Merrill Lynch Q2 2007 Earnings Call Transcript

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 |  About: Merrill Lynch & Co. Inc. (MER)
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Merrill Lynch & Co., Inc. (MER)

Q2 2007 Earnings Call

July 17, 2007 10:00 am ET

Executives

Jonathan Blum - IR

Jeff Edwards - CFO

Analysts

Glenn Schorr - UBS

William Tanona - Goldman Sachs

Mike Mayo - Deutsche Bank

Richard Bove - Punk Ziegel

Prashant Bhatia - Citigroup

Meredith Whitney - CIBC World Markets

Doug Sipkin - Wachovia Securities

Presentation

Operator

Good morning, and welcome to the Merrill Lynch second quarter 2007 financial results conference call. (Operator Instructions) I would now like to turn the conference over to Jonathan Blum, Head of Investor Relations. Please go ahead.

Jonathan Blum

Good morning and welcome to Merrill Lynch's conference call to review second quarter and first half 2007 results. The following live broadcast by Jeff Edwards, Chief Financial Officer, is copyrighted to Merrill Lynch.

Statements made today may contain forward-looking information about management's expectations, strategic objectives, growth opportunities, business prospects, investment banking pipeline, acquisition synergies, anticipated expense levels and financial results, and other similar matters.

Such forward-looking statements are not statements of historical facts and represent only Merrill Lynch's current beliefs regarding future performance which is inherently uncertain. Investors are cautioned not to place undue reliance on such statements which speak only to the date on which they are made, and may be impacted by a variety of factors Merrill Lynch cannot control.

Merrill Lynch generally does not undertake to update these statements to reflect the impact of subsequent circumstances or events. Investors should consult Merrill Lynch's reports filed with the SEC for any additional information, including risk factors specific to Merrill Lynch's business described in the company's 2006 Annual Report on Form-10K.

Investors should also read the information on the calculation of non-GAAP financial measures, and is posted on Merrill Lynch's Investor Relations website, www.ir.ml.com, where an online rebroadcast of this conference call will be available today at approximately 1 p.m. Eastern time.

Unless otherwise indicated, comments will exclude the impact of the one-time compensation expenses related to adopting FAS-123-R in the first half of 2006 from comparisons to that period, as well as the one-time net gain from the closing of the combination of Merrill Lynch Investment Managers, or MLIM, with BlackRock in the third quarter of last year from the determination of quarterly records.

Full GAAP financials, which include the one-time compensation expenses, are available in the attachments to the Merrill Lynch earnings release, as are schedules reconciling those data to the numbers that will be discussed.

Now I will turn the call over to Jeff.

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Jeff Edwards

Thank you, Jonathan. Good morning to all of you on the call. Today Merrill Lynch again reported a very strong operating quarter. Total net revenues for the second quarter of 2007 were $9.7 billion, up 19% from the second quarter of last year, and just 1% below the record first quarter. More reflective of our ongoing businesses, year-on-year growth excluding results from MLIM in 2006 and BlackRock in 2007 was even stronger, up more than 27%.

This outstanding revenue performance was broad-based, with significant year-over-year increases in all major business lines and regions, and is a testament to the successful execution of our diversification and growth strategies. The critical importance of these efforts was evident in the quarter, as we were able to deliver these strong overall results, despite lower revenues from our private equity business, which contributed significantly less than in recent quarters; and in spite of persistently challenging conditions in the U.S. sub-prime mortgage market.

We also demonstrated good operating leverage, as the second quarter pre-tax profit margin of 31.1%, was up 2.4 points from last year's quarter. Earnings per diluted share of $2.24 were up 37% from the year ago period, and net earnings of $2.1 billion were up 31%, as our active share repurchase program continues to enable our EPS to grow faster than net earnings. Both diluted EPS and net earnings were effectively in line with record first quarter levels, each down less than 1%.

Return on average common equity was 22.4%, up 3.8 percentage points from the 2006 second quarter. Book value per common share was $43.55 at the end of the quarter, up 17% from the 2006 second quarter and 3% sequentially. All in all, a very strong quarter reflecting continued momentum and confidence in all of our businesses.

Our quarterly results capped an exceptional first half of 2007. It set a number of records. Highlights include: Record revenues of $19.6 billion, up 21% from 2006. Record pre-tax earnings of $6.1 billion, which increased 30%, resulting in a pre-tax margin of 31.2%, up 2.1 points. Record net earnings of $4.3 billion, up 31%. Record diluted EPS of $4.50, up 37%. And an ROE of 22.8%, nearly 4 points higher than last year's first half.

International growth was again critical to our success. Non-U.S. revenues comprised 42% of Merrill Lynch's total net revenues for the second quarter, the highest percentage ever. Here are a few of our non-U.S. highlights for the period. Non-U.S. revenues grew at 4X the rate of U.S. revenues over the 2006 second quarter. Revenues from India grew strongly, more than doubling the previous quarterly record.

