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Executives

Sara Furber – Investor Relations

John Thain – Chairman and Chief Executive Officer

Nelson Chai – Chief Financial Officer

Analysts

Meredith Whitney – Oppenheimer

Roger Freeman – Barclay’s Capital

Glenn Schorr - UBS

William Tanona - Goldman Sachs

Merrill Lynch & Co., Inc. (MER) Q3 2008 Earnings Call October 16, 2008 8:00 AM ET

Operator

Welcome to the Merrill Lynch third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the call over to Sara Furber, Head of Investor Relations.

Sara Furber

Welcome to Merrill Lynch's conference call to review our third quarter and first nine months 2008 results. The following live broadcast is copywrited to Merrill Lynch. Statements made today may contain forward looking information. While this information reflects management's current expectations or beliefs, you should not place undue reliance on such statements as our future results may be affected by a variety of factors that we cannot control.

You should read the forward looking disclaimer in our quarterly earnings release as it contains additional important disclosures on this topic. You should also consult our reports filed with the SEC for any additional information, including risk factors specific to our business and the information on calculation of non-GAAP financial measures that is posted on our Investor Relations website, www.ir.ml.com, where an online rebroadcast of this conference call will be available.

With that, I’ll turn the call over to John Thain, Merrill Lynch's Chairman and Chief Executive Officer.

John Thain

I’m going to make a few comments on big picture and then a couple comments about the quarter, and then I’ll turn it over to Nelson to give you the details.

On the macro basis the package put together by the US Treasury, the Fed and the FDIC announced on Monday I believe resolves the core issues with the US financial institutions. The combination of the capital injection, the access to FDIC insured debt and the ability to issue CP through the Fed facility provides the capital and liquidity and financing that I think is necessary to start to unlock the credit markets and I think you will gradually see credit conditions get better.

Unfortunately the focus of the markets and of course all the commentators now, is on the real economy. I believe that we are beginning to see a significant contraction in economic activity in the United States that will also impact economic growth around the world. The focus on that slow down in economic activity is going to continue. I think the real question is not whether or not we’re in a recession but the real question will be how deep and how long. Of course Government actions will have an impact on that.

I do think that you will start to see improvements in the credit markets and I do think that any questions about the US financial system and those participants in the program that was announced on Monday have been resolved.

As we enter into a more difficult economic environment I think the logic behind the Bank of America/Merrill Lynch transaction that strategic rationale is only reinforced and made stronger. The combination of Bank of America and Merrill Lynch will be one of if not the leading financial institutions in the world.

The diversity of our businesses and earnings power, the strength of our balance sheet, the access to financing and to liquidity all, I think, make the combination very powerful and I’m optimistic in spite of a difficult economic environment certainly for the next year or two we will be very successful. I am certainly both excited about and happy to be part of that team going forward.

In terms of our quarter, the core businesses did relatively well in a very difficult environment. September was particularly difficult for us but starting first with our Wealth Management business it continued to be very stable, very good business. We were up 160 financial advisors over the quarter. That’s as good an indication of any of the strength of the franchise, the fact that in this environment we were continuing to attract financial advisors.

Net new money was down slightly. Our net annunitized money was up slightly but that business continues to do well and in fact our pre-tax margins were up two percentage points to just under 24%. I think that’s a great example even in a very difficult environment the fact that that business continues to do well.

On our Investment Banking side although activity level was down our market share and our position was good. We are currently the number two global advisors in M&A on an announced basis. Our Trading businesses our Rates and Currency business did well in this environment on a year to year basis, they’re up about 27%. Our Equity Derivatives business particularly given the volatility did very well. Our core businesses in spite of the difficult environment did well.

In terms of strategy we have continued to de-risk our balance sheet in this environment we are now down to less than $1 billion in ABS CDOs. We sold all of our Alt-A positions in our trading book so we have no Alt-A on our trading books. We’re down to $295 million in sub-prime on our trading book. We cut our non-US mortgage business positions in half. We are continuing to sell down our portfolio in our bank. It’s down to about $15.7 billion. Our risk rated assets are down to about $304 billion which is down about 15%.

The de-risking which we talked about before is continuing. Our commercial real estate book was also down about 25%. Leverage book has also continued to shrink; we’re down less than $7 billion on our leverage finance book. Overall just continuing to bring down risky assets and continuing to bring down illiquid assets.

We’ve also, as you already know, boosted our equity position both through the completion of the sale of our 20% stake in Bloomberg and in the $9.8 billion common stock offering that we did. We both improved our common equity position and improved our total equity position so common equity was up to $29.8 billion which is actually up about 40% and our total stockholders equity was up about 10% to $38.4 billion.

