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Merrill's Repairman

John Thain, an MIT-trained engineer, will have to mend morale and overhaul risk controls as head of the world's biggest brokerage. He may also have to write off billions more in bad debt.

By Lisa Kassenaar and Yalman Onaran Bloomberg Markets February 2008

The markets have just closed on the first Monday in December when John Thain pays a visit to Merrill Lynch & Co.'s seventh-floor bond trading room, with its 550 seats and 1,000 computer screens.

The company's new chief executive officer, who has been on the job for 48 hours, tells the crowd he's honored and a little nervous to be in charge of the world's biggest brokerage. Then he breaks into a story about a phone call from David Komansky, the former broker who ran Merrill from 1997 to 2002.

"David Komansky called me up and he said, 'I can't believe a Goldman guy is going to be in my office,"' says Thain, 52, adopting a low, gruff Bronx accent to mimic his 68-year-old predecessor. He pauses for the laughter and applause to die down. "Well, I'm not a Goldman guy anymore," he says.

He certainly isn't. While Thain's old employer, Goldman Sachs Group Inc., has emerged from the subprime crisis relatively unscathed, his new firm, Merrill Lynch, had to take a $7.9 billion writedown on its mortgage-backed assets, one that cost Thain's predecessor, Stan O'Neal, his job.

The 6-foot (1.8-meter) Thain, who learned risk management at Goldman and consensus building as CEO of the New York Stock Exchange, will need all of his skills to repair 94-year-old Merrill.

Thain is moving swiftly to restore order. On Monday, Dec. 3, the new boss chaired an all-day board meeting. That day, he also handed Nelson Chai, his chief financial officer from NYSE Euronext, the same job at Merrill.

Like many people who know Thain, Chai praises the newcomer's high-wattage intelligence: Thain holds a degree in electrical engineering from Massachusetts Institute of Technology and a Master of Business Administration from Harvard Business School.

"When you're the smartest guy in the room, which he typically is, you come at things from a different altitude," says Chai, 42, who also has a Harvard MBA. "It's good for him to have someone like me who walks on the street."

Thain has a lot more plans for Merrill. He'll create an executive committee of business heads whose members will report directly to him, he said in an interview on Dec. 14. Prominent on the committee will be a chief risk officer leading a reorganized unit designed to catch the kinds of missteps that allowed the fixed-income division to drag down the firm.

"The people who were here -- and who are not here anymore -- did not do a very good job of managing risk," Thain says.

The CEO is also hiring senior traders, whose ranks are thin, he says. And he is going to change how top managers are paid.

"I want to refocus on the company as a whole rather than on individual businesses," he says, sitting in a conference room on the 33rd floor of Merrill's World Financial Center headquarters in lower Manhattan. "There was too much of a siloed structure here."

For now, bonuses will be cut for the few at the heart of Merrill's recent travails. The firm may reduce the 2007 bonuses for fixed-income traders by an average of 40 percent and those of traders of mortgage-related securities by as much as 80 percent, according to two people briefed on the matter.

On Dec. 24, Merrill announced it would receive a cash infusion of as much as $6.2 billion from Singapore's Temasek Holdings Pte. and New York-based Davis Selected Advisors LP. Both investors will pay $48 a share. The firm also agreed to sell its commercial finance business to General Electric Co.'s finance arm for an undisclosed price.

At his meeting with the bond traders, Thain walks up a small staircase and looks over the fixed-income room. Hanging from the 20-foot ceiling are blue flags emblazoned with Merrill's trademark bull and company slogans, including "Client Focus" and "Individual Responsibility."

Thain reminds the crowd that he once traded mortgage bonds for Goldman Sachs in the 1980s. He invites everyone to weigh in on how Merrill is run. "I grew up in a relatively small town in the Midwest, and I am a very straightforward kind of person," the Illinois native says. "I would like to hear what you think we should be doing.

"We do have a few problems," he adds.

Thain and his team must begin by cleaning up Merrill Lynch's balance sheet, digging out whatever subprime-related losses are left on the company's books, says Charles Peabody, an analyst at New York-based Portales Partners LLC. That could mean another $11.5 billion in Merrill writeoffs related to mortgages, including collateralized debt obligations, according to William Tanona, an analyst at Goldman Sachs.