We continued to make significant progress in the Middle East, including obtaining a full banking license in Saudi Arabia, joining the Dubai Mercantile Exchange, and being the first ever international institution to lead a sale on the Kuwaiti Stock Exchange. We led the first-ever international traunch of a Korean domestic IPO.

In Europe, we ranked #1 in completed M&A, and we advised on four of the top five deals announced during the quarter. Most importantly, we generated record quarterly net revenues in both EMEA and the Pacific Rim, the two largest non-U.S. regions. We believe the theme of non-U.S. growth outpacing U.S. growth will remain intact.

We continue to invest in our platforms around the world, and remain well positioned to fully capitalize on this trend. It is no coincidence that under our new management structure, the global heads of two of the three major business lines within global markets and investment banking are based in London: Osman Semerci as Head of Global Fixed Income Currencies and Commodities, or FICC; and Andrea Orcel as Head of Global Origination.

Now for some more specifics on our performance in the second quarter beginning by segment. Global Markets and Investment Banking, or GMI, again generated very strong results, as our investments in all three core business lines continue to produce robust and diversified year-on-year growth. GMI's second quarter net revenues of $6.2 billion, were 36% higher than the second quarter of last year, and down just 5% from the record first quarter. For the first time, non-U.S. revenues represented more than 60% of GMI's total net revenues for the period.

Pre-tax earnings for the quarter were $2.1 billion, up 43% from the prior year period and down 10% sequentially. The pre-tax margin of 34% was up 1.9 percentage points over last year, and 1.8 points lower than the first quarter, as investments continued across the business.

Looking at GMI's second quarter net revenues by major business line, FICC net revenues were the second-best ever at $2.6 billion, up 55% from the second quarter of 2006, and only 7% lower than the record first quarter. For the first six months, FICC generated record revenues of $5.4 billion, up 45% from last year. Compared with the second quarter of 2006, the increase in revenues was driven primarily by increases from trading both credit and interest rate products, the latter of which set a record for the second consecutive quarter. Revenues from commodities were also up substantially. The depth and strength of these increases more than offset a decline from mortgages.

The sequential decline in FICC revenues was driven primarily by credit, commercial real estate and currencies, which had offset revenue records in the first quarter, as well as commodities. Partially offsetting these declines was a substantial increase from structured finance and investment, which primarily reflect a better performance from our U.S. sub-prime mortgage activities, and to a lesser extent the continued growth in global rates.

While we have seen some positive signals such as improving first payment default levels for First Franklin, the environment for U.S. sub-prime mortgages and related CDOs has yet to fully stabilize. 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.

Importantly, we have increasingly diversified our FICC business within and across asset classes and regions, creating many different drivers of growth. Our strong 55% revenue increase in the quarter reflects the breadth of both very active client flows and attractive markets for proprietary risk-taking.

Some additional highlights for FICC in the second quarter include: record revenues in EMEA and the Pacific Rim for the second consecutive quarter; continued strength in distressed and structured credit trading; continued innovation in the CDO space, including the development of unique new CDO products involving foreign exchange and hybrid long/short structures; and in commodities, continued diversification of the platform with the first meaningful revenues from trading coal and our first major structured transaction in metals.

Turning to equity markets, where the second quarter revenues of $2.1 billion were up 15% compared with a year ago quarter and down 10% from the first quarter. Notably, excluding private equity revenues, equity markets revenues actually increased 4% over the strong first quarter, and nearly 75% year on year. First half net revenues for equity markets reached a record $4.5 billion, up 31% from the prior year period.

We have always said that by its nature, the private equity business produces lumpy revenues, and that was evident this quarter as our larger publicly traded holdings did not generate as much revenue. Second quarter net revenues from private equity were $125 million, down from the record $705 million in the prior year period, and $445 million in the first quarter.

Apart from the private equity, significant revenue increases from the equity linked and financing and services business lines, both of which set new quarterly records as well as cash trading, and strategic risk, all drove the strong growth relative to last year's second quarter. Compared to the first quarter, both financing and services and equity linked generated strong revenue growth, while revenues from strategic risk, which set a record in the prior period, were lower.

Equity markets highlights from the very strong second quarter include: financing and services, which set a new quarterly record that exceeded the prior record by more than 50%, on the strength of yield enhancement activity in Europe, an area where we have made focused investments; equity linked trading where the record revenue performance was driven by emerging markets, as well as structured and indexed products; cash trading, where our continued progress in electronic and algorithmic trading enabled us to increase market share on most global exchanges, including New York, London, and Tokyo; and private equity, we announced important new investments in Nuveen and Data Advantage, and we continue to see attractive opportunities on a global basis.