If you pro-forma our capital ratios for the $10 billion of preferred stock agreed to on Monday we will have a Tier 1 equity to risk rated asset ratio pro-forma again of about 12% and we’ll have a total equity to risk rated assets ratio of about 19%. The themes that you heard before shrinking our balance sheet, shrinking our risk rated assets, improving our capital position, improving our capital ratios is what we’ve been focused on.

Finally, we have also been focusing on our liquidity positions. You’ve seen from the release our excess liquidity pool was about $77 billion at the end of our quarter. That was impacted by some of the events of September but we continue to focus on and pay a lot of attention to our liquidity positions. Of course we will shortly have access to both the CP facilities and the FDIC facilities as those programs come online.

We are moving forward with the transition teams on the completion of our deal with Bank of America. That is progressing smoothly and as I think you all know we are targeting to close that transaction at the end of this calendar year. With that I’ll turn it over to Nelson

Nelson Chai

Let me take a moment to review our major segments. In our Global Markets and Investment Banking third quarter net revenues were negative $3.2 billion and a pre-tax loss for the quarter was $6 billion. However, as we have detailed in Attachment VIII of our press release GMI adjusted revenues were positive $2.5 billion for the quarter.

To remind you, adjusted revenues exclude significant items both positive and negative that are less indicative of the underlying performance of our franchise such as the gain on the Bloomberg sale, write downs on legacy exposures and fair value gains on our debt. While adjusted GMI revenues are down substantially from prior periods as John mention our results were particularly impact by the month of September which represented one of the worst months in the history of the credit markets on top of the typical late summer season slow down.

The difference between adjusted and GAAP revenues in GMI was primarily attributable to five things. First we had $5.7 billion in write downs, our previously announced CDO sale and the related hedge terra. Secondly, we had a $4.3 billion gain from the sale of our Bloomberg stake. Third, we had $3.8 billion of losses arriving from severe market dislocations in September including real estate related asset write downs and losses related to certain government sponsored entities and major US broker dealers.

Fourth, similarly impacted by the severe movements in September we had $2.8 billion in net gains due to the living of our credit spreads on our debt. Finally, we had $2.6 billion of net losses arising from completed and planned asset sales across residential and commercial mortgage exposures predominantly for cash.

Turning to the revenues detail by business line, FICC revenues were negative $9.9 billion in the quarter. As strong rates and currencies and solid performance in commodities were more than offset by asset write downs, realized losses from sales and overall weakness across other business areas. FICC recorded significant losses as the result of severe market dislocation in September including unusually high credit spread and the default of a major US broker dealer. A positive fair value adjustment on our debt mitigated the impact of the losses to some extent.

If you turn to Attachment VI in our release I will briefly walk you through our major exposures starting with the US ABS CDOs and related Monoline exposures. As we discussed previously we sold $30.6 billion of gross notional value CDOs to Lonestar and to most of our associated hedges with the Monoline.

Largely as a result of this we ended the quarter with next exposures of $1.1 billion and if you net out secondary trading positions that number is actually less than $1 billion. The majority of the remaining hedges on this portfolio are with highly rated insurance companies and banks that typically have strong collateral posting requirements. Under a billion dollars of exposure is hedged with MBIA and the carrying value of these hedges is $1.4 billion at the end of the quarter.

We also have hedges in place of monolines on asset classes away from CDOs primarily corporate CLOs, CMBS and RMBS. The market value deterioration of these asset classes has been modest relative to CDOs. During the quarter our credit valuation adjustment on these exposures was not material and our remaining carrying value was $4.5 billion.

With respect to residential mortgages which are detail in Exhibit VII the vast majority of our exposure continues to be US prime mortgages that we have primarily originated with our high net worth First Republic and GWM clients. These are not the typical prime mortgages you see in the marketplace, they are much higher quality. On average, these clients have FICO scores in excess of 750, loan to value ratios are less than 60% and is virtually zero loss history.

We did recognize the $123 million loss in prime exposures this quarter but this loss is driven by the sale of six entire prime RMBS trading portfolio in our trading book for approximately $400 million during the quarter.

Away from the US prime mortgages and on a pro-forma basis we decreased our other residential real estate exposures by 64% effectively eliminating Alt-H in our book and significantly reducing sub-prime and non-US exposures.

On the Commercial Real Estate and Leveraged Finance front, in Leveraged Finance we reduced our exposure by approximately $1.4 billion in the quarter through sales and syndication partially offset by a new commitment made during the quarter.

