Merrill Lynch Q3 2007 Earnings Call Transcript

Merrill Lynch & Co., Inc. (MER)

Q3 2007 Earnings Call

October 24, 2007 10:00 am ET

Executives

Sarah Furber - IR

Stan O’Neal – Chairman and CEO

Ahmass Fakahany - Co-President

Greg Fleming - Co-President

Jeff Edwards - CFO

Analysts

Glenn Schorr - UBS

William Tanona – Goldman Sachs

Roger Freeman – Lehman Brothers

Mike Mayo – Deutsche Bank

Prashant Bhatia – Citigroup

Michael Hecht – Banc of America Securities

Jeff Harte - Sandler O’Neill

Douglas Sipkin – Wachovia

Meredith Whitney - CIBC World Markets

Presentation

Operator

Welcome to the Merrill Lynch third quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the call over to Sarah Furber, Head of Investor Relations. Please go ahead.

Sarah Furber

Good morning and welcome to Merrill Lynch’s conference call to review results for the third quarter and first nine months of 2007. To address the market environment and our performance, I am joined today by Merrill Lynch’s senior management team, including Chairman and Chief Executive Officer Stan O’Neal; Co-Presidents Ahmass Fakahany and Greg Fleming; and Chief Financial Officer Jeff Edwards.

The following live broadcast is copyright 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 we cannot control.

I would direct you to 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 the 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 today at approximately 1:00 pm Eastern time.

Unless otherwise indicated, comments will exclude the impact of one-time compensation expenses related to adopting FAS 123-R in the first quarter of 2006, as well as the one-time net gain from the closing of the combination of Merrill Lynch Investment Managers or MLIM with Black Rock in the third quarter of last year In addition, comments will exclude the operations of Merrill Lynch Insurance Group, or MLIG, which is being reported under discontinued operations.

Full GAAP financials, which include these items, are available in the attachments to 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 Stan O’Neal.

Stan O’Neal

Thank you, Sarah and thank each of you for joining us today. Sarah is our new Head of Investor Relations and an important addition to our team. If you haven't already, you will get to know her in the coming months.

This morning, I will make some comments on the quarter, our performance and our focus going forward, and then Jeff Edwards will briefly take you through our operating results. After that, Jeff, Ahmass Fakahany and Gregory Fleming and I will be happy to answer your questions.

Today, we reported a net loss per diluted share of $2.85 which is larger than our previously announced expected loss of up to $0.50. As you know, earlier this month we announced a number of important changes, beginning with the appointment of David Sobotka into his new role at the helm of FICC These changes have occurred in a market environment that has shown renewed signs of volatility and weakness, as evidenced by recent residential mortgage-backed securities and CDO downgrades by rating agencies; increased expectations of future rating agency actions; and increased default and delinquency trends.

Over the past few weeks, our FICC management team, led by David, has worked with our finance staff to undertake a rigorous and comprehensive review of our remaining CDO and sub-prime-related exposures. This collective review has resulted in the use of more conservative valuation assumptions and a total net writedown of approximately $7.9 billion for this quarter; a significant increase from the writedowns and overall net loss we had previously estimated. While Jeff will provide specific details around our remaining exposures and valuation assumptions, let me start by giving you a summary of the events that have occurred over the course of this year and have led to the losses that we're reporting today.

The bottom line is we got it wrong by being overexposed to sub-prime, and we suffered as a result of an unprecedented liquidity squeeze and deterioration in that market. No one -- no one -- is more disappointed than I am in that result. As the market for these securities began to deteriorate in the first quarter, we began substantially reducing our warehouse risk by constructing CDOs and retaining the highest parts of the capital structure, which we expected then to be more resistant to market disruptions in terms of both liquidity and price. We sold and hedged our exposures to the lower-rated traunches of these securities but our hedging of the higher-rated traunches was not sufficiently aggressive, nor was it fast enough.

Despite the fact that nearly all of our remaining CDO exposure is super senior, it turned out that both our assessment of the potential risk and our mitigation strategies were inadequate. By the end of August, it became apparent that we were in the midst of an unprecedented event; a complete withdrawal of liquidity from the market for these securities. As events progressed throughout August and into September, it became clear that these were now structural changes in the market, driving values far lower than contemplated by our models' most punitive stress event scenarios.

