your doctor gave you a pill and said that it had a 1% chance of killing you immediately and a 99% chance of curing you immediately. What would you do? Personally, I'd take the pill. Merrill's management may have thought they could make a lot of money from the subprime market and that there was only a small chance of a large loss. Nothing wrong with making that decision, as long as you disclose that is the decision you are making to your investors. I have no evidence that that is the decision Merrill made. Nevertheless, some of the statements management made had that flavor. Stanley O'Neal told investors in 2005 that the brokerage firm would become more aggressive investing its own money. However, that strategy would "not in any material way add to the risk profile of our firm." I wasn't there when Mr. O'Neal said such things. I am depending on the New York Times, a dependable, but not infallible source of information. But if I were a Merrill investor and he really said such things, given the way things have worked out, I would want his head on a pike.
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"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.