CDOs are packages of debt securities that bundle subprime mortgages, bonds and other loans. Thain declines to comment on any future writedowns at Merrill.

Speaking about all of the banks affected by the mortgage crash, he says, "If people were long CDOs in the third quarter, they are going to have losses in the fourth quarter. I think the market expects that." Merrill's fourth quarter ended on Dec. 31.

Thain's toughest task may be to revive a corporate culture that was damaged under O'Neal, says Barry Friedberg, a former chairman of global markets and investment banking. O'Neal, 56, sliced more than 18,000 jobs and closed 250 Merrill Lynch offices when the economy faltered in 2001 and '02. He fired so many managers in his immediate circle that others avoided face time with him, former employees say. Before O'Neal, the firm was long referred to as Mother Merrill for its reputation as being kinder to its employees than other Wall Street banks.

"Stan was unique in his capacity to drive away talent," says Friedberg, 67, who left Merrill in '03 after 19 years. "O'Neal's principal legacy is not the mortgage loss but the loss of hundreds of outstanding people."

O'Neal declined to comment for this story.

Thain, Merrill Lynch's first CEO from outside the company, should restore the balance between the 16,600-strong brokerage force, which brings in steady fees, and the volatile practice of trading with the firm's own money, says Richard Kovacevich, chairman of Wells Fargo & Co., the fifth-largest U.S. bank.

Proprietary trading, which is replete with risks, became the engine that drove Wall Street profits -- Merrill's included -- during the boom years. "Stan decided to significantly change the investment banking business and hope the brokerage business would continue to do fine," Kovacevich says. "But the inherent strength of Merrill Lynch today, if they have anything, is the brokerage."

Amy S. Butte, chief financial officer of MF Global Ltd., a futures and options brokerage business, says Merrill's advantage over other investment banks lies in its superior securities distribution network. Since 2006, that's included BlackRock Inc., the world's largest publicly traded mutual fund manager, in which Merrill bought a 49.8 percent stake.

"Merrill Lynch is not Goldman Sachs," says Butte, who was Thain's CFO at the NYSE and also worked as a securities industry analyst at Bear Stearns Cos. and Merrill. "One has long been a culture of volume, and the other is a culture of risk."

Thain says he recognizes the distinction. "The Merrill brand is very important," he says. "The focus on clients and giving them good advice is a very powerful element of what Merrill Lynch is."

(Merrill Lynch is a passive, minority investor in Bloomberg LP, parent of Bloomberg News.)

O'Neal's mistake, say people who worked with him, was that he tried too hard to make Merrill Lynch like Goldman Sachs. Merrill has traditionally made close to half of its money from wealth management. Goldman is an investment bank that depends on riskier proprietary trading for its success.

As late as September, with credit markets deep in the doldrums, Merrill Co-President Gregory Fleming wrote in a memo to his staff that Merrill should take risks like Goldman does.

Merrill Lynch's sales and trading operation accounted for 43 percent of revenue in 2006, up from 37.4 percent two years earlier, according to financial statements. Merrill's wealth management division, including the retail brokerage, brought in just 35 percent of revenue in 2006, down from 52 percent in '04. Profit in 2006 was a record $7.5 billion.

After the meltdown in the prices of subprime assets that triggered the third-quarter loss, the numbers reversed. Wealth management represented about 52 percent of revenue for the first nine months of 2007 versus 30 percent for trading, all delivered from the equities side.

"O'Neal was a copycat, and he said, 'Look, we can produce more short-term returns by taking more proprietary risk,"' says Portales's Peabody, who put a "sell" rating on Merrill in late 2005. "It came back to bite him."

As CFO at Goldman Sachs from 1994 to '99, Thain worked with his team to put together a checks-and-balances risk-control system that's still in place, he says. It includes a group of committees that watch over each other.

"At Goldman, there was an equal balance between the traders and the risk managers, and there was actually a very good dialogue," Thain says. "And when you add into that the involvement of senior management, it works."

Thain himself will be keeping constant track of the new risk management system to avoid any repetition of the subprime mortgage debacle. "I don't think it's an accident that the firms that seem to have avoided these problems the best have CEOs who get very actively involved in the business," Thain says. "You look at Goldman and you look at Lehman."