To further broaden this business model, we also added senior professionals with significant experience in key industry subsectors, including financial services and media and telecommunications. We generated outstanding growth in both the Pacific Rim and EMEA. In each of those regions, cash and equity linked revenues now exceed those in the U.S.

In investment banking, we generated record revenues for the third consecutive quarter, with $1.4 billion in total, up 41% year-on-year and 5% sequentially. Revenues for the first six months increased 44% over the 2006 period, to a record $2.8 billion. This exceptional performance reflects increasing breadth of our banking franchise and our commitment to developing strong client relationships globally. Originating non-traditional revenues from our investment banking clients is also a key element of our strategy.

This quarter, our underwriting businesses stood out. Equity origination set a new revenue record at $547 million, up 74% from the 2006 second quarter and 51% from the 2007 first quarter, including one significant and creative transaction where we utilized our balance sheet and risk management capabilities to raise capital for a key client.

Debt origination revenues were also strong at $479 million, up 19% from last year, but down 19% from the record first quarter. Advisory revenues were $397 million, up 34% from the year ago period, and down less than 1% from the strong first quarter. Importantly, we ranked second in announced and third in completed M&A globally for the quarter.

On a regional basis, while investment banking revenues were strong globally, EMEA and the Pacific Rim stood out, both setting new revenue records. The increasing strength of our franchise is evident in many transactions, but one in particular stands out this quarter, illustrating how we are utilizing both our brains and our brawn to deliver smart solutions for our clients. In Europe, we are acting as exclusive advisor and lead financier to a consortium of clients in their efforts to acquire ABN Amro in the largest financial services transaction in history.

Our pipeline ended the second quarter higher than the first and substantially higher than at this time last year, with particular strength in advisory and leveraged finance mandates. Our dialogue with clients remains active in all regions, and we are confident in our ability to execute on this record backlog.

To round out the discussion of GMI, some overall year-to-date numbers that underscore the strong growth trends across the business. First half net revenues were a record $12.7 billion, up 39% from the first half of 2006, driving record pre-tax earnings of $4.4 billion, up an even stronger 46%. As I noted, each major business line achieved record net revenues, demonstrating the progress we have made in building out our franchise, and positioning it for future growth.

Turning to Global Wealth Management, or GWM, which generated record revenues, pre-tax earnings, and profit margin in the second quarter, driven by strong results in both Global Private Client, or GPC, and Global Investment Management, or GIM. Aggregate GWM net revenues of $3.6 billion were up 18% year on year, and 6% sequentially. Pre-tax profits exceeded $1 billion for the first time, and were up 39% and 20% respectively. The pre-tax margin reached a new high of 27.9%, driven by the revenue growth and operating leverage.

GPC revenues for the quarter were $3.3 billion, the second-highest total the business has ever generated. Revenues were up 13% compared to the second quarter of last year, and 5% from the first quarter of this year. For the first half, GPC net revenues increased 12% to $6.5 billion, reaching a new record level that surpasses the old record set during 2000.

Compared to both prior quarters, record fee-based revenues driven primarily by asset-based fees combined with higher transaction and origination revenues to drive the overall increase. Year on year, net interest also increased substantially.

Highlights for the quarter within GPC include success in recruiting and training and then retaining high quality FAs, as we net added 270 during the quarter. Notably, we had net positive recruiting against all our major competitors and we had the lowest turnover among our top two quintiles of FAs on record. Continued momentum with ultra high net worth clients, a segment which continues to grow faster than GPC as a whole.

In the Pacific Rim, we are rolling out a new ultra high net worth business model focused on what we call private investment banking. This effort brings GPC and GMI together to seamlessly deliver a full array of both wealth management and institutional products and services.

Turning back to the U.S., we have launched our new unified management account platform, which has already attracted new high quality asset managers, and is even more appealing to our clients.

Finally, we look forward to the consummation of the First Republic transaction in enacting our plans to accelerate the growth from this unique private banking platform. We continue to make progress towards the necessary regulatory and shareholder approval, and we expect that the deal will close during the third quarter.

Moving on to GIM. Record net revenues of $305 million were up 119% compared to the second quarter of 2006, and 17% higher than in the first quarter of 2007. First half GIM net revenues were also a record at $566 million, up 133%. Relative to the 2006 second quarter, growth was driven by the inclusion of our share of BlackRock's results in the current period but not in the prior year period, as well as growth in revenues from our investments in other alternative asset management companies, and a pickup in revenues from our alternative investment distribution platform.

Sequentially, the growth reflects increased revenues from our investments in both alternative asset management companies and BlackRock, which is scheduled to report its earnings tomorrow morning.

Two important transactions that we announced this quarter position us for future growth in this segment. At the end of the quarter, we closed on investments in GSO Capital Partners, an alternative asset manager focused on the leverage finance markets; and Sterling Stamos, a fund of funds manager.

