Merrill Writedowns Could Be Watershed For Banks

Merrill Lynch's latest effort to shed its subprime debt could set the standard for a final round of writedowns in the financial sector.

The New York Stock Exchange, downtown New York City.
Oliver Quillia for
The New York Stock Exchange, downtown New York City.

The battered Wall Street titan's move to sell its collateralized debt obligations (CDOs) at 22 cents on the dollar was viewed by some market leaders as a watershed moment in the billions of writedowns related to bad bets on high-risk mortgages.

With Merrill setting the price on the $30.6 billion of the packaged debt vehicles, other banking giants, particularly Citigroup , likely will face pressure to follow suit, analysts said in the aftermath of the company's announcement.

"This was a very painful step that management inevitably had to take," Fox-Pitt securities analyst David Trone said on CNBC. "This is interesting, because Citi has I think an obligation to Wall Street to mark to this level." (See video below.)

Merrill Misery: Is the Bottom Finally Here?

If the remaining banks with massive subprime exposure move forward using Merrill's price on the CDOs, that could led to Wall Street clearing off its vast subprime exposure, getting the worst news out and sending the market off its prolonged bear pattern and onto a higher level.

To be sure, there have been kitchen-sink moments like this in the year since the credit crisis began. But there was sentiment that the bargain-basement price Merrill CEO John Thain set for the subprime debt would be a defining moment.

Stocks rallied off the start and continued to climb as financials were broadly higher, even though Merrill and Citi dipped, and oil continued its slide.

"They've established a benchmark for everyone else," said Michael Cohn, of Atlantis Asset Management. "These guys who have cash waiting on the sidelines for the final puke of these securities are now making phone calls trying to find out who else wants to puke, who else wants to sell at 22 cents on a dollar. There, that's where the bottom hits."

Others reacted positively to the Merrill announcement as well.

Analyst Meredith Whitney at Oppenheimer widened her loss view on Merrill but "applauded" the company's efforts to find reality amid the subprime mess.

"We believe the stock is getting closer to fairly valued levels as now the hardest work is behind the company," said Whitney, who put Merrill's loss at $10.50 a share, an increase from her prior estimate of $8.37.

UBS , Bank of America and Credit Suisse also noted the better transparency of Merrill's numbers that will come with the sale but noted that the company paid a high price.

Waiting for Citi

Analysts quickly tried to put a price on what the Merrill move would mean to Citi.

Mike Mayo of Deutsche Bank said he expects Citi to write down $8 billion on its CDOs in the third quarter, applying the Merrill price to Citi's $22.5 billion of net CDO exposure. He also said that Citi's "decision about raising new capital could be closer than we previously thought."

Some viewed the move, though, as a reminder of how much trouble looms ahead because of the subprime mortgage industry collapse.

"It's a process that's working its way through, but we don't think we're near the end of it yet," Steve Hochberg, chief market analyst for Elliot Wave International, said on CNBC. "Bottoms are created when you have the greatest amount of pessimism. It's a little perverse, but I think people need to get scared." (See video here.)

And there is a level of disbelief remaining that the banks are still being completely open about their balance sheets.

"The current environment is not one where people are prepared to give the benefit of the doubt," Gerry Rawcliffe, group credit officer for financial institutions at Fitch Ratings, told Reuters. "There's a broad loss of confidence in banks."

Market pros believe that a full accounting in the banking industry will be an integral part of a market turnaround.

"Merrill basically marked these things to market for a lot of people," Cohn said. "We're actually feeling out a bottom here. Everyone now has to price off of this number with the same similar securities."

Cohn sees a true bottoming and a long-term rebound a few quarters off yet, but said there would continue to be opportunity for cautious investors going forward. He pointed out that stock indexes have not held notable gains over the past decade, making a recovery all the more difficult.

"You've just got to prepare yourself for a good market going forward and just chip away at things that are at fire sale prices. Selected financials you can buy here," he said. "The bottoms of a 10-year market don't happen overnight. It's a painful process."