Review of The Financial Crisis:

The financial crisis occurred for a host of reasons, but there were four prominent factors that heightened the collapse, dating as far back as the 1980s. Firstly, beginning with the Carter administration1, successive governments began deregulating the financial services industry, increasing the scope for higher leveraging, thus allowing institutions to take on greater risk. Coupled with this were attempts to build a stronger real-estate market through government subsidised initiatives such as the Community Reinvestment Act (CRA) and more notably, Fannie Mae and Freddie Mack2. The deregulation of financial services meant borrowers had greater access to funds and as a consequence, mortgages, which meant an increase in the number of homeowners in the US. With stringent targets in place, mortgage lenders began to provide subprime mortgages, requiring less than a 10% down-payment3. This continuous lending to un-creditworthy borrowers, predatory lending and the historically low interest rates from 2001 effectively pushed the real-estate market higher, increasing prices throughout, fuelling the growth in the housing bubble. Low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system4. It was not poor lending that necessarily caused the crisis, but the actions of bankers who fed off the growing market, creating assets in the form of Mortgage Backed Securities (MBS) and other Collaterised Debt Obligations (CDOs). Driven by large profits, the banking world looked to create exotic securities to fulfil the needs of institutional investors. By 2007 banks were holding over a third of those sub-prime MBSs5 supposedly safe assets on their balance sheets, exposing them to the risk of systematic default. Safe was a word easily thrown around at the height of the boom, to the extent that credit-rating agencies did not understand what was being sold and the tools used to rate securities were dated and in some cases did not apply to sub-prime loans. To add to this, it is argued there was a conflict of interest because rating agencies were enticed to give better ratings in order to continue receiving service fees6. Finally, investors played a significant role, in that without their demand for high yield assets, the extent to which collaterisation occurred may have been restricted. Their inability to differentiate between quality investments fuelled the creation of these assets and their greed rivals that of the bankers. These factors were the key causes of the financial crisis, but the underlying issue was the creation of the housing bubble. The bubble burst and there was systematic default around the country, which brought house prices crashing and made CDOs worthless.

What Merrill Lynchs Acquisition Tells Us:

Merrill Lynch in the early 2000s represented greed at the highest level on Wall Street and in corporate America, contributing to the housing bubble, compromising the reliability of credit agencies and creating complex exotic securities. Bank of Americas acquisition of Merrill Lynch in
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http://www.bus.indiana.edu/riharbau/RePEc/iuk/wpaper/bepp2009-02-fratianni-marchionne.pdf pg1 Book 6 http://www.investopedia.com/articles/07/subprime-blame.asp#axzz2DYiF0vCr

many ways typifies the financial crisis; a traditional commercial bank having to acquire a risky, aggressively profit-driven investment bank. Merrill Lynch sought to generate higher returns, saying, the firm would take more risks7. The firms acquisition of mortgage origination companies was an efficient way for it to originate to distribute, increasing its presence in the CDO market, giving it a value of $136 billion8 by the end of 2008. They earned income of 0.4%-2.5%9 for underwriting bonds, giving them further incentive to extract as much profit from the market as possible, by taking on more risks. Bank of America had long exited the sub-prime market and was in a more stable position, allowing it to come out of the financial crisis relatively unscathed. The juxtaposition of these two companies shows that firms involved in excessive risk taking (Lehman Brothers, Bear Stearns & Merrill Lynch) were most susceptible to bankruptcy, having overexposed themselves to the sub-prime market and through over collaterisation left high risk liabilities on their balance sheets, highlighted by the $9bn holdings they had written off. Ultimately, the acquisition tells us that not only did Merrill Lynch fuel the financial crisis through securitisation of sub-prime loans, but it also fell victim to it.

Bank of Americas Balance Sheet:

The first indicator to analyse is the firms debt to equity 8 ratio which is a measure of 7 financial leverage. Bank of 6 Debt to Equity BoA Americas ratio is relatively 5 constant and ranges Debt to Equity WF 4 between 2.95 to 3.57 over Debt to Equity JPM 3 the 5 year period. What this Debt to Equity Citi 2 essentially means is that for every $1 of shareholder 1 equity, there is $3.57 of 0 2004 2005 2006 2007 2008 debt in 2008. It is not surprising for a commercial bank to have a debt to equity ratio greater than 1. To truly understand whether the banks leverage was high, we must compare it to other Universal and Commercial Banks. From the graph it is evident that their debt to equity ratio is similar to that of its nearest competitors, suggesting it had a stable bank structure, with low exposure to debt financing.
9

7 8 9

Other key measures are the firms Tier 1 Capital Ratio a measure of a banks financial position based on 50.00% the equity it holds in relation to its 40.00% assets. Bank of Americas ratio has Tier 1 Capital 30.00% consistently been over the 6% Asset Growth Basel requirement, thus covering 20.00% Liabilities Growth the firm against a run on the bank 10.00% or any immediate market losses, putting it in a relatively safe 0.00% position. From the data it seems 2004 2005 2006 2007 2008 Bank of America has a safe structure and tends to be a risk-averse firm with a view for sustainable growth. They expanded their business greatly from 2003-2004 increasing their assets and liabilities by over 50%, giving it a greater presence in the market.
60.00%

Next we take a look at the firms group structure. The banks Consumer & Small $10,000.00 biggest revenue generator is its Business Banking $8,000.00 Consumer & Small Business Banking, suggesting it did not Corporate & $6,000.00 Investment Banking want to deviate from its $4,000.00 traditional business structure, Wealth and $2,000.00 which was profitable. Its Investment Corporate & Investment Banking $0.00 Management division was also profitable, but 2004 2005 2006 2007 2008 -$2,000.00 saw a sharp decline in 2007 and 2008, which were heightened by the financial crisis. Even though the firm posted significant profits between 2004 and 2006 through their investment banking arm, they concentrated on capital markets and lending to large cap businesses with less emphasis on trading, which only represented 13.34% of total investment banking revenues in 2006.
$12,000.00

Looking at the firms balance sheet and group structure it is clear to see why the firm, prior to its acquisition of Merrill Lynch was in a stable position and came through the financial crisis without substantial losses.

Merrill Lynchs Balance Sheet:

Year 2004 2005 2006 2007 2008 Asset Growth 15.82% 1265.08% 2.49% 76.23% 159.50% Liabilities Growth 14.80% 1571.15% -0.47% 78.93% 164.76%

Merrill Lynch Profit in Millions

1000000 500000 0 -500000 -1000000 -1500000 -2000000 2004 2005 2006 2007 2008 Profit

Internal Risk Regulation:

Much emphasis has been placed upon banks to implement their own measures to curb risk taking. The recent banning of all proprietary trading was forced by regulation authorities and governments, but the final move had to be made by investment banks. Trading activities are what needs to be assessed. Even still investment banks have posted substantial losses, notably JP Morgan and UBS in 2011. They both posted losses because of excessive risks and reckless trading strategies, which extended to the highest levels of management.