Returning to GWM as a whole, second quarter asset flows into private client accounts were solid, despite a quarter that is typically the slowest of the year due to client tax payments. Net inflows into products that generate annuitized revenues were $12 billion for the quarter, and $28 billion for the first half while total net new money into the firm was $9 billion and $24 billion respectively. Period end client assets again set a new record at $1.7 trillion, up 14% from a year ago.

For the first half of 2007, GWM's results also achieved new highs. Net revenues were a record $7 billion, up 17% from 2006 and pre-tax earnings were a record $1.9 billion, up 35%. The pretax margin improved by 3.6 points to 26.4%, driven by the impact of the BlackRock investment and good operating leverage across the business.

That concludes my discussion of the segments, now I will return to the income statement for the firm as a whole beginning with expenses.

I will start with compensation. The ratio of compensation expenses to net revenues for the second quarter was 48.9%, down a little from the first quarter and bringing the year-to-date comp ratio to 49.3%. This is about 10 basis points lower than the first half of 2006, reflecting continued operating discipline in a strong revenue environment, even as we continued to hire talented people to drive our growth initiatives forward. As always, the progression towards the full year ratio will depend on the environment, our business mix, the pace of recruiting and hiring, and competitive compensation trends.

Moving on to non-compensation costs, which were $1.9 billion for the quarter. Most line items increased only modestly from the first quarter, despite continued investments in the business. The ratio of non-compensation expenses to net revenues in the second quarter was 20%, down 2.6 percentage points from the second quarter of 2006, and up 1 point from the record low set in the first quarter of 2007. On a year-to-date basis, this ratio was 19.5%, down 2 points from last year, as we remain focused on controlling non-comp expenses in order to drive operating leverage.

Now the effective tax rate, which for the second quarter was 29.2%, down 1.1 points from the first quarter rate as we recognized a small discrete net benefit relating to settlements and changes in estimates for prior years. For the first half, our effective tax rate was 29.8%. At this point, we continue to expect that rate to increase modestly in the second half, subject of course to the usual factors, business mix, changes in tax laws and settlement.

Lastly, Capital Management. As I noted earlier, our second quarter ROE of 22.4% was up 3.8 points from last year and down less than a point from the first quarter. At the same time, book value per share of $43.55 was up 3% sequentially and a full 17% year on year. As a management team, we remain intensely focused on driving improvements in both these important performance measures.

Our stock buyback program remains active, even though we had to withdraw from the market late in the quarter as required with respect to the First Republic acquisition. For the quarter, we repurchased 19.8 million shares for $1.8 billion. As we enter the second half of the year, let me remind you that we will need to continue to stay out of the market for certain periods prior to the closing of First Republic.

Repurchases have had a material effect on our share count. Average diluted shares for the quarter were 923 million, down 5% from this time last year, while period end shares are down 4%. Obviously the full benefits of this reduced share count should become evident in future quarters as an accelerator of growth in both EPS and book value per share.

Importantly though, even as we have returned a tremendous amount of capital to shareholders we have continued to invest in expanding our businesses as we find attractive opportunities to deploy capital and drive organic growth.

This concludes my formal review of our results. Again, we are very pleased with the strength and diversity of our performance.

Before I open it up to questions, let me make a few comments on our outlook. Most importantly, we believe the long-term drivers of secular growth remains solidly in place and thus we remain fully committed to implementing our strategy to further grow our global franchise. We recognize of course that we are heading into a quarter which is typically the least active of the year from a seasonal perspective. The limited periods of time and in any given market or sub sector, the environment and our related performance may be uneven.

But now, we are more able than ever to successfully navigate challenging markets with more revenue pistons firing in more places globally, driving growth and underscoring the depth and breadth of the Merrill Lynch franchise, its talented professionals, and its earning power.

Now I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

First of all let me caveat with everything is so strong on the revenue growth side, we have to pick apart some of the risk issues that people are concentrating on, so forgive me. Can you talk about, maybe start with what your non-investment grade loan commitments are this quarter versus last quarter? Usually you have to wait for the Q but it is so topical now, I figured I would ask.

The process on how you have it marked, how much has been put back or delayed, how you are comfortable with your hedging position, and what you have seen in terms of the readjustment as that market looks for price discovery?

Jeff Edwards

I am going to take that as a broad question, Glenn, around the prime CDO market.

Glenn Schorr - UBS

Well, I want to talk about the leverage lending side. I am thinking leverage lending first, just as you have seen some of the private equity commitments delayed as the market tries to digest the supply coming in and come to a common ground.

You and others have either participated in some bridges or have a lot of lending commitments. I think there are lots of questions I get around how big is it and how much risk is there, really? If you could talk anything towards your position and how you are hedging and how you are thinking going forward, that would be awesome.

Jeff Edwards

So broadly speaking about the leverage finance market, I would make the following points: Certainly as I mentioned in the call, our backlog is up and we are very happy with that. We certainly have confidence in our ability to execute that going forward.