In Commercial Real Estate excluding First Republic Bank we reduced our exposures to about $11 billion down 25% from the second quarter on a pro-forma basis primarily due to sales of whole loan conduit exposures in the EMEA region. Net exposures related to First Republic Bank were about $3 billion up 10% from the second quarter.

Finally, within our US Banks Investment Securities Portfolio, we recognized net pre-tax write downs of approximately $850 million during the third quarter. At quarter end our total portfolio was down to $15.7 billion. For much of this portfolio we continue to believe the market prices ahead of fundamentals and we continue to have the intent and ability to hold these securities until fair value recovers. As of quarter end the banks remain well capitalized.

Turning to Equity Markets, third quarter net revenues of $6 billion were up significantly on a GAAP basis largely due to the gain of the Bloomberg sale and positive fair value adjustments on our debt. On an adjusted basis strong sequential revenue growth in equity loan trading was offset by revenue decline in other business areas due to seasonality and the volatile market environment at the end of the quarter. Particularly in prime brokerage and our equity trading business. Private Equity revenue is also continuing to be a headwind in this quarter with negative revenues of $289 million.

Investment Banking revenues were down 27% sequentially and a 12% increase in advisory revenues is more than offset by substantially reduced underwriting fees in the quarter. In the third quarter we ranked number two in announced M&A and year to date continue to be ranked in the top five in global debt, global equity, global IPO and global announced M&A. Our investment banking pipeline remains stable down 11% from year ago levels and down only 7% from the second quarter, although execution continues to be dependent on market conditions.

Turning to Global Wealth Management, GWM continued to be our most consistent segment in this environment, with quarterly revenues of $3.2 billion down 4% from the second quarter despite the continued market depreciation and persistent market volatility. However, pre-tax earnings of $774 million were up 5% despite our continued spend on growth initiatives.

Our profit margin increased from 22% to nearly 24% during the quarter demonstrating our strong focus on operating discipline. Notable highlight for GWM during the quarter include $2 billion in net new annuitized inflows, client assets of approximately $1.5 trillion, record proportion of recurring revenues and continued international FA growth of 9% year over year including Japan.

Global Private Client net revenues in the third quarter of $3 billion were down 5% from the second quarter largely driven by declines in transaction origination revenue as a result of the market environment. During the quarter net new money was negative $3 billion mostly the result of the activity of the last month of the quarter.

We believe this is largely reflective of client’s reaction to persistent equity market declines across the industry. We continue to invest in our market leading technology and product platforms to increase our FA population which grew by nearly 160 professionals during the quarter and about 240 from the year ago period.

Let me now discuss expenses overall for the firm. I’ll start with the Compensation Expenses for the quarter which were $3.5 billion flat from the second quarter but up versus the prior period quarter. The increase was due largely to timing of compensation accruals as we reduced incentive compensation accruals in the third quarter of 2007 that had been taken during the first half of the record year last year. In fact, on the year to date basis comp expense is down slightly from comparable 2007 levels.

Non-Comp Expenses included two previously disclosed items, the $2.5 billion payment to Temasek and a $425 million expense related to auction rate securities. Non-Comp costs including these items decreased 12% sequentially. Finally, our effective tax rate was 37.9% for the quarter.

As John mentioned earlier this we agree along with a number of other US major financial institutions to participate in the TARP capital purchase program. As part of Bank of America’s $25 billion participation in the program we’ve agreed and expect to issue $10 billion of non-voting preferred stock and related warrants to the US Treasury.

At quarter end our Tier 1 and total capital ratios were approximately 8.7% and 14% respectively, pro-forma for the planned asset sales and the preferred issuance to the Treasury are Tier 1 ratio will be 12% and total capital ratio will be 19%. Again, these figures exclude any impact from the contemplated sale of the controlling stake in FDS in light of the pending transaction with Bank of America.

This concludes my prepared remarks and lastly I’d want to echo John’s comments that we look forward to completing our announced transaction with Bank of America.

Now we’ll open up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Meredith Whitney – Oppenheimer.

Meredith Whitney – Oppenheimer

Could you help me with Lehman exposure in terms of what was included, or break that out, for the quarter and break out future exposure? If you don’t want to quantify just qualify it.

Nelson Chai

We don’t actually specify specific exposures to specific counter parties, we haven’t. I would tell you that obviously the dislocations that happened in September with Lehman were certainly a big driver of the numbers that we disclosed. I would say that they were across a couple different lines. Some of it had to do with just receivables we had with Lehman. Some of it had to do with just unwinding trades where there were counterparty.

Frankly, there was an add on effect if you will over the overall credit markets regarding their default if you will. It was across a couple different areas. Some were direct, some were more indirect but again we’re not going to disclose the specific numbers.

