From the December 2007 issue of Research Magazine • Subscribe!

December 1, 2007

Subprime Mortgage Crisis 2, Financial-Service CEOs 0

Merrill Lynch says it hired former NYSE Euronext CEO John Thain on November 14 to replace the brokerage firm's ex-CEO and chairman, Stan O'Neal, who "retired" on October 30. O'Neal's departure came six days after the firm announced a write-down of some $8 billion due to its mortgage-related holdings. That amount represents about one-eighth of Merrill's total value at the end of the third quarter.

"John will be adept at balancing the focus on risk management and controls while taking the steps necessary to ensure the company evolves and grows," says Alberto Cribiore, Merrill Lynch's interim non-executive chairman and chairman of the company's search committee. "He understands both the company's challenges, and as his track record shows, he appreciates the value associated with the Merrill global brand. We are delighted to welcome him aboard."

Thain, whose hiring was announced November 14, is set to begin work at Merrill on December 1. He joined the NYSE in January 2004, after serving as president and chief operating officer of Goldman Sachs Group since July 2003 and president and co-chief operating officer from May 1999 through June 2003. From 1994 to 1999, he occupied several different posts with Goldman.

Reports had circulated in early November that BlackRock CEO Larry Fink was being considered for the top post at Merrill.

"This is a big plus for the company, since Mr. Thain appears to have the necessary characteristics to solve the company's key problem, which is the risk-management business," says Richard Bove of Punk, Ziegel & Company in a note.

Bove adds, though, that Thain has a reputation of being "a cerebral and austere manager, similar to Mr. O'Neal. "This style of management does not work at Merrill as Mr. O'Neal discovered. This company is still, first and foremost, a retail sales organization with 16,000 sales people."

Merrill's mortgage-related write-down surpasses what the company had predicted, though it was "partially offset" by the results of global wealth management, or GWM, and other units, the company says. For the third quarter, the company had a pre-tax loss of $3.5 billion.

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The situation regarding Stanley O'Neal and Merrill unraveled fairly quickly in late October, while Citigroup's break with Charles Prince -- who retired from his post as chairman and CEO in early November -- had been brewing for some time. "Prince's head had been called for during the past few years, while O'Neal was quite a poster child who appears to have made some big errors here at the end," explains Chip Roame, head of Tiburon Strategic Advisors, a Tiburon, Calif.-based financial-consulting firm.

Merrill Lynch Chairman and CEO O'Neal "retired" on October 30, about one week after the firm announced a write-down of some $8 billion due to its mortgage-related holdings; that amount represents about one-eighth of Merrill's total value at the end of the third quarter. And at press time in early November, CNBC reports that Merrill Lynch has asked Lawrence Fink, the CEO of BlackRock, to replace O'Neal. Merrill owns 49 percent of BlackRock, which manages $1.3 trillion in client assets

Meanwhile, at Citigroup, former U.S. Treasury Secretary Robert E. Rubin, who now chairs the company's executive committee and sits on the board of directors, will serve as its chairman. Sir Win Bischoff, chairman of Citi Europe and a member of several Citi committees, will be acting CEO. "It may take months, however, before a new executive is found to fill the post," explains Richard Bove, an equity analyst specializing in financial institutions with Punk, Ziegel & Company in Lutz, Fla.

The short list of candidates, says Bove, include NYSE Euronext CEO John Thain; Jamie Dixon of J.P.Morgan Chase; Victor Menezes, ex-vice chairman of Citigroup; Dick Kovacevich of Wells Fargo; Bob Druskin, Citi's COO; Gary Crittenden, Citi's CFO; Vikram Pandit, head of investments at Citi; and others. "We intend to complete our search for a new CEO as expeditiously as possible," says Rubin, "reviewing qualified CEO candidates from outside as well as within our organization.

Recently Citigroup told investors about significant declines in the fair value of the some $55 billion in U.S. sub-prime related direct exposures in its securities and banking business. It estimates that this exposure should result in about $8 billion to $11 billion in decreased revenues and a decline of roughly $5 billion to $7 billion in net income on an after-tax basis.

"I am convinced that there will be smaller but consistent write downs of these portfolios for the next 12 to 24 months," says Bove. And Citi will not be alone in this regard. "Moreover, other financial firms will announce similar hits to earnings," he concludes.

