Merrill Offering Rate Discounts to Win Mortgages

Merrill Lynch

Merrill Lynch got stung so badly by holding sub-prime mortgages that they almost went out of business. This time around though, they are eyeing the cream of the crop.

Merrill Lynch once lost almost $19.2 billion in just 12 months in the mortgage market, and was among the biggest losers in the subprime mortgage crisis. Mortgages gone bad nearly brought down this venerable brokerage and nearly wiped out almost a hundred years of company success.

Once the subprime mortgage market started to tank, this left Merrill with a very high level of exposure, and with a position of the size that they held, there really wasn’t a good way to handle this and have the company not taking a huge hit.

It is not that Merrill Lynch didn’t try, but with such systemic risk, you can sell some of the risk through credit default swaps, which is like buying insurance against this, but if the house comes down, they will too and won’t be able to cover their obligations either.

This is exactly what happened, and insurance company MBIA ended up suing Merrill for, among other things, misrepresenting the risk of the credit default swap contracts that they bought from MBIA, classifying them as AAA investments.

As we know, this was as far from the truth as you could get with these collateralized debt obligations, but this is what you can get when you have an investment broker and an insurance company venturing into the complex world of financial derivatives.

If we looked into what sort of debt obligations were being passed around here, we would have seen how seedy a lot of this debt was. The housing bubble didn’t burst because it just went up too much, and we’ve gone quite a bit higher than this these days. It was because they figured out a way to mix in a lot of garbage into what have been traditionally a very solid and conservative investment, when mortgage debt was of much higher quality and merited the AAA ratings that it would receive.

How A Normally First-Class Investment Became Poisoned

This mixture of good mortgages and terrible ones were passed off by Merrill as AAA as well, which MBIA took Merrill to court over and were awarded damages for misrepresenting this risk and therefore breaching their contract. While we would think that an insurance company would do their due diligence and would have discovered the true nature of these investments, people just kept telling themselves that these were collateralized, not appreciating what would happen if the collateral became devalued greatly from a price crash.

From a banking perspective, mortgages at best represent a fair potential for risk, at least the way we sell them. If we required far bigger down payments, this could be reduced a lot, but then you’re turning away a whole lot of business, almost all of it in fact. Subprime mortgages, especially the extremely sub-prime ones that were being sold in that time, can be managed in theory at least, provided that they were treated as such and the risk was transparent.

What securitization brought to us is the opportunity to co-mingle the bad mortgages with the good ones, and therefore hide the risk from lenders. While any bank with any sense of risk wouldn’t have touched a lot of these applicants, including people who did not even have a job, if you can put them together in securities and sell this debt to the public, and pass this all off as a very low risk investment, a lot of people can get fooled.

Given that Merrill Lynch has built its business on catering to the other end of the spectrum, the very well-off, it is even more ironic that they were brought to their knees by essentially lending a huge amount of money to those on the financial fringe, who were set up with mortgages that they did not have even a reasonable expectation of being able to pay back.

This was all more like a Ponzi scheme than anything. If housing prices kept going up at the same pace, lenders could just keep lending them money to make their payments, but this could not have continued forever, and once things stopped going up in this scenario, the whole thing was doomed to crash.

Merrill Goes Back to Being Merrill, Sort Of

After being bailed out by Bank of America, Merrill Lynch went back to their strength, wealth management, and left the banking to the bankers, and now settling for being just a division of the bank, who have rebranded the company as just Merrill not long ago.

Although Bank of America has its own wealth management division, the name of Merrill has not been so tarnished as to be a liability for those who are willing to forget their debacle and look at the sum of over a century of providing investment advice and brokerage services to their clients.

While a lot of higher wealth clients may not need to hold a mortgage, a lot of people look to mortgage rates and average returns on investments and decide that they will use a sort of arbitrage here, investing money they would have otherwise used to pay debt and look to pocket the difference.

We’ve been in a strong bull market ever since the dust settled with the housing crisis, which is approaching its 10th anniversary, and therefore this spread has been a very nice one, at least so far. Investors do need to be aware though that when this does come to an end, this completely alters the dynamic here, where people will be faced with paying the rates to essentially borrow the money to invest, and lose on the investments on top of this.

We’re not there yet though, and the culture of investing, where it’s seen as wise to both borrow and invest discretionary funds, still remains strong, and will probably take quite a bit of a hit to get people off of this thinking.

This presents some cross-selling opportunities between the institutions, where Merrill has clients with what we could call super-prime mortgages, clients who both hold a mortgage and significant liquid assets to augment the collateral of their homes, with mortgages held elsewhere, and Bank of America has been eyeing this business more lately.

Merrill has now rolled out a program of rate discounts on Bank of America mortgages, offering 50 basis points to those who have investments with them of $500,000 or more, with lesser discounts for those who have at least $250,000 with the firm, as well as reductions in closing costs and other lender fees.

This has only been rolled out in 7 states so far, but this includes some big ones such as California and New York, as well as New Jersey, Florida, Connecticut, Washington, and Oregon. The possibility exists that the institutions will look to expand this should the deal work out well enough in their favor in these test states.

We do need to realize though that preferential pricing is nothing new to the mortgage lending market, and in fact, lenders are famous for inflating their posted rates so that they will appear to getting a bigger discount, much like car dealers do.

Still though, a discount as big as this is a pretty significant one, although, in the end, it is not where the rate has come from, it is where it ends up relative to what competitors are offering. Some people shop for rate a lot, others may not rate shop at all, and the more conservative clientele of Merrill are probably more of the sort that won’t look around too much and therefore view the rate reduction as a pure benefit.

It does make sense to offer bigger discounts to clients like this, as there are risk premiums built into mortgage rates, and these clients would merit a smaller one. Driving clients to bring more of their investments over to Merrill to meet these thresholds is also part of this deal.

Whether or not people want to be doing this right now, keeping their money in their investments instead of reducing or eliminating their need to borrow is another question, but if you choose this and have your investments with Merrill, and you have enough with them to earn this extra love, and you live in one of these states, they may have a deal for you.