The market over the course of the last month has seen some selectivity on the part of investors, particularly around structure and pricing. I think that is both long term healthy for the market and I would describe it as just a correction in the market as we have seen in this market from time to time.

Importantly, what we are not seeing is a deterioration in the fundamental credits, and we are not seeing a decline in the liquidity that is coming into the market. We are simply seeing a selectivity. I think we will be able to work our way through that market through that adjustment, I think the overall market will. Already I think the feedback loop is as you would expect. As new transactions get structured, it reflects that adjustment.

I would also say that well-structured, well-priced credits continue to effectively be executed in the market. We have priced a number of transactions recently and continue to believe that the undertones of that market remains strong.

Glenn Schorr - UBS

Do I have to wait for the Q for the actual commitment size? I am reading into your comments that you are pretty comfortable with your positions, how it's hedged, and don't expect material financial burden going forward on the adjustments we have seen in the market?

Jeff Edwards

What I would say and this is an important point to make, it is a reflection of what I think is broadly important, which is we have very effective risk management. We look at these credits on an individual basis and as we underwrite them, we obviously undertake extensive due diligence. But we too are selective in what we underwrite. I think we have been very effective thus far in that process, and we remain comfortable. It is not to say that there is not going to be some indigestion in the market broadly and clearly, that will impact us to some extent. But overall, we think this is a market that is just going through a correction and we are very happy to have a substantial backlog to execute here.

Glenn Schorr - UBS

That is good enough color. Can we switch to the other one that you brought up in terms of both sub-prime and CDO exposure? You are the largest underwriter of CDOs, and maybe try to give some color around myth versus reality, and how people should think about what is on your books in terms of residuals and exposure, and maybe even comment related to some of the bear hedge funds, what collateral you have taken on your books or have not? Just overall comfort there, as well.

Jeff Edwards

Again I want to make two points. The first is that this is another example where I think proactive aggressive risk management has put us in exceptionally good position. Obviously the market has gone through a period of flux. We think that remains the case. But aggressive risk management, I think, has certainly helped transform our risk profile since the end of the year.

We have seen significant reductions in our exposure to the lower rated segments of the market. Our warehouse lines are down materially, our whole loan inventory is down materially, as was the case in the last quarter. We will see a modest increase in our residual position but it will be small relative to our overall retained interest piece. And I think the majority of our exposure continues to be now in the highest credit segment of the market.

The second point I want to make before I leave the question is this is obviously an area that has received a lot of attention, and it receives a lot attention as we work to risk manage it. But it is only a part of our business, our broader business. It is a part of our structured finance and investment business, which has many other pistons around the world, other asset classes. And in turn, Structured Finance is only a part of our broader FICC business, which is obviously only a part of GMI, and a part of the firm. I think the importance of diversification came through yet again this quarter in these results.

Glenn Schorr - UBS

Maybe just last thing, yes or no; obviously yes, but a point of clarification. Therefore, anything you are financing in your repo business or through your prime brokerage business or on your own books, to the best of your knowledge at the end of quarter it is marked to an effective market, even if it's a mark to model type of security?

Jeff Edwards

Yes. That is right. Obviously we have a very robust process around marking these assets. We are confident in how they are marked.

Operator

Our next question comes from the line of William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

If you look at the net interest profit in GMI, it doesn't look like it really existed this quarter. You saw a sharp sequential decline in the overall firm's net interest profit, and then the corresponding jump in the principal transactions. I know some of that probably has to do with the seasonality around dividend recapture. Can you just give us a little bit more color as to what went on in the GMI segment on the net interest profit side?

Jeff Edwards

Absolutely. I think you made a key point. We have said for some time, and we will reiterate here, that you should look at net interest and PTs together. On that basis, the combined net interest and PT line for the firm overall is up 2% from the first quarter, 77% from the second quarter. Two things that are going on there that I would like to point out. One, as we increase our risk-taking capabilities and increase our focus on trading, you will see and you have seen a general migration in our revenue lines from net interest to PTs.

This quarter, that tends to be highlighted by some of the activity around dividend and yield enhancement season in Europe. As I highlighted on the prepared remarks, that was a strong performer for us this quarter. The nature of that business is such that you see the revenues show up in PTs, the expenses show up in interest expense and so it can exacerbate that effect.

William Tanona - Goldman Sachs

Can you give us just a little bit more details in terms of when you can be in the market and when you can't be in the market in terms of repurchasing your shares around your First Republic transaction?

Jeff Edwards

We will still be out for a period of time here at the beginning of the quarter. The way you look at averaging for the diluted share count calculation, obviously that will have more of an impact than if we were out later in the quarter, which was the case at the end of the second quarter. But we can't predict exactly when that will be. Overall, we would expect that we will be able to be active for most of the quarter, but not all of it.

