This is a complex but interesting case that covers three topics in great detail: fair value; the fair value option, and; segment disclosures. Those disclosures are closely related in the case. Although complex, they do let students understand why Merrill Lynch collapsed and understand how to value Merrill after the collapse.
The FASB issued new reporting rules for fair value and the fair value option that were required for 2008, but firms could elect early adoption for 2007. Merrill Lynch and most other large financial institutions elected early adoption, so this case includes highly detailed fair value and fair value option disclosures just as the sub-prime mortgage market collapsed.
The case includes Merrill’s financial statements and selected notes from its June 30, 2007, 10-Q and from its December 31, 2008, 10-K. That lets students understand what occurred during the 18-month period when Merrill Lynch went from the world’s largest and most valuable brokerage firm to a bankruptcy that was prevented by an apparently government-forced acquisition by BankAmerica.
The case includes three notes for each time period: fair value, fair value options, and segment disclosures. The fair value notes help students understand the value and limitation of fair value disclosures. One problem is that Merrill Lynch suffered about $70-80 billion of losses from its sub-prime mortgage investments, but reported those as Level 2 investments, not Level 3 investments. As a result, investors probably believed that most of Merrill’s reported fair value numbers were relatively objective and were unlikely to decline by much. The fair value notes can show that the detailed loss and gain reporting for Level 3 assets is highly misleading. Level 3 gains or losses are often offsets to hedges that include securities classified as Level 1 or Level 2 securities, so a major Level 3 reported gain or loss is meaningless. A major Level 3 reported gain could have been hedged with a Level 2 investment; the net effect could have been a nearly complete offset of gains and losses, or a net loss.
The fair value option notes also show that when Merrill adopted the fair value option rules, it elected the fair value option for some available-for-sale securities with unrecognized losses. That let Merrill transfer the unrecognized losses directly to owners’ equity without first recording the losses on its income statement.
The fair value option notes also show that Merrill elected the fair value option for some of its outstanding debt. When Merrill reported major investment losses, and the market value of its debt plummeted, Merrill was required to debit bonds payable so its bonds were reported at fair value. The offsetting credit was to a gain account. Many interested parties criticized the proposed FASB fair value option rule for a firm’s own debt for exactly that reason—it let firms in financial difficulty, with no ability to repurchase outstanding debt, record a gain on that debt as the firm collapsed.
Students can also estimate the profitability by business segment for the 18 month period from June 30, 2007, to December 31, 2008. Merrill has four major business segments: retail and institutional brokerage; investment banking; investment management, including mutual funds, and; proprietary trading. During that period the first three business segments remained highly profitable, although they were generally less profitable than prior to the recession. After expenses, Merrill’s proprietary trading group probably lost about $80 billion.