We were left with a position difficult to manage and suffered significant value erosion as a result. During the quarter and throughout the year, we have substantially reduced our net exposures and continue to work to do more, but our exposures remain subject to market valuations.

As part of our valuation process, we mark to observable trading levels wherever possible and we are judicious in applying model-driven valuations where necessary. As always, our valuation processes are fully reviewed by independent finance and control staff and as I mentioned, in finalizing our valuations, our FICC management team has worked with that staff, including our independent price verification group, to review the validity of our pricing assumptions and ensure that these assumptions are consistent with levels we see in the marketplace.

As a result of completing this process, we recorded a more significant loss for the quarter than we had initially estimated on October 5. I am not going to talk around the fact that there were some mistakes that were made. I am accountable for these mistakes just as I am accountable for the performance of the firm overall. My job, our job, the leadership team's job is to address where we went wrong, what changes were necessary to make sure that we respond to changes in risk dynamics early, correctly and in every asset class at every stage of the market's evolution.

So as I mentioned, we have made a number of changes -- important changes -- beginning with our moving of David Sobotka into his new role leading the FICC organization. David brings the right mix of strong leadership, trading acumen and experience, and risk management skills to his new position. He's a business builder who developed a culture in our commodities group based on risk management. I am looking to him to bring that same orientation to the rest of the FICC organization.

We have also moved Ed Moriarty, who did an excellent job of stewarding our leverage finance exposures over the past few years and through this liquidity squeeze, we have moved him into the role of Chief Risk Officer for the firm. Ed Moriarty is going to assume responsibility for market risk, in addition to his existing brief in credit risk and now has the title of Chief Risk Officer, integrating both of those functions. He's already at work creating entire linkages among market and credit risk and the businesses and he has begun reevaluating parts of our risk framework.

Given the current and expected market environment, we are continuing to resize our balance sheet, including rescaling our CDO, mortgages and First Franklin businesses. We're optimizing our capital allocation across businesses firm-wide where we see higher growth and higher return opportunities.

As part of this optimization, we continue to explore the divestiture of certain non-core assets, along the lines of the recently announced transaction related to our insurance manufacturing business. Opportunities being actively explored include the potential divestiture of other non-core capital intensive businesses and monetization of one or several of our private holdings.

We take risk in many parts of our firm as a natural consequence of our position in the markets, as we have been doing effectively and consistently across all of our other businesses. In commodities, for example, we have successfully and profitably managed risk, both for our clients and for ourselves. We are expanding our platform beyond natural gas and power into asset classes such as coal, oil, metals and into key markets, especially the Pacific Rim.

Importantly, we have achieved this despite periods of extreme market volatility and disruption over the past few years, such as during the collapse of the hedge fund Amaranth.

In other areas of FICC, we continue to actively increase risk-taking capabilities. Rates and currencies are running at record levels and we continue to invest in these businesses. In credit trading, our businesses away from CDOs has performed well. We're capitalizing on the explosive growth in emerging markets and products such as credit derivatives. Our performance in equity markets demonstrates that we are also managing our risk well and earning appropriate returns on the risks that we're taking.

We have successfully built our proprietary trading capability and are completing groundbreaking deals such as the $19 billion Rice issue for Fortis. This transaction was the largest international equity deal ever done and the largest single equity commitment we have ever made.

In private equity, despite a weaker result this quarter which was primarily driven by fluctuations in our publicly-traded positions, that business continues to deliver a strong risk/reward proposition. In leverage finance, which is important to our investment banking business, our coverage of private equity firms, our M&A practice, it's impossible to participate and avoid taking risks. We're a big player in this marketplace and have been for years, but we've managed our aggregate exposure well by aggressively selling down our positions, successfully hedging and maybe most importantly, by being selective in our choice of deals to underwrite.

We remain confident in our business capabilities in risk management, but we recognize we still have exposure in specific areas where the markets remain illiquid. We continue to manage our remaining positions by reducing risk at prudent transaction values wherever possible.