Goldman Sachs, under CEO Lloyd Blankfein, and Lehman Brothers Holdings Inc., under Richard Fuld, both used credit default swaps and other hedges to offset losses from mortgage-backed assets like those at Merrill. Even so, on Dec. 13, Lehman reported that fourth-quarter earnings fell 12 percent from a year earlier, in part due to a $830 million writedown of its subprime assets.

Observers raised Thain's name as a possible CEO of Merrill as soon as speculation about O'Neal's survival began in October. Thain was also a candidate for the top job at Citigroup Inc., which on Dec. 12 chose Vikram Pandit, the company's head of investment banking and trading.

"They truly have a good leader in Thain," says Tom Jalics, an analyst at National City Bank in Cleveland, who helps manage $34 billion, including Merrill shares. "He's proven. The Street likes him. He'll be able to get people on board."

Investors like him too, at least so far. As Merrill Lynch's reported losses in the mortgage market worsened, the company's shares plunged 47 percent to $51.23 on Nov. 26 from their January 2007 peak of $97.53. That cut the company's market capitalization by $20 billion. By Dec. 10, ten days after Thain's appointment, the stock was up to $62. The shares closed at $53 on Jan. 2, knocked back down by increasing estimates of the firm's fourth quarter writedown.

Changing CEOs doesn't come cheap. Merrill Lynch's board awarded Thain a pay package worth about $64 million, including a base salary of $750,000; 1.8 million option shares, two-thirds of which he'll be able to cash out when Merrill's stock reaches a certain price; and another 500,000 shares awarded to him outright.

Thain also got a $15 million bonus for 2007 when he walked in the door in December. O'Neal, 56, retired with a payout worth $161.5 million based on his employment contract. The board refused to give him severance.

For all of his time on Wall Street, Thain has never run a brokerage -- or any other retail business. "The flagship at Merrill Lynch is the brokerage, and Thain doesn't have any experience at all there," says William Fitzpatrick, an analyst at Racine, Wisconsin-based Optique Capital Management, which oversees $1.7 billion. The company sold its Merrill Lynch shares in 2006.

Thain says he is busy educating himself. On Nov. 14, the day he was appointed to the job, he joined a reception for brokerage clients at Merrill's headquarters. When he entered the room, he was greeted with applause. He says he's been to several other wealth management functions since taking over as CEO, meeting executives and financial advisers. "This is a people business, and I have to spend time with people," he says.

Wealth management, the bulk of which is a private client operation catering to individual investors and small businesses, has more than 600 offices around the world. It oversees about $1.8 trillion in assets.

The brokerage has brought in more than $8.7 billion in revenue every year since 2002, including a record $11.6 billion in '06. In the first nine months of '07, sales were $9.6 billion, up 16 percent from the same period in '06.

In 24 years at Goldman Sachs, Thain built a reputation as a man who knew how to hedge risk and was cool under pressure, former colleagues at the bank say. He was the highest-ranking executive present at Goldman's 85 Broad St. headquarters on Sept. 11, 2001, when terrorists struck the World Trade Center towers a half mile away. His office became a crisis control center, and he established teams to locate Goldman employees and secured telecommunications for the firm.

"He was the ultimate straight-arrow boy scout," says Suzanne Nora Johnson, a former Goldman vice chairman and managing director in charge of global research. Thain isn't naturally a backslapping broker eager to mix it up with colleagues and clients. "He's an ascetic sort of a guy," says another former Goldman managing director who worked with him there. "This is not a guy who will play Santa Claus."

Thain does have a wry sense of humor. At a meeting in 1999 of lawyers, accountants and bankers to discuss taking Goldman's 130-year-old partnership public, Thain outlined his strategy and then invited comments. Several dissenters spoke up. "Would it hurt you to suck up to me once in a while?" he quipped, according to a person who was there.

John Thain grew up in Antioch, Illinois, population 13,400, a town 60 miles (97 kilometers) from Chicago. His father, Allan, was a doctor on the town's redbrick Main Street who has since handed his practice on to Thain's two brothers, Dennis and Robert, both general practitioners.

