It was a long time coming–24 years to be exact. But from the
beginning a bite-the-bullet decision by Merrill Lynch & Company was
clearly inevitable. Yet as we’ll see in a minute, what happened on
June 1 may not in fact turn out to be the bad news for Merrill that many on
Wall Street seem to fear.
We speak of the news that the firm–its hand finally forced by the
onrushing growth of Internet day trading–at last announced that it had
decided to confront a corporate demon that has been stalking it for nearly
a quarter-century: the superexorbitant commission rates that much of the
rest of Wall Street began abandoning when Saigon had not yet fallen to the
Communists and G.M. was still cranking out the Chevy Vega.
Specifically, the company announced that beginning Dec. 1 it would offer
discounted stock brokerage services over the Internet for a flat fee of
$29.95 per trade–a direct attack on the business of its
brokerage-world nemesis, Charles Schwab & Company, which offers the
same discounted service for exactly the same price.
But more than that, Merrill also used the occasion to announce a
related, but much more radical, risky and far-reaching initiative. The
news? Beginning next month, on July 12, it will be possible for any–or
all–of the company’s roughly 5 million retail clients to switch
their accounts from Merrill’s pointlessly expensive “full-service
brokerage commission” structure to a cheaper,
one-fee-covers-everything setup.
Taken together, these moves have ramifications that reach throughout the
whole of Wall Street, from the $3 trillion mutual fund industry to the
14,000 mainly brain-dead account execs at Merrill who have built
$300,000-and-up annual incomes by collecting around $75 a pop for telling
their clients to buy and hold the I.B.M.
Thanks to the June 1 announcements, by July a Merrill client will be
able to pay a flat annual fee equal to roughly 1 percent of the net assets
in his account, and in return avail himself, for free, of every retail
investment service Merrill has to offer.
Want to buy and sell stock? Want to buy a mutual fund? Want to take out
a mortgage on your house, or refinance an existing one? Want Merrill to
prepare a financial plan and/or asset allocation plan for you, then update
it annually? Pay the flat annual fee and everything will be free. Or
alternatively, leave your accounts as they are, and trade your own stocks
for $29.95 a trade. Or if you somehow feel reassured when gazing into the
eyes of someone who’ll charge you $65 for pithy advice like buying
Boston Chicken at $40 per share–then go ahead and do that, too.
It’ll all be up to you.
To say that investors weren’t overjoyed by this turn of events
would be the understatement of the week. From a closing price of $84 at the
start of the Memorial Day weekend, Merrill’s share price fell 16
percent in the following two trading days, to barely $70 per share, on the
heaviest trading volume in more than six months.
But a closer look at what Merrill has in fact decided to do suggests
that the sell-off may in fact have been misguided and that, over the long
haul, the company will emerge stronger and more profitable as a result.
True, there are opportunities galore to game the system as Merrill has
now set things up. For example, let’s say someone has $5 million in
Merrill accounts. Nothing would seem to stop him from putting $1 million of
it in a fee-based account to get everything for free that Merrill Lynch has
to offer, while putting the other $4 millionin a cheapo account in which
you can trade for $29.95 per transaction. A Merrill official says the firm
fully expects many people to do exactly that.
And taking the longer view, Merrill could come out ahead, anyway. Main
reason: those thousands upon thousands of shockingly overpaid account execs
who will (or at least should) very likely soon find themselves behind the
wheels of New York taxicabs.
To see why, however, we need to go back to the early 1970’s,
to behold the long-term decline Merrill has in fact undergone from
resisting the inevitable–a decline masked, as it happened, by a
17-year Wall Street superboom that made the company seem healthy almost in
spite of itself.
It has been 24 years since the New York Stock Exchange, confronted with
a gun to its head by antitrust regulators at the Justice Department,
abandoned its take-it-or-leave-it commission structure for member firms and
declared that henceforth member firms could charge clients whatever they
liked for brokering the purchase and sale of New York Exchange-listed
shares.
It was this action, which took effect on May 1, 1975–or, as it is
still referred to by old timers on the Street, “May
Day”–that opened the floodgates to the discount brokerage
industry–the Quick & Reilly Groups, Charles Schwabs and so on.
Such firms seemed to materialize out of nowhere–almost in the way
that a drop of rain falling anywhere in midtown Manhattan will instantly
sprout hundreds of young men selling pocket umbrellas on every street
corner. But instead of selling umbrellas, they were selling the same basic
service that firms like Merrill Lynch had been selling all along–but
at one-fourth the price.
… Which grim state of affairs forced Merrill, as the biggest of the
full-service brokers, into a pathetic, nearly 25-year-long struggle to
defend itself with the indefensible assertion that the smart investor is
one who pays four times the going price for a stockbroker’s services
because, by doing so, he gets access to a lot of biased and basically
worthless research from Merrill’s analysts.
