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The Merrill Lynch Conundrum: What Will Bank of America Do?

By John Maxfield - May 15, 2016 at 8:05AM

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How Bank of America got where it is, where it might go, and why investors might not want to dismiss the company outright.

It's been nearly eight years since the financial crisis, yet Bank of America (BAC 0.72%) is still earning half as much money as it should be given its size. 

In this episode of Industry Focus: Financials, analysts Gaby Lapera and John Maxfield explain why the Merrill Lynch acquisition has hurt Bank of America much more than it's helped, which federal regulations are cutting at the bank's revenues the most, and whether it would be in Bank of America's best interest to just sell or spin off Merrill Lynch. Also, John explains why he's still bullish on the company.

Thanks to Audible for supporting this episode. Get a free 30-day trial at A full transcript follows the video.

This podcast was recorded on May 9, 2016. 

Gaby Lapera: This episode is brought to you by Head to for a 30-day free trial.

Hello, everyone! Welcome to Industry Focus: Financials edition. Today is May 9th, 2016. My name is Gaby Lapera. I'm in the studio, and joining me on the phone is financial analyst John Maxfield. How are you doing?

John Maxfield: I'm doing great, Gaby. Happy to be here, as always.

Lapera: Fantastic. I am also excited to be here. You guys will have to excuse any auditory vocalized pauses I might take, because I haven't had any caffeine yet, as I was explaining to John, and I'm not at my best and brightest without caffeine. So, here we go, rolling right into our story of the day. We're going to be talking about Bank of America and Merrill Lynch. As many of you may have noticed, if you're a Bank of America customer, Merrill Lynch and Bank of America are in some way joined. I think Maxfield can give us a little more background on exactly how they came to be together.

Maxfield: That's right. Bank of America purchased Merrill Lynch in September of 2008. To set the scene a little more, one of the things we've seen in the years since the financial crisis is that some banks have recovered, and even actually thrived as a result of the financial crisis. Wells Fargo (WFC 7.55%) is a perfect example of that. It's more than doubled in size, it's making more money than it's ever made, and even in this tough interest rate environment, Wells Fargo is such an incredibly vibrant and viable business model that you wouldn't even guess that it had just survived the financial crisis. JPMorgan Chase is doing pretty well, too. But Bank of America is really struggling. Mind you, this is the nation's second-largest bank. It's a really important bank of the United States. 

The question is, why is it struggling? And one of the reasons it seems to be struggling is because of the acquisition of Merrill Lynch that it did in September of 2008, in the trough of the financial crisis. It was over a very fast weekend, the same weekend that Lehman Brothers failed. The Treasury Department and the Federal Reserve approached Bank of America to see if they would be willing to basically just buy Merrill Lynch over the course of the weekend, and that's what they did. They paid something like $50 billion for Merrill Lynch.

But the thing that's important to keep in mind in all of this is, that happened before the post-crisis regulatory regime changed the name of the game for banks.

Lapera: Yeah, and I think what listeners have to understand, too, is that people were worried about a domino effect, just like they were worried about Vietnam and communists being a domino effect. People were worried about banks. So, Lehman Brothers failed, and then they were convinced that the banks, from smallest to largest, would fail one right after the another. That's why the federal government stepped in and asked Bank of America, "Hey, do you want to buy Merrill Lynch before it fails?"

Maxfield: That's right. If we go back in time to 2008, in March of that year is when the Treasury Department directly approached JPMorgan Chase to say, "Can you guys step in and save Bear Stearns?" Bear Stearns was the fifth largest investment bank. Lehman Brothers was the fourth largest, and Merrill Lynch was the third largest, then you had Morgan Stanley and Goldman Sachs. To Gaby's point, it looked like that was the way the dominoes were tumbling. You had Bear fall in March, you had Lehman fall in September. And the thought was, if you didn't draw the line somewhere, all five of them would go, and that would cause a global catastrophe.

Lapera: Do you think Merrill Lynch actually would have failed if Bank of America hadn't bought them up?

Maxfield: That's a great question. (laughs) Gaby, I have to be honest, that's an amazing question. Let me answer it this way -- there are some banks out there, JPMorgan Chase and Wells Fargo in particular, who basically said, "We don't need the federal government to step in to save us." And to a certain extent, that is right, because Wells Fargo and JPMorgan Chase had plenty of liquidity and plenty of capital. They were fine as institutions. It was really just a handful of other commercial banks that were struggling, then all the investment banks.