Operator

Our next question comes from Mike Mayo - Deutsche Bank.

Mike Mayo - Deutsche Bank

Can you give more color on the linked quarter non-U.S. growth? It looks like you had a pretty good jump. Also in terms of backlogs, can you give more color by category? U.S. versus non-U.S.?

Jeff Edwards

Sure, Mike. As you heard in the comments, the results were extremely strong on a linked basis in both Pac Rim and in EMEA, across a broad range of our GMI businesses in particular. It reflects both the investments that we are making in each of those regions to drive growth, as well as strong market conditions there.

In terms of backlogs from a product perspective, I think I highlighted M&A and leveraged finance in particular. From a regional perspective, I would say there is more breadth to that, with particular strength I would say in the non-Americas regions again; EMEA particularly strong; parts of the Pac Rim particularly strong. But the U.S. growth was decent here as well. So I would say overall, regionally balanced.

Mike Mayo - Deutsche Bank

If I am doing my math correctly here, it looks like you didn't have any revenue growth. If you slice it U.S. versus non-U.S., you didn't have growth in revenues in the U.S. It all kind of stemmed from outside the U.S. That is not different than most of the others. Any color on that?

Jeff Edwards

I would say we certainly experienced growth in the U.S. compared to the second quarter of last year. So I would dispute your observation.

Mike Mayo - Deutsche Bank

Linked quarter is how I was looking. I was just wondering if there was anything?

Jeff Edwards

Sorry. Yes, linked quarter we were obviously down overall. But on a year-on-year basis, we saw good growth in the U.S. despite some of the challenges in the markets that are more specifically U.S., I would say. This is just part, though, of a long-term growth pattern that we have seen and we expect to continue.

To give you some sense in GMI as recently as 2005, EMEA was only about half the size of the U.S. Today, it is almost 85% the size of the U.S. The Pac Rim was less than one-third two years ago. Today in the second quarter it was more than half. So the growth trends here internationally are something that we have seen for some time. We expect them to remain in place. I think the results reflect that we are well-positioned to capture more than our share of that growth.

Mike Mayo - Deutsche Bank

Back to the other topic. Can you remind us what percent of your earnings are related to mortgage or sub-prime mortgage? And if you could include in that CDOs, warehouse lines, or anything else.

Jeff Edwards

Well, just to remind everybody, we made the comment in the first quarter that over the previous five quarters, all of that activity as broadly as we could define it, represented less than 2%. As I said, the business overall was down compared to last year, it was up compared to the first quarter. I don't think there is anything that would change that comment that I made in the first quarter.

Mike Mayo - Deutsche Bank

Lastly, a tougher question perhaps. How much of your capital is at risk? How much in total assets do you have that is somehow related to that same category?

Jeff Edwards

Well, we obviously have a robust economic capital model that we employ to address risk around all of our different assets. From an overall asset standpoint, again the point I would make there is that there has been, we think, an important transformation of the components of that asset base, where the exposure that we retain is in the higher rated traunches of the exposure. What we have done is reduce exposure in some of the broader lower rated categories.

Mike Mayo - Deutsche Bank

Do you have an overall number though, for how much capital you have at risk related to sub-prime mortgage, CDOs, warehouse lines?

Jeff Edwards

We don't disclose our capital allocations against any specific or even broader group.

Operator

Our next question comes from Richard Bove - Punk Ziegel.

Richard Bove - Punk Ziegel

I was wondering if you could go further into the Bear Stearns transaction. I don't know if the press reports are anywhere near correct, but they are suggesting that you loaned $800 million to this fund that Bear Stearns put together and that at the present time most of the collateral was still held by Merrill Lynch, and that most of the assets in that fund are not worth $0.10 on the dollar.

So I am just wondering, why would Merrill Lynch lend $800 million if that number is at all correct, to a fund which had not been in existence for a year? Secondly, whether the valuations stated in the press are anywhere near correct? If they are, how you are valuing the collateral that you now hold in that fund?

Jeff Edwards

Well, let me start by saying that we don't normally comment on client matters which are not material. But there obviously has been a fair amount of media attention here. So let me just say that we think our net exposure in the situation is both limited and well under control. We obviously have acted in ways that we think are prudent in managing our risk.

I think again, as a demonstration of our proactivity here. At this point, we remain in active dialogue with Bear Stearns Asset Management, but I think our exposure here is limited, it is contained and it is appropriately marked.

Richard Bove - Punk Ziegel

Can you explain why Merrill Lynch would lend as much as $800 million to any fund which is less than a year old and which has no track record?

Jeff Edwards

We look at all of our hedge fund clients on an individual basis. Obviously providing financing to hedge funds is what the financing and services business is all about. When we undertake to make such loans, we do so in ways that we believe are structured prudently from a credit perspective. We expect to resolve this in a reasonable way and a reasonable amount of time.

