Merrill Lynch: Subprime Mortgage Crisis

By Michael Berman For more information, see: Merrill Lynch

Merrill Lynch had been given $10 billion in the Troubled Asset Relief Program, or TARP, by the U.S. government to repay its creditors and investors.

Overview

Merrill Lynch became a major player in the subprime mortgage arena in September 2011, riding the wave of a boom in the U.S. housing market.

The plan was to offer subprime mortgage lenders discounted lines of credit so they could write more loans. These mortgages were offered to people who would not qualify for a conventional mortgage due to a poor credit rating or low income. These loans would traditionally have a higher interest rate or less favorable terms for the borrower or be adjustable rate mortgages (ARMs) where the interest rate would skyrocket after the first year.

The investment house would then purchase the loans and market them as securities, packaging the riskiest loans into Collateralized Debt Obligations (CDOs). The CDOs would be purchased in the form of bonds by investors who obtained a line of credit from Merrill to make the purchase. This resulted in what Merrill believed to be a "win-win" strategy with the firm making money on both ends of the deal.

Unfortunately, many of the people that took out these subprime loans ended up defaulting on their mortgages due to the higher interest rates. They ended up refinancing their loans to increase debt they couldn't afford or taking out subprime equity loans to help pay their bills.

This, along with a decline in real estate values, resulted in foreclosures and bad debt. This was the beginning of the downfall of the huge Wall Street investment firm.

Failures and Bankruptcies

The purchase of First Franklin from National City Bank in 2007 gave Merrill what it thought was the final piece for the company to take advantage of the subprime market. Merrill began funding subprime mortgages through First Franklin and selling many of them to Fannie Mae and Freddie Mac. They also paid higher premiums for subprime loans than their competitors.

First Franklin was already showing signs of failure. Many of the subprime loans it had written before being purchased by Merrill were becoming delinquent and the housing market began to deteriorate. Faced with mounting debt, Merrill closed the mortgage brokerage in March 2008, only a year after it had purchased it.

In addition, Bear Stearns hedge funds had borrowed $50 million from Merrill so it could purchase more subprime loans. Merrill took control of the hedge funds, but it was too late to rescue them. The Bear Stearns hedge funds collapsed in August 2007, ushering in the world financial crisis.

The collapse of the national housing market resulted in $8.4 billion in losses for Merrill in November 2007, the sale of its commercial finance business to General Electric and major shares of its stock to Temasek Holdings. This brought in $6 billion, but it wasn't enough to cover increasing losses in the subprime market. Temasek invested an additional $3.4 billion in Merrill, but that wasn't enough to cover the $4.9 billion the firm had already lost in the fourth quarter of 2007 or the $19.2 billion it lost between July 2007 and July 2008. Merrill's total loss attributed to the subprime mortgage crisis was $51.8 billion.

Merrill Lynch attempted to recover some of its losses through a CDO called Norma, which bet on loans issued to investors that were less credit-worthy than others. Essentially the company was betting that these loans would fail. Norma failed instead.

Rabobank, a Netherlands-based financial services provider, sued Merrill in 2009 claiming that it had incurred huge losses after a hedge fund named Magnetar Capital invested in Norma. They said Merrill had not informed Rabobank that Magnetar had bet against the funds.

Mounting losses in the subprime market and a loss of confidence by investors resulted in the sale of Merrill Lynch to Bank of America, which was already heavily invested in the subprime mortgage market through Countrywide, its subprime mortgage brokerage. Bank of America purchased Merrill for $50 billion, which was 38 percent more than the value of the company.

The Future

Merrill Lynch had been given$10 billion in the Troubled Asset Relief Program, or TARP, by the U.S. government to repay its creditors and investors. Instead, the company used$3.6 million of those funds to reimburse itself for bonuses it paid to its executives before its purchase by Bank of America. In addition, Bank of America received $20 billion as reimbursement for its purchase of Merrill.

Merrill continues to write mortgages through Merrill Lynch Home Loans. The company also offers other products ranging from interest-only financing to home equity loans.