(FORTUNE Magazine) – ON A WARM spring afternoon, the scent of freshly mowed grass fills the air at Merrill Lynch's Princeton, New Jersey, corporate campus. It wafts in the open office windows of Chief Executive William A. Schreyer, who, springlike, fairly exudes optimism about his company: ''The future is now,'' says the 60-year-old Schreyer. ''I intend to go out on a high. I'm not going to wiggle-waggle my way through the next five years.'' He predicts that over that period Merrill will earn a return on stockholders' equity of at least 15%. A tough mark for Schreyer to hit. In four of the past five years, during a raging bull market, the company failed to achieve that 15% return. Its retail brokerage operation -- the famous thundering herd that accounted for about two-thirds of Merrill's $11 billion in revenues last year -- has steadily lost market share even as its profit margins eroded. The effort to build an investment banking division has had spectacular successes, an equally spectacular disaster, and a continuing inability to control costs. The future may indeed be now, but perhaps not in the sense that Bill Schreyer intended. Mention his predictions to Donald Regan, former Secretary of the Treasury and Merrill's chief executive back in its glory days of the 1970s, and back comes a blast addressed to the company's current management: ''How long does it take to get your act together?'' he asks. ''You guys have had over three years. To use a hockey metaphor, the puck is on the ice.'' The implied message is clear: Schreyer's team had better start scoring goals soon or it won't be on the ice much longer. A Merrill spokesman argues that Regan has been away from the business eight years. He says, ''Current management does have its act together.'' Still, in the assessment of an investment banker: ''If Merrill has a few losing quarters and the stock tanks, then Daiwa or Nomura could gobble it up in a second.'' The shares recently sold for $23, vs. a high of $41.50 in August 1987. What happened? How could Merrill Lynch -- a household name in America, the firm that brought Wall Street to Main Street -- be brought to a state where its managerial excellence was even debated?

Responsibility begins with the dreams of Don Regan. ''My hope was to see Merrill become a diversified financial services company,'' he says. ''I believed that skilled management could control all phases of the business so that each area would be profitable on its own.'' Toward that end, in the early Seventies he began moving the firm away from reliance on its traditional strength, selling stocks and bonds at retail. Regan correctly feared that the coming of discount brokers would mean thinner profit margins in the brokerage business. He also discerned that the securities industry would be increasingly dominated by institutional investors and companies doing deals. Regan aimed to grab a larger share of the new markets for Merrill. His idea to take the company deeper into investment banking seemed plausible enough. Merrill would underwrite securities for corporations, and then sell them to retail customers through its branch office network. In 1978, Regan served notice of his intentions by snapping up the investment banking house of White Weld. The acquisition of that venerable firm gave Merrill's thrust into investment banking a bit of pedigree and brought with it dozens of skilled investment bankers, traders, and research analysts. Soon Merrill had in place the pieces for its so-called capital markets division: departments devoted to mergers and acquisitions, underwriting, block trading, and institutional sales and research. By 1980, Regan was feeling pretty happy about his move. Investment banking revenues were $271 million, 96% higher than 1978, with a big share coming from the underwriting of bond funds. Says Regan: ''We were poised to make a lot of money. We had momentum. Reasonable control over expenses. An excellent back office. And management was in place.'' LOOKING at the figures, it's hard to dispute this. In 1980, Merrill achieved record results -- $3 billion in revenues, $203 million in profits, and a 21% return on equity. On that high note, Regan quit to become Secretary of the Treasury. He had long dreamed of a Cabinet seat and already owned a home in Virginia near Mount Vernon, just a few miles from the White House. Regan left in charge his longtime No. 2, Roger Birk, then 50. Bright, scrupulously ethical, Birk had saved Merrill's back office in the Sixties when paperwork threatened to swamp operations. But in the top job, his attention to detail manifested itself mostly as paralyzing indecision and an inability to step back and see the larger issues. Regan's sharply etched vision for the company began to slip out of focus. In the 1981 annual report, Birk summarized his strategy thus: ''Whatever direction the financial services industry may take, Merrill Lynch will be in front.'' Oddly, for all of Birk's obsession with detail, Merrill was slowly losing its grip on costs. From 1982 through 1984, revenues increased 20%, but expenses mounted by 33%, as Merrill expanded into everything from commercial lending in Hong Kong to selling life insurance in the U.S. Some of the biggest cost increases came in investment banking. Led by two former retail brokers, the unit added people at a frenetic pace. Overall, the company's head count swelled from 37,900 to 44,000 from 1982 to 1985. Observes a former chief financial officer: ''Nobody wanted to hear about cost cutting. They explained all the spending as being for the future.'' Four years after Birk took over, the firm seemed headed for its first annual loss in history. As costs exploded, brokerage