Richard Bove - Punk Ziegel

Finally, just overall in the broad high yield market, it appears that yield on high yield bonds has gone up 65 basis points in the last five to six weeks and the ABX index which I guess has a lot of relevance or no relevance depending upon how you use it, has dropped about 40% over the year. What has that done to the valuation of the overall assets of Merrill Lynch?

Jeff Edwards

Well, let me take the two pieces. The price action in high yield markets that you described is, as I said in response to an earlier question, I think part of a normal correction that you would see in this market. The activity that you highlighted in the ABX is something that certainly has been a focus of the broader markets since it began to demonstrate volatility earlier this year in the first quarter.

At any point in time, we have got assets and hedges in place that are directly affected by all of these items. And in the course of the quarter, we seek to mark all of those things. Again, it highlights, I think the importance of having effective risk management, which we believe thus far we have demonstrated has been very effective.

Richard Bove - Punk Ziegel

Does the change in the value of the high yield market, or the cost of operating in a high yield market, of the cost of hedging, and of what apparently are higher margin requirements now from the banks, does that change the ability to handle the backlog that you now have? Does it reduce the number of yields that will be brought to market? Or do people find the change in economics is not impacting their ability to do these deals?

Jeff Edwards

Well, again, I would distinguish between the two markets. I would say the leveraged finance market, you are seeing a correction. You are seeing selectivity, you are seeing selectivity around pricing. I think that will work its way into transactions as this risk works its way into distribution. But the fundamental credits remain attractive and remain performing.

I would say in the sub-prime market, you have got more of a credit dislocation that is working its way through. At the same time, you see responses in say, the CDO market as new classes come about. I think I mentioned a couple of them in my earnings call, as investors look for diversification plays there. But that market remains more in flux, and is likely to remain so for a period of time.

Operator

Our next question comes from the line of Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Just in terms of capital management, can you talk a bit about the relationship between the growth that we are seeing on the borrowing side? I think up about $90 billion over the past year, and the equity up about 6. Is that kind of the similar incremental leverage we should look for going forward?

Jeff Edwards

Well, as we have looked to grow, we have obviously looked to do so in a way that puts appropriate permanent and long-term capital in place. Markets have been strong from an issuing perspective. We have used those markets to put in place a strong capital structure, build our liquidity. It is all part of putting in place a capital management structure that allows us to further drive our return on equity, which we think we have done effectively.

Clearly, I would not expect to grow the long-term debt faster than equity at that rate forever. Our overall capital structure reflects our evaluation of the economic capital that we need to have in place to support the activities that we have.

As you point out, we have grown our equity and expect to continue to do so. We have used hybrid structures, as well to add a further layer in place in a cost effective way. And all of that has come together to allow us to grow the business and drive return on equity.

Prashant Bhatia - Citigroup

Also, you have clearly got a far more diversified business than you have ever had before and we can see that in the revenue performance. Can you talk a little bit as the risk appetite may be for institutions that were chasing yields goes out of the market? Where you are seeing some of the offsets on the positive side in some of the businesses? Were you benefiting from that trend?

Jeff Edwards

Yes, I think in general there is more diversification, not just to the business, but to the risk-taking, as well. You see that in many of the drivers in our other businesses. Looking at FICC, for example, comparing ourselves to where we were at this time last year. I described good results in a number of different business lines, which were driven both by active client activity as well as proprietary risk-taking opportunities.

Rates was a highlight, set a new record again. The commodities business was very strong. We were up year on year in our credit trading businesses. The equity businesses broadly were all up outside of private equity year on year, with strong results in financing and services in particular, equity linked in particular. But cash also on a year-on-year basis.

A lot of that activity as I highlighted was outside the U.S. as well, where there were particularly strong results. There are many different areas where we are seeing increases in risk-taking, increases in client activity, all of which serve to offset weakness in any one area.

Prashant Bhatia - Citigroup

On the private equity side you mentioned that being down, obviously, that is a lumpy business, and probably points to how strong your equity this quarter was compared to last quarter. Can you give us an idea of just the pace of investments on the private equity side? Maybe directionally the capital being allocated to the business and how it compares to last year?

Jeff Edwards

Yes, it's certainly up overall from last year. Last year it was about this time that we announced the HCA transaction which closed at the end of last year. I mentioned a couple of other transactions this quarter that we have announced that we intend to close later in the year, Nuveen and Data Advantage. Earlier this year, at the end of the first quarter I also announced some acquisitions investments at that time.

So we continue to see opportunities to broaden out that business. We added a couple of very senior professionals to that business with specific industry expertise in the areas where we believe there will be more opportunity for growth. So that business, while the revenues will be as illustrated this quarter lumpy, continues to organically build itself, and position itself for further growth.

