What do Merrill’s financial results tell us?

By Edward Harrison On Jul 18, 2008

Merrill Lynch reported abysmal financial results yesterday, in marked contrast to JP Morgan Chase. The company was forced to take $9.5 billion in writedowns, leading to a loss in excess of $4.5 billion. The writedowns also forced Merrill to sell its 20% equity stake in Bloomberg in order to partially recapitalize. Nevertheless, Moody’s was not impressed and promptly lowered Merrill’s rating from A2 to A1.

Moody’s Investors Service downgraded Merrill to A2 from A1 after the results.

The sale of the Bloomberg stake and plans to sell Financial Data Services will cushion the impact of Merrill’s second-quarter loss on their firm’s capital ratios, the ratings agency said. But it also warned that Merrill has lost some financial flexibility.

“Management’s options to sell assets or raise more common equity to offset unexpected losses are now reduced given the difficult industry and capital markets environment,” said Peter Nerby, a senior vice president at Moody’s.

Merrill may suffer another $10 billion in pre-tax writedowns, mainly from exposure to CDOs and other mortgage-related securities, Moody’s predicted. If losses exceed that, the agency said further downgrades may be needed.
–MarketWatch, 17 Jul 2008

So what did we learn from Merrill? Well, certainly we learned the difference between JP Morgan and Merrill in terms of risk on the balance sheet. The juxtaposition is very telling about prudent management at JP Morgan Chase versus Merrill Lynch. However, we also learned that Jamie Dion at JP Morgan with better results is more cautious about near term prospects than John Thain of Merrill with terrible results.

In Jamie Dimon’s conference call he said “prime is terrible,” in reference to prime mortgages. This suggests that default rates there should climb. So, naturally we should look to Merrill’s 8-K filing to see what their exposure there is.

Merrill Lynch & Co., Inc.						Attachment VII



(Unaudited)						(dollars in millions)

	Net exposures as of Mar. 28, 2008		Net gains/(losses) reported in income			Other net changes in net exposures ⁽¹⁾			Net exposures as of Jun. 27, 2008		Percent Inc/(Dec)
Residential Mortgage-Related (excluding U.S. Banks investment securities portfolio):

U.S. Prime ⁽²⁾	$	30,750	$	67		$	2,901		$	33,718	10	%

Other Residential:
U.S. Sub-prime		1,435		(544	)		121			1,012	(29	)%
U.S. Alt-A		3,172		(549	)		(1,081	)		1,542	(51	)%
Non-U.S.		8,769		(229	)		(1,092	)		7,448	(15	)%
Total Other Residential ⁽³⁾	$	13,376	$	(1,322	)	$	(2,052	)	$	10,002	(25	)%

		Net exposures as of Mar. 28, 2008		Net gains/(losses) reported in income ⁽¹⁾			Unrealized gains/(losses) included in OCI (pre-tax) ⁽²⁾			Other net changes in net exposures ⁽³⁾			Net exposures as of Jun. 27, 2008		Percent Inc/(Dec)
U.S. Banks Investment Securities Portfolio:
	Sub-prime residential mortgage-backed securities	$	3,327	$	(91	)	$	(212	)	$	(123	)	$	2,901
	Alt-A residential mortgage-backed securities		5,330		(1,378	)		601			(215	)		4,338
	Commercial mortgage-backed securities		5,088		13			270			5			5,376
	Prime residential mortgage-backed securities		3,580		(211	)		82			(337	)		3,114
	Non-residential asset-backed securities		988		(7	)		2			(152	)		831
	Non-residential CDOs		770		(1	)		(20	)		(4	)		745
	Agency residential asset-backed securities		532		2			–			(29	)		505
	Other		229		–			2			(5	)		226
	Total	$	19,844	$	(1,673	)	$	725		$	(860	)	$	18,036	(9	)%

–Merrill Lynch 8-K, 17 Jul 2008

Notice the massive exposure to prime of $33.7 billion (in the first table in red) compared to only $2.5 billion for Alt-A and Sub-prime combined. If JP Morgan is right and the prime sector deteriorates in the coming months, the paltry $67 million that Merrill made in this area, should turn to losses.

Even at JP Morgan Chase these losses are expected to mount. The NYTimes said the following about JP Morgan’s net charge-offs in that area:

Prime mortgages are supposed to have a very low chance of defaulting. For example, in the second quarter of 2007, the firm wrote off just 0.05 percent of its prime mortgages, for a charge of $4 million. That rose to 0.91 percent in the latest quarter, amounting to a $104 million charge-off.

A tripling of the losses stemming from its prime mortgages would mean a $300 million loss. It would force the firm to increase its reserve pool, belting down even more capital to soak up the markdowns.

–New York Times, 17 Jul 2008

If the actual loan charge-offs are rising 18x in one year and could rise another 3x, this would devastate Merrill’s RMBS holdings for Prime mortgages.

Merrill also has a whopping $10 billion of exposure to non-U.S. mortgages (in red). Where are these mortgages: Spain, the UK, Ireland? Losses may be hiding there as well.

Ultimately, Merrill’s financials leave more questions to be answered and should cause great worry about the future for Merrill Lynch as an institution. I see more writedowns ahead and their capital base is that much weaker after this terrible report. Stay tuned.

Related posts
See Merrill Lynch‘s past writedowns at the credit crisis timeline.