Meredith Whitney – Oppenheimer

Given the fact that you’ve cleaned up your books so extensively during the quarter I’m just trying to be paranoid about what addition risks could take place this quarter market exclusive, from what we know.

Nelson Chai

As you know, over the past year John and I have been very focused on basically addressing our exposures, understanding where the market was and moving forward to try to de-risk our balance sheet. I think you’ve seen us quarter after quarter continue to do so. If you look at where the exposures are that I talked through briefly I think you’ll see us continue to try to reduce some of our real estate exposures particularly outside of the US.

You will see us continue to focus in other key areas where there is opportunity. We are hopeful, obviously, that some of the actions taken this week, as well as actions around the world will help free up some of the credit markets. I think you will see us continue over the fourth quarter continue to find opportunities to risk the balance sheet.

Meredith Whitney – Oppenheimer

Can you give me an update on your technology initiatives and then what type of technology synergies you’ll have with Bank of America or how that all works in its early stages?

Nelson Chai

There have been a number of different technology efforts across the firm. I would bucket them in three primary areas. Again, Tom Sanzone and Chris Augustin who both joined the firm during the course of the year have been very focused at looking across all of our technology platforms and certainly there is tremendous opportunities given the fragmentation or the way the businesses were run. I think they were making good progress in terms of coming up with what I call an initial plan.

As you try to optimize, if you will, technology trading platforms those are long lead time type projects. I would tell you that we actually had a very good game plan we were developing. The second area would be really around the collateral management area in terms of the way the trading business operated, if you will. Again, I think there was a lot of progress made towards there. If you look at both our sales and our ability to manage our collateral I think it’s improved dramatically. Again, Mark Alexander, who works with Tom, has done tremendous progress there as well.

The last area which is closer to home for me is our financial trading systems where we’ve actually been out front from firm and it started before actually I got here. They were actually moving pretty far down along in terms of taking our sub-letters and there are numerous sub-letters if you will that go into our general ledger and we’re going to continue to make that progress.

In terms of your question of where it goes relative to Bank of America, it’s hard to answer that. I would tell you that we are, as John mentioned earlier, engaged with the transition teams with Bank of America. We are going through a process of both evaluating our systems and their systems and we will take the best of the two systems and work them through that. It is premature to comment on both which system we are in our progress to date but I would tell you that the teams are fully engaged. We actually have segregated teams that are specifically working just on that.

Operator

Your next question comes from Roger Freeman – Barclay’s Capital.

Roger Freeman – Barclay’s Capital

First a couple macro questions, with respect to the latest Treasury announcement is it fair to think about your short term financing such that you’ll look to move repo financing into short term unsecured borrowings given the three year and less maturities are going be backed by the Government? Secondly, with respect to the $10 billion coming in what are the directives with respect to how that capital can and should be allocated. Should we look at that as merely as a capital cushion or over time could that actually be put to work to generate higher returns?

John Thain

The capital injection is a cushion and in this environment I think you will see us continue to shrink our assets and continue to improve and de-risk our balance sheet. That capital cushion will provide an opportunity. It will be really after the merger closes. I think you really have to think about it more from the point of view of the combined companies which of course will have $25 billion of this capital injected into it. I think we will have the ability to re-deploy that on a combined basis going forward but at least for the next quarter it’s just going to be a cushion.

In terms of liquidity, we do have access because of the way the deal was structured we have the ability to issue somewhat north of $40 billion of FDIC guaranteed long term debt and we also have the ability to access the Commercial Paper program. I think that also provides us with incremental liquidity. It doesn’t really change how we’re going to fund ourselves going forward.

Roger Freeman – Barclay’s Capital

Back on the capital injection, again I was asking more from a macro perspective than longer term. Are there stipulations where capital ratios have to remain any extent above where they were prior to the Treasury injection?

Nelson Chai

I don’t know if there is stipulations or not but if you look at the injections were made or that the firms are getting it seems like people are kind of going around the 10% Tier 1 ratio. Again, as you know, those numbers fluctuate over time markets versus more challenging markets but it looks like they’re trying to earmark based at least from our view that they’re on a 10% Tier 1 ratio.

Roger Freeman – Barclay’s Capital

Is it fair to think about the majority of the exposure on Lehman being CDS protection that you had read? There’s some $6 billion in the system that has to get settled and then I think they will try to figure out where those exposure are. Is it fair to assume that that’s your exposure in there?

Nelson Chai

We’re not going to be specific.

John Thain

It is a significant part of it but there’s also as Nelson said there’s also a fair amount of disruption I would say in the settling out of the Lehman contracts and also because Lehman was one side of a trade we also had to close out or re-hedge the other side of the trade. The closeout process of both the Lehman side and the other side I think turned out to be significantly more expensive than anybody would have thought.

