BofA-Merrill Merger: Still a Good Idea

Hailed as a brilliant move in September, Bank of America’s purchase of Merrill Lynch is now widely regarded as a debacle. Yet the initial reasoning behind the deal remains intact despite the challenges.

Bad news came from several fronts in the past week or so.  Merrill reported a larger than expected loss for the fourth quarter and revealed financial-reporting weaknesses that caused it to understate losses by around half a billion dollars. New York State Attorney General Andrew Cuomo subpoenaed BofA chief executive Kenneth Lewis. Prosecutors questioned former Merrill leader John Thain about bonuses. The fear that BofA and Citigroup will be nationalized spooked bank stocks. These developments came on top of doubts as to how successfully Merrill’s swashbuckling investment bankers and traders can work within BofA’s fussier culture.

Let’s first dispose of the notion of culture clash. Investment bankers are no longer in a position to swagger for the simple reason that the merger and acquisition boom in which they thrived depended on easy credit. As the credit bubble deflated, so did the M&A boom. This new fact of life is not specific to Merrill, of course. Incidentally, investors such as  endowments are trying to get out of their private-equity commitments because prospects for leveraged buy-outs look pallid.

Another part of the investment bank, proprietary desk trading, was capable of lassoing huge profits as long as the trades could be geared up. But no bank can do that anymore.  Yes, there are still (smaller) deals and prop trading, but the cycle has turned and these activities are no longer the great money-making engines that sidelined more traditional functions.

We come to the key reason Mr. Lewis presumably made the deal in the first place-he believed Merrill’s “thundering herd” of broker-financial advisors, integrated with BofA retail branches, would boost sales.  The market for advisory services is up for grabs. Retail investors, hit by huge losses, are said to be  looking for better professional advice. Some have fired their advisor and seek a replacement.

Demand for financial advisors is likely to remain strong in years to come as investors seek to shore up their nest eggs. The BofA franchise, combining Merill’s far-flung network of local brokers with a top retail bank brand, is more likely than competitors to emerge as a winner in this mom-and-pop mainstay of financial services. On that basis the merger plan makes sense, whether or not Mr. Lewis continues to head the transformation.

True, Merrill rises and falls with its symbol the bull, so a stagnant or sinking stock market is a big threat to its business model.  But right now there aren’t too many options for banks regardless of what happens to the market. They’re certainly not going to make a lot of money by collateralizing debt obligations any time soon.

What about the threat of nationalization?  Let’s consider Federal Reserve Chair Ben Bernanke’s comment: One goal of the Treasury’s bank program is to ensure that banks don’t lose their franchise value and that is why the government won’t attempt to take complete control of them. Bernanke described banks like Bof A as having substantial franchise value.

Under current conditions, a retail-broker network uniting two big names looks better than most other financial services — an excellent reason not to nationalize it.