Monday, January 21, 2008

Trend Following Strategy of Investment Banks

According to T. Clifton Green, a finance professor at Goizueta Business School investment banks follow trends and have a history of transforming themselves in ways that emphasize profitable aspects of their range of services. The persons who command influence in the organizations also change with the trend. In the 1980s, junk bonds were king and bond traders were influential people within investment banks. By the 1990s, the stock market was hot, so investment banks emphasized underwriting and equity research,

After the debt markets heated up again, collateralized debt obligations became very profitable. Presently, the investment world has turned to commodities that are producing an increasing share of the profits, with oil and energy specialists taking on larger roles.

From a bank’s perspective, it can be risky not to spot and enter a new profitable business line when other banks are doing it profitably. They worry about getting missing the opportunity that is being exploited by their peers. This is how laggard organizations end up following the pack.

But if the gamble of entering the hot new area doesn’t payoff, the entry can be a death knell for a firm’s leader, and possibly for the institution, Ray Hill, an adjunct senior lecturer of finance at Goizueta, points out that management skills come into play, when the firm’s leader learns to exploit the trend without losing control of the entire firm. Essentially, the trend of the moment cannot have too much influence over the entire shop. Richard Fuld of Lehman Brothers, who has had the longest CEO tenure in the industry, rose to the top and stayed there by making it clear that Lehman’s strategy would always be tied to a long-run view of the value of various franchises rather than the short term performance business lines. Goldman also uses a similar policy.

The tried and the true business areas can sometimes be the right path, but in the investment business, growth doesn’t come without some level of risk. Weighing the risks accordingly is the key.

Merrill's Sub Prime Crisis

Merrill had a reputation as a great brokerage franchise, but it was not in the same investment banking league as these other three big firms. Stan O’Neal seems to have tried to enhance Merrill’s status by expanding their capital market presence. This, inevitably, involved taking on new risks.

In retrospect, an interesting question to consider about risk in relation to Merrill Lynch is assessing whether or not O’Neal simply made a bet that could have paid off well, but instead went sour, or did he poorly understand the risk/return profile of the business Merrill was taking on in the collateralized loan market. If the answer is he simply made a bet that went sour, then this is just a story about a strategy that might have paid off, but didn't. CEOs are often fired for this. If the answer is a poor understanding of the collateralized loan market, the strategy can be a more serious error.

The current remaining problem for Merrill, and for other banks and investment firms, is the illiquid nature of these financial instruments. Without a liquid market, Merrill must record these assets on its books at a lower value than they could be worth in the long run. It is a much more subtle point to say that O’Neal was fired for failing to anticipate that these assets could become illiquid than to say that O’Neal was fired for allowing the firm to invest mortgages with higher default rates than expected.

According to Roy T. Black, a professor in the practice of finance at Goizueta Business School, O’Neal’s strategy of taking greater risks in the pursuit of higher returns was a bad move, especially in light of placing such a large bet on an asset class whose true risks were unknown.

This post is based on the article "Merrill Lynch: After Write-Downs, O’Neal’s Ouster, & Thain’s Appointment" Published: November 15, 2007 in Knowledge@Emory

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