As Merrill Lynch announced that it will be taking additional write-downs of at least $5.7bn in the third-quarter (talking the firm's writedown total to a massive $46bn since the credit crisis began last year), management and staff over at Merrill are left to reflect on a decision made by senior officials of their firm last summer which directly affected the viability of two Bear Stearns hedge funds (and ultimately the future of Bear Stearns itself), and, more significantly, caused Merrill itself to sustain huge losses and severe capital adequacy problems. This decision was perhaps the worst ever made by anyone at an investment bank. Here's the story, originally flagged up by Bloomberg earlier this year.

Merrill Lynch and Bear Stearns enjoyed strong ties, and a close business relationship. Merrill had been selling hundreds of millions of dollars in CDOs to two Bear-managed hedge funds, the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leveraged Fund. Now the hedge funds basically purchased these CDOs on credit, with Merrill effectively lending 90% of the value to the funds against the security of the value of the CDOs themselves.

Problems first surfaced in June last year, when the value of the Bear hedge funds' CDOs started to fall, and Merrill demanded that the funds provide more collateral to secure their credit line, or sell assets to reduce the debt. Bear executives are said to have pleaded for more time, pointing out a forced sale of their CDOs to raise cash at this stage would simply push the prices of all CDOs, included others held by Merrill, down. Merrill executives are said not to have listened, and on the 15th June 2007 seized $850m of CDO assets from the Bear-managed funds (something it was legally entitled to do), and tried to sell them on the open market.

After receiving offers of only 20 cents on the dollar, Merrill gave up its efforts. It was too late for the Bear-run hedge funds, however, as other creditors followed Merrill's lead and pressured Bear to pay down credit lines. In July, after selling $3.8bn of CDOs at knocked-down prices, the funds declared bankruptcy, with investors losing $1.6bn. But, more importantly, this episode set off a chain-reaction which resulted in the general re-pricing of CDOs - and among them were $23bn in Merrill's own portfolio. The result was a $7.9bn third-quarter write-down for Merrill - and that was just the start of it. The upshot of this tremendously short-sighted decision was, of course, huge losses, liquidity problems, job cuts and a firm in crisis.

Bloomberg has quoted William Fitzpatrick, from Optique Capital Management, who said that although 'the end was inevitable....Merrill could maybe have bought some time if it hadn't blown the whistle on the Bear funds..........It was in Merrill's interest to wait it out and allow the Bear Stearns funds to recapitalize, so they wouldn't have to re-price their assets. And Merrill could have used that time to reduce its CDO portfolio, or buy hedges against it'. It didn't, and the rest is history (like Bear Stearns).

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