How convincingly this argument has gone over with investors may be
judged from the fact that since 1991, Merrill’s commission business
has barely tripled, to about $6 billion a year–and that includes
institutional as well as retail business. By contrast, Schwab’s
commission business–which comes with no research or other such bells
and whistles–has nearly quadrupled and is now running at more than
$1.3 billion annually. And now, on top of everything, has come the
explosion of trading via the Internet, where the same exact raw data used
by the analysts to create their own reports, is now available free of
charge to literally anyone on earth.
In fairness, we should perhaps point out that Merrill’s research is
in fact no worse than the junk that comes from Prudential Securities Group
or Lehman Brothers Inc., or anywhere else. The truth is, none of it
is really much good, because nearly all of it is fatally compromised by an
inherent conflict at the very heart of the whole business: The firms use
happy-faced, positive research to drum up underwriting business from their
corporate clients–and this very research is then fobbed off on the
retail clients to convince them to buy the corporate client’s
paper.
Then, when–as inevitably happens–the market turns against
them, the analysts either all fall silent, or come up with weaselly excuses
to avoid admitting they were wrong. Sometimes they just tough it out and
let the retail clients ride their stocks all the way into the toilet to
avoid angering the institutional clients–which is what happened with
Merrill’s love affair with Boston Chicken Inc., which it underwrote
and took all the way to $41 per share, then let collapse back to $4 before
telling clients to sell. In a similar spirit–anyone heard from Henry
Blodget lately? In case you’ve forgotten, he’s the
wise-before-his-time young man at Merrill Lynch who personally helped talk
Amazon.com Inc. up to a split-adjusted $200 per share back in December and
now says “near-term weakness” explains why it has since lost half
its value. This is analysis? I call it toadying.
What all this means for Merrill is now really quite simple. Without
actually having come out and said so, they’ve basically decided to
give up trying to sell what fewer and fewer people have wanted to buy,
anyway: their inherently conflicted research advice. Instead,
they’ll now be shifting their “Financial Consultants”
toward a service in which–if they’re any good–they can
actually provide a useful service: genuine, long-term financial planning.
Informed, mature financial planning is something that everyone needs,
and companies like the American Express Company are already tapping into
it. American Express Financial Advisors employs 10,300 people who do
nothing but prepare financial plans and sell insurance and annuities to
individuals. Merrill Lynch ought to be able to eat their
lunch–especially if they fire half their existing reps and double the
salaries of all who remain.
Besides, the core of Merrill’s business isn’t retail
commission income, anyway. In 1998, the company took in roughly $3 billion
in retail commission income. But it also paid out $9.2 billion in salaries
and benefits for its 63,800 employees–and close to 21 percent of them
(13,600 to be exact) were financial consultants. So let’s say half of
them get the ax. There’s close to $1 billion saved right off the bat.
If the remaining 7,000 or so are at least as productive as the bunch at
American Express, they’ll bring in net after-tax income of $818
million minimum.
More importantly, the key activity for the entire retail operation
isn’t those sky-high fixed commissions at all, it’s the net
interest income the company earns on its margin lending to clients. These
days, the margin rate is 8.5 percent at Merrill, but Merrill itself pays
only about 4.5 percent to borrow the money it relends to you at that fat
markup. Result: a 4 percent spread that in 1998 looks to have translated
into nearly $1.3 billion of net interest income on its margin business.
That’s virtually the entire net profit of Merrill Lynch in 1998.
Upon that fact alone we may thus assert that the whole rest of Merrill
Lynch–from the underwriting business to the mutual funds, from the
Visa cards to the jumbo mortgages and the 670 branch offices all over the
globe–in other words, the whole entire thing–is being run as a
loss leader for the singular purpose of pumping out margin credit to retail
customers.
And that margin business isn’t going to go away by getting rid of
the company’s over-the-moon commission structure. Only the
superstructure of personnel costs and redundant branch offices that have
affixed themselves to the commission game will start coming down. Every
numskull registered rep who gets canned because he can’t do anything
except cold-call his client list and regurgitate what he hears on his
squawk box from the analysts’ morning call is one less slab of
deadwood that the company didn’t need in the first place.
And besides all that, Merrill doesn’t need to worry for one second
about seeing droves of clients disappear out the door once the deadwood is
set adrift. From my own experience, I can say that there are probably
ka-billions of people out there who would like nothing better than to dump
the knucklehead who had been duty broker of the day back when the client
first walked in the door 15 years ago and has barnacled himself to the
person ever since.
So to sum up, for a while at least, Merrill may have some tough going.
But if it does the right thing and uses the opportunity at hand to run a
hefty dose of Drano through the system, the only stuff that will get
flushed out in the process is what most brokers don’t know from
Shinola, anyway. And what if it doesn’t do the right thing, and
just stumbles along with the same cost structure in the face of imploding
commission revenues? Well, you know what happens when the toilet backs up
and you just stand there watching it. Pretty soon, you’ve got a
problem that’s no longer confined to the toilet. Anyway, enough of
that.
You can reach me by e-mail at cbyron1@home.com.