commissions stagnated and investment banking fees fell. Only the decision by Birk and then second-in- command Schreyer to sell Merrill's Wall Street headquarters and book a $127 $ million capital gain kept the company out of the red. As it was, in 1984 Merrill earned a slim $95 million on revenues of $6 billion, for an embarrassing 4.6% return on equity. MERRILL needed help. Birk was suffering from sleepless nights, which did nothing to improve the speed of his decision-making. Increasingly he delegated matters to Bill Schreyer, who had been overseeing the bulk of Merrill's business since 1978, when he became chief operating officer of both the retail brokerage and growing investment bank. Everyone liked Schreyer, a smiling, backslapping son of a former manager of Merrill's branch in Williamsport, Pennsylvania. The only knock against him, insiders say, was that he was too nice, too much of an old boy to shake up his colleagues. Schreyer turned for assistance to McKinsey & Co., the management-consulting firm, to find ways to cut costs. ''Let's let McKinsey be the lightning rod,'' Schreyer recalls thinking to himself. The consultants' six-month study revealed that Merrill needed far more than corporate liposuction. It made clear what most people at the company already knew -- that Merrill lacked strategic direction and was poorly organized. Most important, the study resulted in the first economic map of Merrill, whereon every expense was allocated to a product or service. The consultants uncovered a ton of hidden costs. Schreyer emerged from the study with a plan to revamp the firm. Merrill would be rearranged into three separate businesses within a holding company: a U.S. retail brokerage; a much expanded capital markets group; and an international division that would be part brokerage and part investment bank. Each unit was to focus on a particular set of clients: retail on individual investors in the U.S; capital markets on institutional investors and corporations issuing securities; and international on overseas investors and issuers. In a sense the plan was too much for Birk. Over the Memorial Day weekend in 1984, Schreyer presented his agenda for the future to his boss in private. According to Schreyer, the CEO responded, ''Look, I want to retire at age 55. That's a year from now. I think you've got the thing pretty well figured out. I'm going to have to stay far longer than I want to if the job's going to get done.'' Schreyer says that he neither urged his boss to quit nor argued against his leaving. ''He had said before that maybe he wanted to do nothing for a while,'' recalls Schreyer. ''And I said, 'If you're sure, let's sit down and do it.' '' So they did. A month later, in June, Birk announced that he was stepping down as CEO and kicking himself upstairs to become chairman of the board for the next year. No sooner was the crown placed on Schreyer's head than he received a shock -- to his heart. ''I'm out in Chicago,'' he recalls, ''entertaining clients, playing tennis. My partner is Marty Riessen, the former doubles champion. Near the end of the second set, I get a little chest pain.'' The ache was acute angina. Schreyer's doctor scheduled him for a triple-bypass operation. A bit ominously, the surgery, scheduled to be performed on November 1, All Saints' Day, was postponed by the hospital until November 2, All Souls' Day. Schreyer remembers Birk saying to him, ''Don't die on me, you son of a bitch.'' After the operation, Schreyer spent two months away from Merrill headquarters recuperating. In his absence, his top subordinates began fighting among themselves over how to cut costs to meet the plan. The chief administrative officer, Robert Rittereiser, wanted to fire brokers and bankers. Daniel Tully, then head of those units, vehemently opposed the idea. Not coincidently, Rittereiser and Tully were both jockeying to become Schreyer's chief operating officer. From afar, Schreyer watched the high-level tussle with growing annoyance. ''Being away,'' he says, ''gave me a chance to see who I could count on.'' UPON HIS RETURN in January 1985, he decided that he did not want to count on Rittereiser. He thought Rittereiser had overreached himself by pressing for Merrill to severely prune its retail brokerage, which Schreyer, the branch manager's son, loved as much or more than anyone else at the firm. Says Schreyer: ''I told him that what I wanted was a chief administrative officer, not a crown prince.'' No jaws dropped when Rittereiser quit Merrill in June 1985 to become president of E.F. Hutton. Schreyer quickly tapped Tully, a bluff 6-foot 3-inch former broker, to become chief operating officer. Within months Schreyer assembled the rest of his team. John L. (Launny) Steffens, now 46, national sales director and a Tully protege, took over the consumer markets division. Jerry Kenney, another relative youngster at 46, remained head of capital markets. He had come aboard when Merrill bought White Weld, where he had been director of research. Abandoning Merrill's tradition of promoting exclusively from within, Schreyer imported a new chief financial officer from Detroit -- General Motors' & Courtney Jones, 48. Schreyer reasoned that someone who could design cost controls for GM could do the same for Merrill. How has the new lineup done in the last three years? Merrill's retail brokerage has fallen short of security analysts' expectations. Says one: ''You would have thought that having the most valuable distribution network on the face of the earth would be an incredible advantage in a bull market.'' But Merrill's brokerage profits remain resolutely average, an estimated 10% return on the capital invested in