But had the government not stepped in and basically backstopped the entire credit market in the United States, every single bank was a threat of failure. JPMorgan Chase may have been fine, but all of its counterparties that owed JPMorgan Chase money ... when one counterparty owes another counterparty money, that's an asset to the company that the money is owed to. So basically, JPMorgan Chase's assets could have been decimated not because of JPMorgan Chase, but because of all its counterparties failing. 

So, the fact of the matter is, yes, I think there's an argument to be made that, if the government didn't step in, not only would have Merrill Lynch failed, but even the biggest and soundest financial organizations in the country would have been at threat of failure.

Lapera: I'm just going to take a brief break and thank Audible again for sponsoring today's episode. is a great platform for audio books, which, if you're in the D.C. area, are fantastic to listen to while you forlornly watch for a train to come. Let an audiobook transport you from the dreary reality of commuting. Just go to for a free 30-day trial.

Bank of America, going back to our story, has purchased Merrill Lynch, and things have changed for them. No one had really thought about it, but the regulatory environment was going to have to change as a result of the financial crisis. So, the financial regulatory climate was completely different from that weekend onward, which really sucked for Bank of America. I don't know if I'm allowed to say that on air, but we're going to keep it in. (laughs) 

So now, Bank of America is running into a few different things. The regulatory requirements have changed. First and foremost, liquidity coverage ratio. Second, capital requirements. Third, believe it or not, their scale is working against them, and fourth, the Volcker rule. So, let's cover that in order. Do you want to start with the liquidity coverage ratio?

Maxfield: Yeah. Here's the issue. A bank wants to earn 1% on its assets. That's really what you need to earn in order for a bank to be able to create value. Bank of America is earning dramatically less than that. One of the reasons it's earning so much less is because its balance sheet has to be much more liquid than a regional bank, or even a large bank like Wells Fargo, but a simpler bank, because Bank of America has both investment banking operations and regional banking operations.

If you think about what a bank is, a bank is really nothing more than a leveraged fund. You have some capital, you borrow a whole bunch of money for really cheap from depositors, and then you invest that money into higher-yielding assets. The key is, if you can invest a larger chunk of that money into really high-yielding assets, and in the banking world, those are loans, then you're going to make a lot more money than a bank that's going to have to invest its money in, say, government securities, which only yield whatever it is, 2-2.5%. 

So, if you look at Bank of America, one of the things you'll notice is that only 41% of its earning assets consist of loans. If you go over and look at Wells Fargo, 51% of its earning assets consist of loans.

Lapera: For our listeners, just so you know, 10% might not seem like a lot. For example, if you got a 46% on a test, and you raise it up to a 56%, you're still failing. 10% can make all the difference in the world in financial terms.

Maxfield: Yeah, 10% is huge. Let me give you some numbers to really back this up. Bank of America has $1.8 trillion worth of earning assets. So, the difference between Bank of America and Wells Fargo in terms of the percentage of their assets that are allocated through loans equates to $11 billion in annual interest income for Bank of America. So, that's basically just free money that, for all intents and purposes, falls to the bottom line after taxes are taken out of the equation. So, the fact that it has to stay so much more liquid than Wells Fargo Dallas is really impacting this bottom line. And the reason it has to stay so much more liquid is because of this thing called the liquidity coverage ratio.

The liquidity coverage ratio basically just tells banks how much cash or high-quality assets they have to hold on their balance sheets.

Lapera: High-quality liquid assets. For our listeners who may be new to investing or finance, liquid means they're easily converted into cash. Before the financial crisis, banks had a much lower threshold for the liquidity coverage ratio, because they just did. No one had to.

Maxfield: That's right. And we've seen this in basically every financial crisis in the past -- one of the main reasons banks fail isn't necessarily for a lack of capital but for lack of liquidity. So, you have depositors that are running on a bank that want their cash very quickly. Well, a bank cannot, as a general rule, transition its assets from loans, government securities, etc., over into cash fast enough to satisfy those runs. 

So, what the regulator saw was, "We need to require banks at all times to hold more liquidity on their balance sheets, and the banks that have to hold the most are universal banks, the ones with trading operations, other types of Wall Street operations, and retail operations." Their liquidity coverage ratio is much higher because the cash outflow under a projected scenario where you have a financial crisis -- they use the same kind of test that they use in the capital, the CCAR process every year, which tests capital standards -- they look at how much liquidity would flow out of a bank under a severely adverse economic scenario. And that's how much a bank has to hold on its balance sheet at any one time.