Thain was regarded as the smartest kid in Antioch Community High School. And he didn't stop at academics. He was a member of the freshman executive board, captain of the wrestling team, a debater and, in 12th grade, valedictorian, according to a wrestling teammate, Tom Rayniak.

"When he made conversation, he would explain the things in detail to almost the point that I didn't know what the hell he was talking about," says Steve Vazquez, another classmate.

When Thain entered MIT in 1973, he had never before been on the U.S. East Coast. After he got his engineering degree, he went directly to Harvard. He joined Goldman in 1979. In the 1980s, he traded mortgage bonds in the fixed-income division. In 1994, he was named chief financial officer and kept that title even after he moved to London in 1995 for two years as head of European operations.

Thain also served as head of operations, technology and finance. He joined the board in 1998 and became president in 1999.

Thain approached his banking career like an engineer, with meticulous attention to the details of how things work, according to former colleagues. In 2003, he visited a nuclear-powered aircraft carrier, the USS George Washington, off the coast of Norfolk, Virginia, with Blankfein. While Blankfein remained outside watching the planes take off and land on the 1,000-foot flight deck, Thain went below for a closer look at the gears of the 60,000-ton ship.

Merrill Lynch is Thain's second rescue mission. In 2003, the board of the NYSE hired him as CEO after the abrupt departure of Richard Grasso, who left the exchange under fire for his $190 million pay package. Thain accepted in part because he thought Goldman CEO Henry Paulson would remain in charge of Goldman for years to come, he said at the time to people he worked with. Paulson, 61, became George W. Bush's Treasury secretary in July 2006.

At the NYSE, Thain walked into an exchange steeped in history, not technology. By adding computer capacity and buying electronic trader Archipelago Holdings Inc., he turned a system that had handled about 15 percent of trades electronically when he arrived to one trading more than 85 percent of shares by computer.

Thain assuaged old-school floor brokers, some with exchange seats passed on from their grandfathers, with public shares that rose 30 percent in their first year. He also began the process of taking the exchange global by buying Paris-based Euronext NV, which runs stock exchanges in Belgium, France, the Netherlands and Portugal.

Thain's sixth-floor office in the stock exchange's classical revival-style building on Broad Street displayed some of the gifts he received when he hosted visitors. In one corner stood a Gibson electric guitar, a memento from Led Zeppelin's Jimmy Page. (Thain is a fan.) Regrettably, Thain says, he had to leave that behind because it belongs to the NYSE.

On a wall hung a large painting by Eric Zener showing a man in a dark suit with a briefcase standing on a diving board over a swimming pool. The work was a gift from Thain's wife, Carmen, and now hangs in his office at Merrill. The couple have four children.

Thain is also a beekeeper, and used to keep hives in the backyard of his Rye, New York, estate. (He also owns an apartment in Manhattan.) The bees all succumbed last year to a virus that is killing bees all over the country. In his time as a beekeeper he was only stung once. "They don't sting unless you aggravate them," he says.

Former Merrill Lynch hands are enthusiastic about Thain's hiring. "I was thrilled," Friedberg says of Thain's appointment. "I had been appalled the situation had gotten so out of hand." Friedberg is now a partner at FriedbergMilstein LLC, a New York-based investment house.

O'Neal, the man Thain succeeded as Merrill CEO, still has his defenders. As Merrill's president under Komansky, he steered the company through the aftermath of the Sept. 11 attacks, which displaced thousands of World Financial Center workers for several months.

In 2002, the year O'Neal was named CEO, earnings dried up in a sluggish economy and Merrill's stock plunged 27 percent. O'Neal repaired Merrill's bottom line, in part through savings from cutting jobs. When the markets came back in 2003, the stock rose 55 percent.

By 2006, it still looked to investors like O'Neal was making all of the right choices. He'd reported three consecutive years of record profit.

"O'Neal cleaned up Merrill, and the BlackRock deal was great," says James Ellman, who manages $200 million as president of Seacliff Capital LLC in San Francisco. "But Wall Street is a place where you are only as good as your last trade, and he will be remembered for a breakdown in risk controls."

