Merrill Lynch: Don't Kill the Cow

About: Merrill Lynch & Co. Inc. (MER)
by: Susan Mangiero, CFA

Free market advocate and famed author Ayn Rand is said to have explained communism with the use of an old Russian tale. It goes like this.

  • In a liberalized environment, Farmer A gets a new cow. Farmer B admires his neighbor's addition and works hard to buy a cow of his own.
  • In a state-run society, Farmer A gets a new cow. Farmer B realizes that he must work to pay taxes to feed Farmer A's cow. With a fixed wealth pie, levies diminish Farmer B's money pot, thereby giving Farmer B an incentive to destroy what he must support. He plots to get rid of Ms. Moo, making Farmer A worse off and arguably costing Farmer B time and money to pursue his wicked ways.

Friction is inevitable when players are encouraged to abide by a "you win, I lose" mentality. Reward silo decision-making and don't be surprised that people behave accordingly.

If the "me generation" characterizes your place of work, look out. Risk management is going to be a tough challenge. Effective enterprise wealth creation requires fluid communication and seamless operations. One hand must know what the other is doing in order to properly identify how various determinants of economic value either offset (hedge) or accelerate loss (leverage, correlation, lack of diversification).

Given its historic, just announced, write-down of $16+ billion, Merrill Lynch is taking the cow tale to heart. When asked by the Wall Street Journal to address "what shocked" the new CEO the most when he took the reins, John Thain replied - "Two things. One was the lack of understanding of the risk in these positions, and the lack of balance-sheet control. The balance sheet really got out of control, and traders were able to put on positions that were way too big, and I don't (think) there was a good understanding of what the risk was." He also added that "Merrill had a risk committee" but that "It just didn't function." (See "Merrill's Risk Manager" by Susane Craig and Randall Smith, January 18, 2008.)

Thain's response? Don't kill the cow. Encourage people to work together. In the same interview, Thain describes a newly mandated weekly meeting with the respective heads of fixed income, equity and risk. The goal is to avoid undue risk-taking that could bring down the house, not just for one group but for everyone - employees, shareholders and so on.

Pension fund managers can learn a few things from the Parable of the Bovine and Merrill's painful progress in managing large losses.

  • Acknowledge the value of working across divisions and job functions. Don't make investment or plan design decisions in a vacuum.
  • Don't empower one or more players to "run away" on their own. Internal controls are imperative. That includes a proper assessment of how external asset managers, custodians, consultants and the like manage their own financial process. If they are exposed to potential trouble spots, so are you.
  • Understand that a buy-in of good risk management practices by you and your peers raises the bar for everyone. Good team players should be rewarded by how the organization fares, not a particular division.

The Cow Theory may not push the Dow Theory off the investment map but it should be heeded nevertheless.