the business. Brokerage headman Launny Steffens has taken steps to improve profitability. He lessened Merrill's reliance on commissions from stock and bond trades by increasing fees earned managing the mutual funds the firm runs for its customers. So-called asset-management income has two advantages. The profit margin averages 35%, and the business takes less of a hit than retail stock trading in a bear market. Assets under Merrill management climbed from $48.1 billion in 1984 to $84 billion by the end of 1987, a feat unequaled by any other securities firm. Steffens also boosted revenues by introducing a raft of new products. For example, in 1986 Merrill sold $648 million of insurance, mostly variable life and single-premium whole life policies. That was 278% more than 1984. But not even Steffens's yeomanly job could return the retail brokerage to the high-profit days of the Seventies, when the return on capital hovered around 20%. No matter how much he goosed revenues each year, his costs rose as fast. Says Sanford C. Bernstein & Co. stock analyst Michael Goldstein: ''Even good managers can't dramatically improve retail margins. A full-service brokerage is a high-cost business.'' Meanwhile, over in capital markets, Jerry Kenney faced a different set of challenges. He managed to jack up revenues, albeit less than Steffens. Investment banking income rose to $996 million by year-end 1987, a not at all shabby 71% above 1984. Debt and equity underwriting grew 284%. Most dramatically, mergers and acquisitions activity increased 159% over the year before. But bigger was not necessarily more profitable. While Kenney created an investment bank whose revenues are in the same league as other big houses, its profits remain smaller than those of its principal competitors. For instance, compare Merrill's performance with Salomon Brothers, which in the Eighties bounded into investment banking from its traditional niche as the master trading house. Mike Goldstein estimates that from 1985 to 1987, Salomon's average profit margin in investment banking was 33%. Merrill barely earned anything. Kenny's strategy now appears to have been flawed from the beginning. Merrill, the high-cost firm, could not profitably gain market share by cutting prices. He underestimated the price of hiring hundreds of new people to compete with the old-line investment banks. Today, Kenney concedes that Merrill's foray into capital markets has cost the shareholders ''a couple of points or more of return on equity a year.'' KENNY WOULD have had even worse results if his mergers and acquisitions team hadn't started hitting homers in 1985. Three of the company's smartest investment bankers came up with a way to increase Merrill's involvement in the mergers and acquisitions game. Barry Friedberg, Kenneth Miller, and Robert Mancuso decided to use Merrill's balance sheet as a substitute for its lack of reputation: They pioneered the bridge loan -- short-term financing for dealmakers intent on leveraged buyouts. Would-be acquirers loved it. In the next 12 months Merrill more than doubled its mergers and acquisitions business. Last year was even better, despite copycat efforts from other investment banks: Using bridge loans, Merrill completed two of the biggest leveraged buyouts ever. The LBOs took Borg-Warner private for $4.8 billion, and Supermarkets General for $2 billion. The fees rolled in, an estimated $128 million on those two transactions alone. Fat city. Unfortunately, the capital markets group made mistakes in other parts of its business that virtually wiped out these gains. Only days before Easter 1987, Kenney was rocked by the news that a 32-year-old trader had lost upwards of $350 million on a bad bet in the mortgage-backed securities market. The trader, Howard Rubin, bet that prices were headed higher. He was wrong. But instead of taking his initial loss, estimated to have been around $50 million, Rubin tried to recoup by doubling his wager -- this time without asking anybody's permission. Says a still-fuming top Merrill executive: ''I hope he goes to jail for hiding his trading tickets from us.'' Rubin's lawyer notes, however, that no criminal charges have been filed against his client, who, he says, ''acted properly.'' An expert on trading, called in by Merrill to help it avoid similar debacles, observes that there's plenty of blame to go around: ''The biggest reason for the loss was that the managers didn't understand the volatile nature of the mortgage obligations that the trader had in his portfolio. They were ignorant.'' While other Wall Street firms lost money trading last year, Merrill dropped the most by far. Because of the April loss, Merrill's 1987 operating income before extraordinary items and taxes plunged 45% compared with the year before. Says Don Regan: ''They are discounters in an upscale business. This means high volume and low margins. Unfortunately, those profits can be wiped out by one huge loss like the trading mess.'' Meanwhile, Merrill's London-based investment bankers have been losing their Turnbull & Asser shirts in Western Europe. Schreyer rolled the international division into the capital markets group in 1986. In trying to build Merrill's global presence, Kenney hired too many dealmakers who underwrote more stocks and bonds than Merrill's institutional brokers could sell to their clients at a profit. Since London accounts for over 50% of the international operation's costs and almost 50% of revenues, as it goes so goes the entire overseas unit. The barons running Merrill's London operation appear to have gone off in the wrong direction at first. Says Kenney: ''They tried to compete head-on against European investment