On the Money Trail
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Corporate America at its Finest
by Al Jacobs, author of Nobody's Fool
December 2007

The public corporation is a fascinating milieu.  Nowhere else will you find achievement, reward, duplicity, and calamity so intimately balanced.  Those of you who recall the Savings and Loan scandal of the 1980s and the Enron collapse in 2001 will recognize many of the same factors in this latest episode: the Merrill Lynch debacle of 2007. 

The events are not uncommon.  A traditionally profitable company of longstanding repute engages in activities that call into question the soundness of its policies, the credibility of its representations, and the judgment of its executives.  In this instance, the firm disclosed in late October a need to write down $7.9 billion for the prior quarter—$3.4 billion more than announced several weeks earlier—the loss attributable to bad debt accumulated through investments in the subprime mortgage industry.

Let me give you a clearer picture of what happened.  In 2006, after watching competitors boost earnings through investment in collateralized debt obligations (CDOs) and subprime mortgages, Merrill’s CEO, E. Stanley O’Neal, decided to join the parade and invest heavily in the area.  Mortgage loans on properties with no securing equity, to borrowers with poor credit, served as collateral for bonds that Merrill packaged and resold to their investors.  The fees generated on these CDOs provided a bonanza that boosted the firm’s quarterly profits.  Everything evolved splendidly until, as inevitable, the chickens came home to roost.

You may wonder why such a fiasco occurred.  It’s not because Stan O’Neal is financially unsophisticated.  A bachelor’s degree in industrial administration from Kettering University and an MBA from Harvard led to his heading Merrill’s leveraged finance division in the early 1990s, promotion to chief financial officer in 1998, and elevation to CEO in 2002.  His depth of experience, together with an 11-member seasoned board of directors, nine of whom he handpicked, indicates something more than a naïve blunder.  The momentous errors in judgment must be otherwise explained.

Perhaps a few numbers will provide a hint as to how American public corporations function.  In 2002, Mr. O’Neal received a salary of $500,000.  However, his bonus and stock options tied to corporate performance totaled $13.8 million.  By 2004 his efforts at boosting annual corporate profits resulted in his income rising to $28.14 million.  Clearly for top corporate executives, the elixir is short-term earnings; everything else is secondary.  On this basis, there is an inducement to pursue activities that enhance quarterly profits despite the likelihood of unfavorable long-term results.  As evidence of this, we’ll fast-forward to October 30, 2007—our CEO’s reconciliation with reality.  Despite the corporation’s abominable performance, resulting in Mr. O’Neal’s ouster, he is nonetheless eligible to receive $161.5 million as an exit package. The key, of course, is enactment of self-serving employment contracts that are of the executives . . . by the executives . . . and for the executives.

In case you believe the misfortune of Merrill Lynch and its CEO to be a rare exception in the world of the public corporation, you need only tune in to the agony of another financial behemoth, Citigroup Inc., as it began to unravel on November 4, 2007.  As an enterprise whose genesis dates to the founding of Citibank in 1812, with 275,000 employees operating in more than 100 countries, Citigroup truly represents banking in America.  As one of the most active participants in the sub-prime mortgage-backed securities market, buying billions of dollars of mortgages and then selling them on to international investors, it mimicked Merrill’s behavior lockstep.  In September, as the inevitable flow of red ink cascaded into a torrent, the firm announced $2.2 billion in estimated losses for the third quarter of 2007, but within two months disclosed the actual figure of $11 billion.  And once again, the full blame for the disaster fell upon the CEO, Charles O. Prince, who was summarily fired (excuse me . . . retired) with a negotiated severance package in the neighborhood of $87 million.

As an aside, Citigroup’s board of directors wasted no time in appointing Prince’s successor.  You might reasonably expect it to be someone with no hint of culpability for the sub-prime mortgage catastrophe, but guess what?  The replacement is Robert Rubin, former Treasury secretary in the Clinton administration, a board member and chairman of the company’s executive committee.  The likelihood that Mr. Rubin, summa cum laude graduate from Harvard College with a B.A. in economics, recipient of an L.L.B. from Yale Law School, and attendee at the London School of Economics, knew nothing of the imperfections of his firm’s mortgage lending activities defies logic.

Almost immediately following the revelations at Merrill and Citigroup, a nationwide flood of revelations began to come out of the woodwork.  Morgan Stanley, a major player in the subprime mortgage-market, admitted to a $3.7 billion increase over the $10.4 billion reported in August.  Indy Mac Bancorp, the nation’s second largest independent mortgage lender acknowledged its subprime write-off to be five times larger than forecast in September.  Almost as an echo, rumblings emanated from Wachovia Corp., Bank of America, and JP Morgan Chase & Co., as each alluded to untold billions of lost dollars.  At this moment, the scope of the coming cataclysm can scarcely be imagined.

A final comment is warranted.  Those firms that exhibited gross malfeasance through their involvement in this subprime-mortgage-house-of-cards do not deserve any special condemnation because of their egregious performance.  It’s the rare public corporation that does not function under the same guidelines and, given similar circumstances, you may expect most companies to perform comparably.  The real criticism should be directed at the investing public that tolerates these activities by continuing to purchase and hold corporate securities while refusing to demand accountability from its boards of directors.

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Al Jacobs has been an entrepreneur for forty years. His business experience ranges from property management and securities investment to appraisal, civil engineering, and the operation of a private trust company. In his book, Nobody's Fool - A Skeptic's Guide to Prosperity, Al presents his Ten Ground Rules for Success for achieving wealth and a prosperous life by outlining a philosophy for spending, borrowing, making sound investments, and how to avoid being victimized by America's many intimidating institutions.