Lapera: Right. So, if you think about it, a retail bank, which is a bank that specializes in taking deposits and putting them back out again as loans, the likelihood of them losing all their capital, because of a bank run is a lot less than people pulling out of the stock market, which is what could happen to a universal bank.

Maxfield: Right. Or, even more importantly, let's say you have your universal bank like Bank of America, and you have a prime brokerage, so you serve hedge funds. Hedge funds keep a lot of money on deposit with you in order to buy and sell securities as opportunities present themselves. Hedge funds are at the cutting edge in terms of knowing what's going on in Wall Street. As soon as they hear there's a problem at a bank, they're going to pull all their money out.

So, that's where that run really starts, whereas retail deposits, with people like you and me -- well, we're a little unique because we follow banks so closely. But the average person doesn't follow banks that closely, so they're not going to know immediately when a bank gets into trouble, so they're not immediately going to run on the bank and pull that money out. So, that's that difference between your Wall Street operations and your retail banking operations from a liquidity perspective.

Lapera: Right. So, now we run into our second hurdle, which is, again, a product of the new regulations that came with the financial crisis, which is capital requirements.

Maxfield: Yeah. Let me give me some numbers to put this in perspective. Going into the financial crisis in 2007, Bank of America was leveraged $9.8 worth of assets for every $1 of equity. That's earning assets. After the financial crisis, that fell to $7.8 of earning assets for every $1 worth of equity. So, the question is, why did Bank of America's leverage fall by 20%? In trying to figure out the answer to this, one thing you can do is ask, did every bank's leverage fall this much? The answer to that is no.

You look at Wells Fargo, it's basically operating with... not exact same, but a very small reduction in leverage relative to where it was before the crisis. It went from $9.5 worth of earning assets for every $1 of equity down to only $9.2 worth of earning assets for every $1 of equity. So, the question is, why is Wells Fargo able to still operate with that much leverage, but Bank of America isn't?

The answer to that is the regulators came in and said, "Look, you large, global, systematically important banks like Bank of America, where you have both retail operations and investment banking operations, you have to hold a lot more capital than more traditional organizations." So, that's where that combination with Merrill Lynch and Bank of America is actually working against Bank of America, even though, when they got into the deal, there was a belief that there would be all these great synergies that would increase profitability.

Lapera: Right. And, again, before the financial crisis, there weren't these kind of stringent requirements on the systemically important financial institutions. I don't even know, did they have that designation before the financial crisis?

Maxfield: No, that's all a new thing as result of the Dodd-Frank Act.

Lapera: That's what I thought. I was also much younger when the financial crisis occurred, so I don't think I was following banks nearly as closely as I am now.

So, the third thing is, you would think Bank of America would be able to, like you said, take advantage of the synergies -- I sound like a consultant now -- between the merger between Merrill Lynch and Bank of America, and leverage that to really profit from it. You're basically sitting here saying, economies of scale, right? Why aren't they making more money? Costco makes more money because they're bigger, and they can pass on savings. It doesn't work that way.

Maxfield: Yeah. One of the main issues is that, going into the crisis, one of the ways that Merrill Lynch made a lot of money was through its trading operations. Well, another part of the post-crisis regulatory regime is that the regulators have really constrained what banks can do when it comes to trading. In 2010, for example, Bank of America earned something like $10 billion worth of revenue from trading, and that was from the Merrill Lynch operations that it had acquired in 2008. Well, last year, it was down to something like $6.5 billion. It decreased something like 36%. 

You have this change in the regulatory regime that basically eviscerates Bank of America -- to a certain extent, large swathes of the Bank of America's trading operations. And it bought Merrill Lynch, thinking, "Oh, the trading operations are so profitable." And now, those trading operations have basically been taken away, and the only reason that banks can trade nowadays, for the most part, is in order to hedge their own risk, to hedge identifiable risks; or two, in order to make a market for clients. That means a bank can no longer trade on its own behalf, which was how they really made money.