O'Neal had arrived on Wall Street from the treasurer's office of General Motors Corp. in 1986. At Merrill, he rose quickly, heading the high-yield-bond business, the debt and equity capital markets group, investment banking and securities trading. In March 1998, he became CFO.

That was a turbulent year for financial markets. Russia defaulted on its debt and devalued its currency, and, a month later, Greenwich, Connecticut-based hedge fund Long-Term Capital Management LP declared it was near bankruptcy. Merrill and 13 other banks and securities firms, who were all trading with LTCM, arranged a $3.6 billion bailout to prevent a larger financial crisis.

Merrill said it would fire 3,400 people in the third quarter of 1998, and the charge it took resulted in its first loss in nine years. "The Street had not had any experience with a liquidity crisis like that in 1998," Friedberg says. "But the question is, having lived through it back then, why was Stan not sensitive to the risks building up in 2006 and 2007?"

O'Neal's romance with structured finance began when he decided, as a new CEO in 2002, that Merrill could burnish its name with institutional clients in a relatively new market, CDOs, according to people who worked with him. Structured finance, the creation of complex financial instruments such as CDOs and syndicated loans for sophisticated investors, had been growing for almost a decade.

Banks were moving to sell innovative new securities to insurance companies, pension funds and hedge funds. About $73 billion of CDOs were issued in '02, an amount that ballooned to $388 billion in '06, according to London-based researcher Dealogic Holdings Plc.

In 2002, with Merrill's CDO business ranked 15th in the league tables, O'Neal lured Christopher Ricciardi to his trading floor from Credit Suisse Group, then the top bank in the business. In Ricciardi's first year at Merrill, CDO underwriting rose fourfold to $8.7 billion, driving the firm to third in the rankings, according to Dealogic. The following year, Merrill moved to No. 1.

Ricciardi worked under Dow Kim, co-head of global capital markets, which included fixed-income trading and sales. Kim had been a Merrill Lynch swaps trader in Tokyo, with a healthy appetite for risk, people who worked with him say. His management style was to let his stars go to work for months at a time with few questions asked and then hold them strictly accountable for the results, according to the people. Ricciardi flourished in that environment.

Demand for CDOs backed by subprime mortgages began to wane in 2005. In one of the first signs of a souring market, near the end of '05, American International Group Inc., the world's largest insurer, stopped writing loss-protection contracts, even for top-rated portions of CDOs. In February 2006, Ricciardi left Merrill.

The firm didn't pull back. Instead, it kept an increasing portion of the CDOs it packaged on its own account. By September 2006, Merrill had $17 billion in subprime CDO holdings, another $18 billion in mortgage-backed bonds ready to be parceled into CDOs and another $14 billion in subprime loans waiting to be made into mortgage bonds, according to a person familiar with the situation.

Merrill was also financing $22 billion of subprime mortgages through arrangements with independent lenders, including Agoura Hills, California-based Ownit Mortgage Solutions Inc. and Middletown, Connecticut-based Mortgage Lenders Network USA Inc. (Both would declare bankruptcy in early 2007.)

By September 2006, Merrill's investments and financing related to subprime mortgages and CDOs totaled about $72 billion, more than the company's stock market value at the time.

O'Neal's team was still confident enough in the future of mortgage-backed assets that it went shopping to secure its own supply of new loans. In December 2006, Merrill paid $1.3 billion for San Jose, California-based First Franklin Financial Corp., a company originating $3 billion a month of new subprime mortgages.

In May 2007, Kim quit Merrill to set up a hedge fund, spurring a reshuffling at the top of the firm. O'Neal filled the president's post, empty since he took over, with two men: Fleming, head of investment banking, and Ahmass Fakahany, Merrill's former chief administrative officer.

How far Merrill Lynch's risk management had gone awry became clear in mid-July, when Fleming and Fakahany alerted the board of directors that they might have to take a $500 million writedown on holdings of mortgage-related assets, according to people familiar with the situation. O'Neal saw no reason for alarm. On July 30, he sent a memo to Merrill's 62,000 employees that said, "We're very comfortable with our current exposure to this asset class."

