Merrill Lynch Reports Biggest Quarterly Loss in Its 93-Year History

Bradley Keoun
Bloomberg
October 25, 2007

Merrill Lynch & Co. reported the biggest quarterly loss in its 93-year history after taking $8.4 billion of writedowns, almost double the firm’s forecast three weeks ago.

The writedowns on subprime mortgages, asset-backed bonds and leveraged loans led to a third-quarter loss of $2.24 billion, or $2.82 a share, six times more than Merrill estimated on Oct. 5. Chief Executive Officer Stanley O’Neal said today that the New York-based firm may sell assets to shore up its balance sheet.

Merrill’s stock fell the most in five years, its credit rating was cut and the perceived risk of default on the company’s bonds rose after O’Neal said the firm misjudged the severity of the decline in debt markets since July. Investors who lauded the 56-year-old CEO for chasing higher returns as the biggest underwriter of securities backed by subprime loans now question his management. O’Neal said the firm increased the writedown after a more “conservative” analysis of its holdings.

“We’re very disappointed,” said Rose Grant, who helps manage about $2 billion at Eastern Investment Advisors in Boston, including Merrill shares. “I don’t think Stan O’Neal will step down, but you do have to look at top management and wonder why they didn’t know the extent of this loss.”

‘Startling’

Standard & Poor’s, Fitch Ratings and Moody’s Investors Service lowered their assessments of Merrill’s credit. S&P cut its rating on Merrill’s senior unsecured debt to A+ from AA-, describing the quarter’s loss as “startling” and citing “management’s miscues” that raised concern about the firm’s risk controls and business strategy.

Financial stocks sank, led by Merrill, which dropped 5.8 percent to $63.22 in New York Stock Exchange trading. Lehman Brothers Holdings Inc., the largest U.S. underwriter of mortgage bonds, declined 1.5 percent to $57.42. Bear Stearns Cos., the second-biggest, fell 2.3 percent to $113.54.

Merrill’s third-quarter revenue fell 94 percent to $577 million, as losses in the fixed-income division overshadowed gains from underwriting stocks and providing merger advice. At Merrill’s retail brokerage, the nation’s biggest with a network of 16,610 financial advisers who cater to individual investors, revenue climbed 23 percent to $3.27 billion.

O’Neal, on a conference call with analysts, said he was “continuing to resize” the firm’s balance sheet. He also said he’s weighing potential divestitures of “non-core” businesses.

BlackRock Stake

The firm owns stakes in companies including BlackRock Inc., the largest publicly traded U.S. fund manager. Merrill is also a passive minority investor in Bloomberg LP, the parent of Bloomberg News.

The BlackRock stake isn’t for sale, O’Neal said on the call. “We want to own this asset for the foreseeable future,” he said. He declined to comment on other investments.

Merrill’s compensation costs fell by 49 percent from a year earlier to $1.99 billion, indicating that the quarter’s losses may reduce year-end bonuses for some of Merrill’s 64,200 employees. The firm said today that it “remains focused on paying its best performing employees competitively.”

Merrill said its holdings of so-called collateralized debt obligations, or CDOs, along with other securities and loans linked to subprime mortgages, lost $7.9 billion of their value in the quarter. CDOs are bonds created from pools of debt securities and loans.

The size of the writedown increased from $5 billion after Merrill conducted “additional analysis” since the firm’s Oct. 5 announcement, O’Neal said on the conference call.

‘Remaining Impact’

“We expect market conditions for subprime mortgage-related assets to continue to be uncertain and we are working to resolve the remaining impact from our positions,” he said in the company statement.

Merrill also wrote down the value of leveraged buyout loans the firm couldn’t sell to investors by $463 million, after underwriting fees.

Taken together, the charges are the biggest ever by a Wall Street firm, said Charles Geisst, a finance professor at Manhattan College in Riverdale, New York.

“It’s safe to say this is the largest writedown” by a U.S. securities firm, said Geisst, the author of “100 Years of Wall Street.” “The only other time we had such big losses was the third-world debt crisis in the 1980s. Even then, the losses didn’t match this one.”

Merrill’s writedown exceeded Citigroup Inc.’s $6.5 billion and increased to more than $30 billion the total third-quarter cost for bad loans and trading losses reported by the world’s biggest securities firms and banks.

Worst Performer

Slumping credit markets have led to the dismissal of industry executives including UBS AG Chief Executive Officer Peter Wuffli and Bear Stearns Co-President Warren Spector, and resulted in Lehman Brothers Holdings Inc., E*Trade Financial Corp., Citigroup and Merrill losing more than 20 percent of their stock market value.

Merrill said it reduced its inventory of CDOs comprised of asset-backed securities by 53 percent during the quarter to $15.2 billion. The firm also whittled down the size of its LBO loan commitments to $31 billion, 42 percent less than at the end of the second quarter. Short-term borrowings climbed 80 percent from the second quarter and shareholders’ equity declined 9.6 percent.

The company’s shares dropped as low as $61.40 today in New York trading, the biggest decline since Sept. 17, 2001, according to Bloomberg data.

The stock is the worst performer among the five biggest U.S. securities firms this year, followed by Bear Stearns, where two hedge funds lost $1.6 billion of clients’ money. Merrill has dropped about 32 percent, and Bear Stearns has fallen 30 percent.

Investors Flee

Goldman Sachs Group Inc., the biggest securities firm by market value, has gained 13 percent. No. 2 Morgan Stanley is down 7 percent. All the companies are based in New York.

Credit-default swaps tied to Merrill Lynch bonds rose 5 basis points to 95 basis points, according to Phoenix Partners Group in New York. That’s more than double where they were two weeks ago and almost six times the spread at the beginning of the year. The cost of the swaps, which are contracts protecting payments on bonds, rises as the perception of credit quality worsens.

Merrill, the third-biggest securities firm, is the only one of Wall Street’s five largest to report a loss from the credit contraction. Investor flight from subprime mortgage bonds and related debt left the company with inventories of loans and securities that had to be written down to depressed market prices.

‘Serious Embarrassment’

“If you can’t guide toward a reasonable expectation over two weeks, clearly you’ve got bigger problems,” said William Fitzpatrick, a financial-services analyst at Johnson Asset Management in Racine, Wisconsin, which oversees $1.7 billion and does not own Merrill shares.

Goldman reported a 79 percent increase in profit for the three months ended Aug. 31 after betting on a drop in prices of securities tied to home loans. Morgan Stanley said profit from operations fell 7 percent in the quarter.

Earlier this month, Merrill fired Osman Semerci, the head of its fixed-income trading division, as well as Dale Lattanzio, one of Semerci’s top U.S. deputies. Merrill also severed ties with Dow Kim, its former co-head of trading and investment-banking, who oversaw fixed-income trading until May, when he left to start his own hedge fund.

“This is a serious embarrassment for O’Neal,” said James Ellman, president of San Francisco-based Seacliff Capital in San Francisco, which oversees more than $200 million.

Skeletons

Merrill said in an Oct. 5 statement that it also had to write off $100 million related to First Franklin Financial Corp., a home-lending company that it bought for $1.3 billion on Dec. 30.

Investors’ refusal to finance mortgages with a high risk of default has made subprime lending unprofitable, forcing more than 110 companies to close, file for bankruptcy or put themselves up for sale since the beginning of 2006. Current and former clients of San Jose, California-based First Franklin say the unit is now barely taking loan applications.

“We’ve got more skeletons to find out about, because the credit cycle has yet to play out,” said Jon Fisher, who helps oversee $22 billion at Fifth Third Asset Management and doesn’t own Merrill shares. “This isn’t over in just a year.”