Prashant Bhatia - Citigroup

Just one final question on the brokerage side of the business. You are up I think about 270 this quarter, 600 for the year. Can you give us an idea for the mix there of trainees versus experienced? And then looking ahead with the AG Edwards acquisition, is that an opportunity to pick up or recruit more experienced hires? How do you think about that?

Jeff Edwards

Well, a couple of points to make here. One, discipline is extremely important here. There are competitors out there with very aggressive packages. We are being very disciplined in how we respond to that. The most important point here is that we believe we have built the best platform for our financial advisors and their clients, and increasingly financial advisors understand the benefits that platform has, both for themselves and for their clients.

As I mentioned, we had very strong recruiting against every major competitor. We do continue to invest in our training program. We believe we can create the best quality FAs in the business. Focusing on retention is also very critical. Retention rates were up very strongly. We had the lowest turnover that we have on record, at least, this past quarter.

All of that, I think is a testament to the investments that we have made in technology and training and products, that allow us to compete effectively for top quality FAs.

Operator

Our next question comes from Meredith Whitney - CIBC World Markets.

Meredith Whitney - CIBC World Markets

I need a little extra help on the values you are ascribing to the mortgage piece and the CDO piece. I appreciate your comments earlier that you are comfortable with how you are valuing them, but for an outsider that doesn't have the benefit of what you see, can you give a little bit more of a qualitative overview in terms of what methods you are using to value these securities? How the methods have changed? At what point have you decided the market deserves a revaluation of these securities? Did you revalue and write down these securities during the second quarter? Any extra color you can give that would help me, and a bunch of others would be appreciated.

Jeff Edwards

Well, of course we are constantly reevaluating these assets and related hedges on a constant basis. So in some cases they get marked down, in some cases they get marked up. The offsets sometimes move in other directions. The broad answer to your question is, yes, we absolutely marked all of that, all of those assets and related hedges during the quarter.

In general when there is an active observable market, we have mark to market. When there are related markets that we can use to interpolate, we also can mark effectively to market. There are some parts, such as the residuals which are more on a mark to model basis based on inputs that we can observe, such as cumulative default curves, for example. And then there are loans that we also make judgments on, using lower cost markets. So, that is a broad explanation as to how we look at those assets.

Meredith Whitney - CIBC World Markets

So, for example, just to get a little more help around this, would the Moody's and S&P downgrade affect your valuations at all?

Jeff Edwards

Everything will affect our valuations and the related hedges. We will constantly be updating for all the new input that comes into the market.

Meredith Whitney - CIBC World Markets

Just one last follow-up in terms of the severity of these marks, would you qualify the second quarter severity to be greater than the first quarter?

Jeff Edwards

Well overall, as I pointed out, the business performed better in the second quarter than it did in the first quarter. Still did not perform as well as it did in the second quarter last year and I think that appropriately gives you a benchmark.

Meredith Whitney - CIBC World Markets

But the indexes are down dramatically from the first quarter this year and the second quarter of last year, so really just speaking about valuations.

Jeff Edwards

All of which is reflected in those results.

Operator

Our next question comes from the line of Doug Sipkin - Wachovia.

Doug Sipkin - Wachovia Securities

First on your appetite for buybacks. Obviously you have been very aggressive, maybe $16 billion or $17 billion worth of buybacks over like a two-and-a-half year period. You have indicated you have ample room to buyback once all of the related lockout periods for First Republic are over.

Has your appetite changed at all, stronger or weaker, now that you guys have put a lot of dollars, also in acquisitions, and things of that magnitude? So I am just looking for some color on how the balance if it all would shift from inorganic to capital deployment, or buyback.

Jeff Edwards

We had a new authorization from our board of directors during the quarter, which we have only scratched the surface on really. I think we are some $500 million or so into our new buyback. So we intend to have buybacks continue to be an important part of our capital management activities; of course it is only one part. Dividends have also played an important role. We have increased dividends, as you know each of the last three years.

The most important point is that we look to deploy capital, and we have found attractive ways to deploy capital organically and we will continue to look for those as well. Net/net, I would say we will continue to balance all of those things over the foreseeable future.

Doug Sipkin - Wachovia Securities

I was surprised how strong the fixed income trading was this quarter, you indicated that rates were very strong. Did that get stronger month on month as the interest rates started to spike, maybe in the late May/June period? Would you say June was probably the strongest month for rates?

Jeff Edwards

I would say broadly for our fixed income business without getting too specific on individual areas within fixed income, I would say it is fair to say that June was the strongest month.

Operator

Ladies and gentlemen, I do apologize, we have reached the allotted time for questions and answers. I will now turn the call back over to Jonathan Blum for some final remarks.

Jonathan Blum

Thank you. This concludes our investor relations earnings call. If you have further questions, please call Investor Relations at 212-449-7119. Fixed Income Investors should call 866-607-1234. Thanks for joining us today. We appreciate your interest in Merrill Lynch.

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