Merrill's Stock--And Image--Take a Big Hit

Merrill Lynch's credibility and stock took a big hit Friday after reports said the biggest brokerage sought to delay billions of dollars of losses on troubled assets by moving them to hedge funds.

Merrill Lynch
Merrill Lynch

Renewed worries about U.S. banks' exposure to subprime mortgage-related assets punished financial stocks across the board Friday.

Merrill, which does not have a chief executive after the departure of Stan O'Neal earlier this week, led the declines, which knocked about $4.3 billion off its market capitalization.

Merrill had its biggest drop in 18 years, falling as much as 12 percent Friday morning, before the company said that it was not aware of any inappropriate transactions. Merrill's stock closed down 7.9 percent, or $4.91, to $57.28.

It shares have lost 38.5 percent so far this year, shaving more than $35 billion off its market cap.

"We have increasingly lost confidence in the financials of Merrill, especially after the sudden increase in (collateralized debt obligation) write-downs," Deutsche Bank analyst Mike Mayo said in a note issued Friday. He cut his rating on Merrill shares to "buy" and said the company might need to find a partner to restore credibility and financial strength.

In the fourth quarter alone, large U.S. banks and brokerages could suffer additional write-downs of more than $10 billion as deteriorating credit trends continue to undercut the value of subprime mortgages and related securities, Mayo said.

The spreads, or the yield premium over U.S. Treasuries investors demand to hold Merrill bonds, widened Friday. Merrill credit is now trading as low as junk.

Merrill has been in turmoil after an $8.4 billion write-down in the third quarter caused a $2.3 billion loss, the biggest in the company's history. Analysts expect additional write-downs on collateralized debt obligations, with estimates of $5 billion to $10 billion.

Analysts Puzzled

Already, the company faces a shareholder lawsuit seeking class-action status over the write-downs and legal experts say more could be on the way.

Write-downs at Citigroup , the No. 1 U.S. bank, could be $4 billion in the fourth quarter, Mayo said. Citigroup shares fell 2 percent, Bear Stearns Cos Inc shares lost 5.4 percent, Goldman Sachs Group Inc fell 4.4 percent and Morgan Stanley's shed 5.8 percent.

Meanwhile, analysts are puzzled how Merrill reduced its net exposure to $15 billion from the $32 billion disclosed in its third quarter report, with only $6 billion in write-downs.

Mayo said that leaves the question of how Merrill reduced the other $11 billion.

Janet Tavakoli, a structured finance analyst, said in a note last week that Merrill had asked hedge funds to take its troubled assets for a year in an off-balance sheet credit facility. The effect of such a deal would reduce Merrill exposure to CDOs, but only temporarily.

"One fund claimed that Merrill was offering a floor return (set buy-back price), so this risk would return to Merrill," Tavakoli said in her note. "That would explain the magnitude of the exposure disappearance, but only if Merrill was able to find counterparties."

In July, as turmoil ripped through the global credit markets, analysts and investors began pressing Merrill for more detail about its CDO exposure. Merrill's point-man for those questions has been Chief Financial Officer Jeff Edwards.

Additional Litigation Likely

Trading Desks

Edwards, who was an investment banker before becoming CFO, declined to give any specific figures on Merrill's CDO exposure but assured analysts and reporters that the company had effective and aggressive risk management in place.

"Risk management, hedging, and cost controls in this business are especially critical during such periods of difficulty, and ours have proven to be effective in mitigating the impact on our results," he said on a conference call in July.

When further pressed about CDO exposure, Edwards said the company had significantly reduced exposure to lower-rated segments of the CDO market. He declined to give specific numbers on total CDO exposure and any reduction.

"And I think the majority of our exposure continues to be now in the highest credit segment of the market," Edwards said on the July call. He added that Merrill's CDO business was only part of a larger fixed-income operation.

One senior executive at a large Wall Street hedge fund, who asked to remain unnamed, said Friday that if Merrill entered into any arrangement, which he doubted, it would likely be done by in-house proprietary trading desks looking to reduce liabilities which could affect year-end bonuses.

And Merrill's partners, this executive said, would more likely be mid-sized hedge funds with around $500 million looking for added fee income from the assets, rather than bigger hedge funds where "an extra $5 million to $10 million" would not be worth the legal risks.

One securities class-action lawyer said that the latest stock declines at Merrill as well as more questions about its CDO business were almost sure to invite additional litigation against the company. The investment bank already faces at least one investor lawsuit filed this week claiming it issued false statements about its exposure to risky mortgages.

"A lot of investors have been hurt, and a lot of investors will probably feel they were blindsided here," said Jeffrey Herrmann, a partner with plaintiffs' law firm Cohn Lifland, which has not brought any such cases against Merrill. "And when an investor is blindsided and loses a lot of money, it's pretty natural for them to think about bringing a lawsuit."