With the surprising news from this weekend that Bank of America has decided to purchase Wall Street investment firm Merrill Lynch, some of the financial thunder has been stolen away from Lehman Brothers. But Lehman and Merrill are two of a kind, and the collapse of both firms in the space of a few days indicates how much confidence has been lost in any firm that took on great exposures to the subprime mortgage market.



The history of Merrill Lynch in the US housing market goes back decades further than the subprime mortgage crisis, though. During the 1980s, as Savings and Loans (S&Ls) were deregulated, Wall Street firms financed some of the frauds that resulted in the collapse of the S&L industry. Deregulation allowed S&Ls to accept brokered deposits where a large investment banking firm would package together accounts of $100,000. They then send these funds to regional Savings and Loans that were searching for funding for commercial real estate projects. Merrill was one of the largest deposit brokers on Wall Street.

In the midst of the post 9/11 American housing market recovery, Wall Street firms were buying billions of dollars of subprime loans from nonbank lenders. By the end of the bubble in housing and subprime lending, Merrill Lynch was one of the two largest firms (along with Citigroup) issuing Collateralized Debt Obligations (CDOs). After purchasing loans from mortgage originators, they would be packaged into Asset Backed Securities (ABSs) and sliced up according to risk. The riskiest parts of several packages would then be grouped together and further securitized into CDOs, and then sold to end investors around the world.

Merrill Lynch and the other Wall Street firms would, of course, generate commissions on every step of the process. Warehouse lines of credit were offered to subprime mortgage lenders in order to make loans to the public. Once the mortgages had been originated, the investment firms would purchase packages of the loans from the originators and securitize them.

However, Merrill took the process another step and actually provided loans to investors to buy their CDOs once they had been securitized. Most of the money on both ends of the transaction came from the Wall Street firm, increasing their exposure to the subprime industry by orders of magnitude. The firm would buy subprime loans from nonbank institutions it offered lines of credit to, securitize them into ABSs, create CDOs out of the riskier portions of the ABSs, then provide more loans to investors to purchase the bonds.

As one of the largest and most prestigious investment firms on Wall Street, Merrill Lynch could also aggressively target the subprime market. The banking giant paid more for loans than any other Wall Street firm, paying higher premiums for subprime than any other investor. As well, it would offer cheap warehouse lines of credit to nonbanks to make loans as long as they then sold the mortgages to Merrill for securitization.

The only piece of the total subprime puzzle that Merrill was lacking by the end of the housing bubble was owning its own origination company. Although it had been interested in purchasing New Century, the mortgage company balked at the deal and ended up in bankruptcy. Even by February of 2007, Merrill did not own a subprime lender, so it purchased First Franklin from National City Bank. Since delinquencies were already rising in subprime generally and at First Franklin specifically and concerns were being raised about the long term value of home prices, this was probably not the best business decision the Wall Street firm had made.

Just a year after buying the company, Merrill closed First Franklin in March 2008. From operating a trading desk where it would compete with Fannie Mae and Freddie Mac in the secondary market as buyers of unsecuritized whole mortgages to only funding subprime loans through First Franklin that could be sold to Fannie/Freddie, Merrill's origination and securitization business had made a 180 degree turn.

Soon after its ill-fated purchase of First Franklin, it was clear that Merrill had begun to see the writing on the subprime wall. The Bear Stearns hedge funds that collapsed in August 2007 had borrowed $850 million from Merrill Lynch in order to purchase more subprime mortgage bonds. Before the collapse, in Spring 2007, the firm issued a margin call to Bear Stearns and then took control of $850 million in bonds as the hedge funds could not meet the calls. A few months later, the hedge funds collapsed and the credit crisis began in the American and then the world financial markets.

Flash forward to this past weekend, and, amidst the attempts to keep Lehman Brothers solvent, Bank of America purchased Merrill Lynch. Now the largest commercial Savings and Loan in the United States, BofA, which just purchased the largest mortgage originator, Countrywide, is consolidating further by purchasing its very own Wall Street investment firm, Merrill Lynch. In effect, the entire subprime scam can be operated from within one corporation, from Merrill lending money to Countrywide to give loans to unsuspecting homeowners, to Countrywide selling the loans back to Merrill, to Merrill offering CDOs to BofA investment funds and depositors.