Lapera: Yeah. This is part of the Volcker rule, which is, which is a ban on proprietary trading, which is what Maxfield just described. It also prohibits banks from owning or investing in hedge funds or private equity. And it came with a slew of liability limitations. So, it really curtailed the bank's ability to do what banks have been doing before, which is good, in terms of financial stability, but bad in terms of them being able to make money, because, as always, the riskier the proposition, the bigger money you could make.

Maxfield: Right. And here's one other piece to this whole puzzle. Because Wall Street operations, trading, mergers and acquisitions, advisory work, stuff like that, it has a tendency to be much more volatile than just your traditional commercial banking operations like taking deposits and making loans. Because of the enhanced volatility in these types of operations, traders give banks with both types of operations, much lower multiples on their stock. And when a bank has a lower multiple on its stock, if it wants to eventually use that stock to make an acquisition, its money doesn't go as far. So not only is this hurting your profitability at a bank, but it's also impacting a bank's valuation, which impacts its cost of equity.

Lapera: Yeah. Another really interesting aspect to this rule that I was reading about was that, for certain big banks, because of the Volcker rule, some of their top traders just left, because they felt like they couldn't do their jobs anymore. So they went off and started their own hedge funds. It hadn't even occurred to me that it might cause a brain drain from banks.

Maxfield: Yeah. It's been a big deal for banks since the financial crisis, with their trading operations in particular, to your point, leaving banks because they're so heavily constrained, going into hedge funds, which don't have the same type of regulatory oversight.

Lapera: Yeah. Bringing it back, do you think Bank of America will sell Merrill Lynch?

Maxfield: Here's the question about Bank of America and Merrill Lynch. It looks to me, and I would say that a lot of bank analysts would agree, that Bank of America, as it is presently constructed, i.e., as a universal bank with this huge slate of operations, both investment banking operations and retail banking operations, it doesn't look like that combination is going to produce the type of profits that investors are going to expect over the long run. 

So then, the question is, what does Bank of America do about this? Does is basically spin Merrill Lynch Back off? And I don't see that happening, because Merrill Lynch does have really valuable wealth management businesses that Bank of America does benefit from a lot, that are really stable and add to its business, as opposed to subtracting from it. Mostly likely, you would think it would keep those wealth management operations. 

The question is, what will it do with those Wall Street operations? Does it just continue to slog along and hope things turn around eventually? Does is shut those down? Does it spin those off to another bank or to a competitor? That's the big question. But I would certainly say that, if Bank of America's profitability does not improve, and because of the regulatory constraints around these things, and the way Bank of America is built, it looks like it's going to have a hard time earning the same type of money as Wells Fargo. And at that point, I mean, two years or five years from now, we'll be more than a decade past the financial crisis. If Bank of America isn't able to earn that 1% on its assets, I would have a hard time envisioning investors sitting pat and just letting things continue on as they are.

Lapera: Yeah, especially because the bank has talked about increasing efficiencies a lot, now that they're done with all their legal woes. Well, for the most part, they're done with all their legal woes. I think they're probably going to start looking internally and seeing what cost-cutting measures they can take. They've already started doing it. This might just be a natural progression of that.

Maxfield: Yeah. Under Project BAC, they've cut over $8 billion in annual expenses on a yearly basis. But you can only cut expenses so far. The problem at Bank of America really is no longer about expenses. The problem now is about revenue. How will it generate more revenue?

Lapera: What do you think should be our final investing takeaway for this episode?

Maxfield: To be honest, I think there's two. First of all, I'm a shareholder of Bank of America. It's actually me and my wife's biggest position. So I'm actually pretty bullish on Bank of America. But the question is, how is the value in that investment going to be unlocked? If they do spin off a piece of Merrill Lynch, and if the two different pieces can get higher valuations than each of their respective stocks, there could be a lot of value created in that. So, I think that is a very potential likelihood.

The other potential is on the downside. If they can't get things to turn around, to a certain extent, investors are going to bid the stock price down even further, which is crazy to think about when it's already trading for something like a 35% discount to its book value.

Lapera: Right. So basically, keep your ears perked for any kind of information on Bank of America and Merrill Lynch. Thank you guys very much for joining us. Thank you, Austin, for mixing sound behind the glass back there. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at, or by tweeting us @MFIndustryFocus. Let us know if you have any questions, because we're doing a mailbag episode eventually. Maybe you're curious about the debacle that's going on at Lending Club right now, or why the heck chip cards take so long to process. Whatever your question is, please email us. Thank you for joining us, and I hope everyone has a great week!

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