firms on their home turf. We have refocused the business toward cross-border transactions where our global origination and distribution capabilities are tops.'' Still, according to a top Merrill capital markets executive, the international group continues to lose money at the rate of $50 million a year. A Merrill spokesman denies this and, without disclosing figures, says the division is profitable. With the stock market in the doldrums and just about everybody's brokerage operation hard hit, 1988 is treating Merrill even worse than 1987. In the first quarter, revenues dropped 5% compared with the same period in 1987. Commissions for the retail brokerage sank 32%. Pretax earnings plunged 59%. Particularly troubling has been Merrill's slump in mergers and acquisitions. Merrill has not been doing the big deals of late. An ex-Merrill investment banker explains, ''Their M&A business is dependent on bridge loans, but now everyone can offer a bridge if they need to. That's why Merrill's been nowhere in that business in 1988 when it is hot as hell.'' Some big producers, including Mancuso and Miller, have already split. Says a recently departed investment banker: ''Frankly, I left because it's worrisome when senior management does not understand one of the two main businesses. It does not inspire confidence that big mistakes will be avoided.'' Merrill still has a cost-control problem. Despite Schreyer's much ballyhooed elimination of 2,800 jobs in 1984 and the impressive cost-allocation system designed by CFO Jones, the number of people on the payroll suggests that management hasn't made the cuts stick. ''We had 44,000 employees in early 1985,'' recalls a former Merrill executive. ''By 1987, they had almost 47,000. That's managerial progress?'' Since the panic of October 19, Merrill has laid off about 3,000 people, which brings the roster back to 1985's 44,000. An investment banker who left the company comments, ''Sometimes, you have to be ruthless about laying people off. They're not.'' A former member of the board says, ''I could run a small Latin American country on what Merrill could save if they knew how.'' A company spokesman responds, ''We've put in place new financial information and control systems to better understand and control costs.'' Schreyer and Tully have no intention of backing off their plan to be the biggest brokerage and investment bank. Says Tully: ''I think it is and was and will be the correct strategy.'' They argue that it's still too early to know how successful the plan will be. Tully notes that he and his compatriots ''all sing the Optimist Creed,'' a piece of inspirational wisdom that includes avowals ''to look at the sunny side of everything and make your optimism come true . . .'' He has enshrined a written recitation of the faith over the john in his executive bathroom. Most security analysts don't share the optimism. A research analyst who covers the company asks, ''Management screwed up in the bull market. Why should they do better now that we have a bear market?'' The analysts say that the extent of Merrill's future woes will depend on how many of its businesses turn down simultaneously. The latest quarterly income statement suggests that most have. Regrettably, fixed costs haven't. That could result in Merrill's first yearly loss ever. Further out, Merrill's prospects don't look bright. As Glass-Steagall gets chipped away, commercial banks will attack with a vengeance. And Merrill will still be competing against its traditional Wall Street rivals who run more tightly focused operations. Says Harvard business school professor Robert G. Eccles, co-author of a forthcoming book on investment banks: ''In any one of ( Merrill's 125 businesses, there will be at least two other firms that will kill to do well.'' The big question now is whether top management can prevent further slippage. Don Regan has reservations. ''We're in a changing financial world. The banks are coming in, and they will have their Third World loans behind them,'' he says. ''If Merrill tries to stand alone against those forces, it will be mediocre in the 1990s. Morgan, Chase, and others will bid away its securities business. Then what will management do?'' THE FORMER CEO argues that Merrill must merge with a commercial bank or some other large financial services company. ''It would give the firm a hell of a competitive edge in servicing the full range of corporations' financial needs,'' he says. ''Merrill is not smart enough to start lending money de novo.'' Regan has a few prospective buyers in mind. They include Morgan Guaranty and -- hold on to your hats -- General Motors Acceptance Corp. Is he trying to put his old firm in play? Its stock sold recently at 80% of book value. Regan will only say, ''This is a matter for management and the board.'' Schreyer replies, ''Right now our determination is to remain fiercely independent.'' But can they?

CHART: NOT AVAILABLE CREDIT: SOURCE: IDD INFORMATION SERVICES CAPTION: This year Merrill underwrote more stock and bond issues than anybody else..... DESCRIPTION: Two charts comparing the number of stock and bond issues sold in 1987 and 1988 by Merrill Lynch and five other leading underwriters.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: .....but in overall profitability, it remains a laggard. Profitability figures for the first quarter of 1988 are annualized and don't reflect seasonal variations in the business. All other numbers are annual figures. DESCRIPTION: Two charts showing profit margins from 1983 through first quarter 1988 and indicating profits as a percentage of stockholder's equity for the same period registered by Merrill Lynch and four other underwriters.