On Aug. 9, the board heard again from O'Neal's lieutenants, this time in a memo doubling their estimate of losses to $1 billion, according to the same people. Hedging strategies were in place and third-Ôquarter revenue from Merrill's fixed-income, currency and commodities department, which administered CDOs, would increase from the prior year, they said.

The man in direct charge of Merrill's massive CDO machine was Osman Semerci, a 40-year-old Turk who took over Merrill's fixed-income division in July 2006. In August 2007, with the market convulsing, Semerci tried to buy insurance on Merrill's CDO bonds. MBIA Inc., the world's largest bond insurer, at first refused to offer a contract at all. On Aug. 28, Semerci and three others boarded Merrill's helicopter for a flight to MBIA's corporate campus in Armonk, New York.

That afternoon, MBIA CEO Gary Dunton agreed to insure $5 billion of Merrill's CDOs. MBIA is itself struggling to keep its top bond rating. Its stock dropped 75 percent percent in 2007, even after a $1 billion infusion of cash from private equity firm Warburg Pincus LLC.

Semerci left Merrill on Oct. 3, 2007.

The $1 billion estimate of losses predicted in August turned out to be far too optimistic. On Oct. 5, Merrill Lynch said it would write down about $5 billion in assets. Just 19 days later, on Oct. 24, the company announced an actual writedown of $7.9 billion, plus another $456 million on its leveraged loans to private equity shops and hedge funds.

O'Neal stepped down on Oct. 30.

The company lost $2.24 billion in the third quarter, its biggest-ever quarterly loss, and its credit ratings were cut.

Fleming was still telling colleagues as late as Sept. 23 that Merrill wasn't taking enough risk, according to an email he wrote on that day. Its subject line read, "Goldman: one off gains in China mining company."

Fleming pointed to Goldman Sachs's gain from its investments in a Chinese coal mine and questioned why Merrill was missing such opportunities. "They have such a backlog of these investments because they never pull back," he wrote.

Former colleagues say that in August and September, O'Neal held frequent emergency meetings to try to blunt the CDO debacle. He also found time for recreation. In the six weeks from Aug. 12 to Sept. 30, as Merrill Lynch's losses mounted, O'Neal played 20 rounds of golf on at least five different courses, according to the U.S. Golf Association's Web site. His handicap dropped to 9.1 from 10.2 during that period.

On an earnings-day conference call with analysts in late October, O'Neal repeated five times that Merrill had made mistakes. It wasn't enough to save his job. After Merrill made a two-week search, Thain was handed the reins.

MF Global's Butte says Thain is better prepared to lead Merrill now than he would have been before working at the NYSE. There, she says, he had to learn to get comfortable with listed company executives, shareholders and the press in a role that included ringing the exchange's opening and closing bell hundreds of times. "He became less stiff as he focused on interacting with people," she says. "With retail brokers, you need that personal touch."

Thain agrees that the NYSE prepared him for a more public role than he ever had to assume at Goldman Sachs. "One of the skills I picked up was being able to be on live TV and be comfortable," he says.

Charles Mangano, Merrill's global head of corporate marketing and brand management from 1995 to 2001, says Thain should look back to the leadership of Daniel Tully, who was CEO from 1993 to '96, and Komansky, as he seeks to mend morale and reinvigorate the stock. O'Neal, he says, didn't understand the power of the company's iconic brand.

Mangano, 53, recalls the 1970s, when Merrill gained customers with an advertising campaign claiming to be "Bullish on America." The TV ads featured a bull sauntering through a china shop without disturbing a single teacup. "It was about intelligence and optimism," Mangano says. "It became known around the world. Heads of state to the average Joe in Des Moines, Iowa, knew who Merrill Lynch was. When Merrill is firing on all cylinders, it's a very powerful organization."

Thain is already looking at Merrill's history for guidance. On Dec. 5, he hosted a lunch for several of its former top executives, including: William Schreyer, who was CEO from 1984 to '92; Winthrop Smith, a former head of Merrill's international brokerage; John "Launny" Steffens, former head of the private client group; Friedberg; and Komansky. Tully was unable to attend.

Thain says he's ready to get Merrill's cylinders pumping again. Still, unless he fixes the breakdown on the fixed-income desk, there may be less vigorous applause the next time he visits the trading room.

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