Prince, 57, became chief executive of Citigroup in October 2003. Many shareholders criticized him openly during his tenure, as Citigroup's stock lagged that of its peers. Its stock closed at $37.73 on Nov. 2, about 20 percent below where they were when Prince became CEO.

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Merrill's write-down of about $8 billion surpasses the $4.5 billion figure the company had announced a few weeks earlier. For the third quarter, the company had a pre-tax loss of $3.5 billion.

On October 26 reports circulated that O'Neal had been talking with Wachovia about a possible deal, which may have included the idea of a merger or takeover. This may have played a role in the board's discussions about and with O'Neal about leaving, though the issue could have become "overblown," experts say.

"I was surprised at the slowness in grasping the magnitude of the response on the part of management [at Merrill]," says Roame, who doesn't believe the Wachovia issue was critical in O'Neal's departure. "The size of the problem [i.e., the loss] roughly was nearly double what was predicted," and that was quite a shock to the board.

"Second, I was surprised at the rashness of what appears to be a 'firing.' [O'Neal] was the poster boy a couple years ago," says Roame. "He may have made one mistake, but he did a lot of good things."

O'Neal reportedly will receive a severance package worth about $160 million. "This is an enormous amount of money," shares Roame. And it points to the mixed messages that O'Neal's exit represents. "If you think someone did such a horrible job, then you don't give 'big bucks' to them on the way out the door."

The former CEO led efforts to reduce the cost of running the business at Merrill by $6 billion, re-orient the firm, improve earnings and produce $7.5 billion in net profits in 2006, shares Bove. O'Neal became chief executive officer in December 2002 after joining the company 21 years ago.

"This was not a bad job," Bove says. "The firm is stronger today than it was when he took over ..." Still, O'Neal failed to institute the proper controls over some market activities and never developed the constituency necessary to maintain power, while firing some 26,000 people, adds Bove.

Along with Fink, there was some discussion about a Merrill insider replacing O'Neal: Bob McCann, head of the brokerage operations, or Merrill Co-President Gregory Fleming.

Historically, Merrill has promoted brokers and those in the brokerage-focused business to lead the firm until recently, Roame points out. "So anyone who hasn't come up through this channel is going to be seen 'as not one of us, not from our team.' " O'Neal's managerial style may have made it hard for advisors to relate to, since it was "top down rather than more walking around, getting to know you," he adds.

"Private client is 35 percent of the revenues of Merrill Lynch," McCann told Research in July. "We have relevance within our own company. In our very roots as a company, we've always been in the private-client business, and we always will be.

"The advisors generating 81 percent of our [private-client] revenues have been with us an average of 11 years. And our top 25 producers have been with our company about 25 years on average," McCann shared. "So people build long careers here as advisors."

Like O'Neal, McCann has worked at Merrill for more than 20 years. He did leave Merrill for several months in 2003 to join AXA Financial, only to return at O'Neal's request. "Merrill has historically always been run by its sales force," says Bove.

In a sharp contrast with the battle at Morgan Stanley to push out former CEO Philip Purcell, which was a protracted one, the move to oust O'Neal was "too strong, too fast," says Bove. Purcell was forced out of his role as head of Morgan Stanley in June 2005. He left after the exodus of many executives and other employees over a 15-month period and after some dissident shareholders and ex-Morgan staff had called for his firing. He was replaced by John Mack.

Merrill's 64,200 employees and executives want change at the top, for a variety of reasons. And how much of a shift is in store at Merrill remains to be seen, cautions Bove, who believes that Merrill must change its "short-term orientation to issues."

"It is time for Merrill to refine its strategy and make it flexible enough to handle the normal cyclicality of its business. Hopefully, this is what a low-profile, detail-oriented CEO with a strong capital markets background will do."

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As for Citi, it's "doing what investors want by changing leadership, taking what appears to be a clean-up write-off, and committing itself to the maintenance of the dividend," Bove explains. "Speculation will develop that Citigroup will be split up. That is not likely to happen."

Others concur. "There's no evidence that there's a lack of synergies" in Citi's business units, says Roame. "The problem seems to be that some seriously talented people were pushed out during Prince's leadership." Advisors and investors alike are ready for some new blood.

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Janet Levaux is managing editor or Research and can be reached at jlevaux@researchmag.com.

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