After disclosing Wednesday that it had taken the hardest hit of any investment bank from exposure to collateralized debt obligations, securitizations, and subprime mortgages, Merrill Lynch & Co. was buffeted by analysts who assailed the firm’s risk management practices and its top executives for failing to anticipate the extent of its vulnerability.
“How could management put the company in a position to lose $10 billion?” wrote David Trone, an analyst at Fox-Pitt Kelton, in a research note after Merrill’s third-quarter earnings call. “How could the company preannounce and then have such a dramatically different number?”
The company announced early this month that challenging credit market conditions would force it to take a $4.5 billion writedown. However, during Merrill’s third-quarter earnings announcement on Wednesday, Merrill chairman and chief executive officer Stanley O’Neal revealed that bad bets on mortgage securities and leveraged loans had forced it to take a $7.9 billion writedown in the quarter, producing its first quarterly loss in six years.
Standard & Poor’s, Moody’s Investors Service Inc., and Fitch Inc. all reacted quickly, trimming the company’s debt ratings.
In announcing its downgrade, S&P referred to the writedown as a “startling announcement.”
“The absolute size of the loss related to CDOs and subprime mortgages, and management’s miscues regarding the valuation of its positions, further heighten our concerns regarding the company’s risk management practices and business strategy,” S&P said in a statement.
Fox-Pitt Kelton’s Mr. Trone added in his note that Merrill can expect a number of investors to sell its stock because of the array of credibility issues surrounding risk management.
Mr. O’Neal pointed the finger squarely at himself and senior management for allowing the setback.
“We are not, I am not, going to talk around the fact that there were some mistakes that were made,” he said during the earnings call. “We, I, am accountable for these mistakes just as I am accountable for the performance of the firm overall, and my job, our job, the leadership team’s job, is to address where we went wrong.”
Mr. O’Neal said the writedown was larger than initially expected because the company reexamined its remaining position in collateralized debt obligation securitizations “with a more conservative assumption,” requiring the writedown’s increase.
“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. “Away from the mortgage-related areas, we continue to believe that secular trends in the global economy are favorable and that our businesses can perform well, as they have all year.”
However, Jeffrey Harte, an analyst at Sandler O’Neill, pointed out that Merrill will continue to face losses from the current credit environment. It still has $15.2 billion of exposure to CDOs and $5.7 billion in U.S. subprime exposure, he noted.
Further, the results may speak volumes about other investment banks. “The magnitude of Merrill’s relative losses lead us to suspect that this is a Merrill-specific issue, but it may lead people to believe other investment banks were not conservative enough in their quarter-end marks,” he said.
In the quarter, Merrill cut its exposure to CDO-related asset-backed securities by 53%, to $15.2 billion, from the second quarter. U.S. subprime-related exposure was cut 35% during the quarter, to $5.7 billion. Jeffrey Edwards, Merrill’s chief financial officer, said during the earnings call that nearly all its remaining exposure to collateralized debt obligations is rated AAA by credit rating agencies.
On Oct. 5, Merrill warned that it would post a net loss of up to 50 cents a share because of the writedown, but the net loss reported on Wednesday was $2.24 billion, or $2.82 a share. A year earlier, Merrill reported net income of $3.05 billion, or a $3.17 share, including a $1.1 billion gain from merging its money-management operation with BlackRock Inc.
Revenue fell 94%, to $577 million, from a year earlier. Analysts had expected $3.25 billion of revenue, according to Thomson Financial Inc. Its share price fell 5.75%, to $63.26, in midafternoon trading Wednesday.
Analysts said the writedown blind-sided investors because three months earlier Mr. O’Neal sent a memo to employees praising the company’s performance. Merrill had just reported that second-quarter profits rose 31% from a year earlier.
Merrill has started to change its risk management practices, but analysts said these changes may come too late for some top executives, including Mr. Edwards. Rumors have started to swirl about his job security, they said, as Mr. O’Neal shuffles the deck.
On Sept. 10, Edward Moriarty was appointed to the newly created role of chief risk officer. Previously, risk management was handled by team that reported to Ahmass L. Fakahany, Merrill’s co-president.
Analysts said Merrill seems to placing a great deal of the blame on Dow Kim, the company’s former co-head of global markets and investment banking, who announced in May that he was leaving to start a hedge fund, and on Osman Semerci, the former head of fixed-income, and his deputy, Dale Lattanzio, co-head of fixed-income for the Americas, who were both fired this month.
Mr. Semerci was succeeded by David Sobotka, who was promoted to global head of Merrill’s fixed-income and currencies and commodities businesses Oct. 1. Mr. Sobotka had been head of the group’s global commodities unit since 2004, when Merrill Lynch bought Entergy-Koch LP’s trading businesses, where he was president.
Brad Hintz, an analyst at Sanford C. Bernstein, said investors’ uncertainty regarding Merrill’s risk management could cost the company about $1 billion in net income and about $1.10 in earnings per share for 2008.