Roger Freeman – Barclay’s Capital

The Fannie/Freddie exposure was preferred primarily?

Nelson Chai

Yes.

Roger Freeman – Barclay’s Capital

On private well, looking at some of the metrics you pointed out net new money was down the second quarter in a row. Cash deposits were down sequentially, transactions were lower. To read anything into that there’s been any sort of fall out in the system because I understand money coming out of risky assets but it doesn’t look like going into cash inside of the Merrill system.

John Thain

I don’t think you can read into much, net new money was down $3 billion, I don’t think there’s any particular trend to that. I don’t think there’s any deterioration in the franchise and the fact that we’re basically adding financial advisors who are bringing their customers here means that the franchise continues to be strong. I just don’t think when you have over $1.5 trillion of assets $2 to $3 billion is really flat for all practical purposes.

Nelson Chai

Since we announced the transaction with Bank of America, the acceleration of the number of FA’s joining has actually increased relative to competitors. I think that is affirmation both of the strategic value of the deal but again then also the health of the franchise.

Operator

Your next question comes from Glenn Schorr – UBS.

Glenn Schorr - UBS

I wondered if you could help us on the liquidity move from $92 billion last quarter to $77 billion generically what are the sources of a liquidity move like that is that just you haven’t issued debt and you had some maturities along the way, if you could help on that?

Nelson Chai

Actually that’s exactly right. As you know, we increase our liquidity pool tremendously in the second quarter. A lot of that was because we did issue a lot of debt in April. During the third quarter, as you know credit markets were tough so we didn’t issue a lot of debt and we had about $20 billion of maturities come due. With all the puts and takes that is largely the answer.

Glenn Schorr - UBS

In terms of the FDIC coverage guarantee the Bank of America deal isn’t thought to close for a little while, do you plan on issuing at all before into the deal, participating in the FDIC plan? You do have upcoming maturities between the fourth and first quarters.

Nelson Chai

The fine tunes, we’re still working through that plan as you know. We are going to have some discussions internally about how best to fund the maturities that are coming due. It would be premature for us to comment on exactly if we’re going to go that route or a different route. As you know, we continue to shrink our balance sheet as low which is a good source of funding for us. John mentioned that risk rated assets are down 15% in the third quarter versus the second.

Our balance sheet, our overall asset base will likely be down 8% to 9% as well. So you’ll see us continue to move down and sell things off our balance sheet which actually frees up liquidity. As you heard in my comments some of the sales we did, the sale of the US residential positions in Alt-A and sub-prime are done all for cash as well. Some of the other sales we have targeted a number of them will be done for cash. We will also try to fund through selling down our balance sheet.

John Thain

The other thing I would just add is that we will coordinate with Bank of America because the debt that we could issue will be up to three years with the FDIC guarantee. We just want to coordinate with them to make sure it’s attractive funding from not only our point of view but also from their point of view going forward.

Glenn Schorr - UBS

Are securitizations, if there was ever going to be another one, covered by the plan or is that not worked out yet or is it just senior unsecured?

John Thain

It is just senior unsecured.

Glenn Schorr - UBS

Do you have any insights when the shareholder votes are going to be?

John Thain

We are expecting them to be mid to later part of November.

Operator

Your next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

The deposits declined by about 10% in the quarter, obviously given everything that’s going on not necessarily surprising. Was that more or less just people getting under what was the FDIC cap at the time because it doesn’t seem that the people necessarily withdrew all that but was it just them shifting out of the deposits into treasuries?

Nelson Chai

I think there is some of the cash sweeping going on that you’re talking about. Other than that as you know there was a little bit of a flight to some of the commercial banks as well. Ken Lewis, during his call talked about the fact that they’re retail and commercial deposits grew by $27 billion in the third quarter as well. Again I think it continues to reinforce what John started with was the strategic rationale for the transaction.

William Tanona - Goldman Sachs

In terms of the investment management revenues obviously they were up pretty strongly quarter over quarter about 25% I guess that was a little bit surprising considering what happened in the marketplace. I just want to get a sense as to what was driving the revenues in that segment.

Nelson Chai

It’s reflective of investments in certain alternative investment managers that delivered good returns.

Operator

There are no more analysts in Q&A at this time. I will now turn the call over to Sara Furber for closing remarks.

Sara Furber

This concludes our earnings call. If you have further question please call investor relations. Fixed income investors should call. Thank you for joining us today we appreciate your interest in Merrill Lynch.

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Source: Merrill Lynch & Co., Inc. Q3 2008 Earnings Call Transcript
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