On the other hand, we expect our other businesses to continue to perform well as they have all year and as they did in this quarter. I would note that year-over-year performance, for example, for the businesses including FICC, where revenues excluding sub-prime mortgages and CDOs were up 11% year over year for the quarter. Our equity markets revenues were up 40%. Investment banking was up 23%. Our global wealth management was up nearly 30% and from my point of view, this is the best business of its kind in the world and continues to get stronger. For the firm as a whole, our non-U.S. revenues were up 25% for the first nine months of the year.

I would also note our BlackRock investment continues to perform exceedingly well. In the marketplace today at the current stock price it is worth roughly $12 billion, which is about a 30% increase in value from the time that we announced the transaction.

The strong performance of these businesses convinces me that overall, we are on the right path and we're executing on the right set of long-term strategies. While we are intensively focused on managing through this period of dislocation, we remain equally focused on driving future growth. Outside of mortgages, our execution has been consistent. Our plan is to continue investing to take advantage of the longer-term secular opportunities we see.

Let me just wrap up by touching on what we see as these opportunities. The first is globalization. Today, Merrill Lynch is truly a global firm. Business outside of the U.S. contributed 55% of the firm's total net revenues for the first nine months of 2007. This percentage was 60% for our GMI business when you exclude the sub-prime mortgages and CDOs.

In the Pacific Rim, for example, our pretax earnings are up 100% year-to-date, and we're continuing to leverage both strong market growth and our on the ground presence in the region.

Another core priority for us is to take advantage of opportunities for our institutional and global wealth management franchises to work more closely together on a fully integrated basis to accelerate growth. This is especially important in the Pacific Rim, India, Latin America, the Middle East and in parts of Europe. In many of these markets, our model for growth will be more of a high net worth, private investment banking model that emphasizes the increasing product and customer overlap which occurs between high net worth individuals and institutions.

The third theme, one I have already touched on, is principal investing, deploying our own and clients' capital to generate growth and returns. We're now applying the discipline that we brought to the private equities space more broadly as recent market events are also presenting opportunities in distressed assets and restructuring, for example.

Finally, we believe Merrill Lynch is uniquely positioned to benefit from the industry-wide growth of alternative investment products for both institutions and private clients. We have made a series of investments in best in class hedge funds such as Sterling Stamos and GSO Capital. The addition of First Republic has added to GPC's already unique service distribution capabilities in the ultra high net worth client segment.

We have a great organization, which despite this event, remains a great organization and is filled with extremely talented people who are committed to the success of this firm, as am I. Accordingly we're focused on ensuring we can retain and reward these people, despite short-term events, because the long-term value of this firm is paramount and is greater than currently reflected in the market and has yet to be fully realized.

Let me now turn the microphone over to Jeff Edwards and we'll come back for questions.

Jeff Edwards

Thank you, Stan. Third quarter net revenues were $577 million, a substantial decline from both the third quarter of last year and our very strong second quarter. Diluted earnings per share and net earnings were also negatively impacted with Merrill Lynch reporting a net loss of $2.3 billion and net loss per diluted share of $2.85.

Let me now review each of our major segments:

GMI third quarter revenues of negative $3 billion were down substantially from prior periods, although away from CDOs and mortgages, our businesses performed well. GMI revenues for the nine-month period were $9.7 billion, down 28% from the prior year period. GMI's pretax loss for the quarter was$4.4 billion.

Turning to the revenue detailed by business line. Total net losses for the third quarter across our CDO and sub-prime mortgage businesses equaled $7.9 billion. The vast majority of these losses were related to CDOs and net exposure related to our trading positions is currently $15.2 billion, down over 50% from the second quarter. As Stan mentioned, almost all of our remaining CDO exposure is in the form of super senior positions and nearly 100% is rated AAA although our current valuations are substantially less than these ratings would indicate.

Let me provide you some detail behind these exposures. Our super senior CDO exposures consist of three buckets: high grade, mezzanine and CDO squared, and is predominantly in the highest attachment point in each category. At the end of the third quarter, our high grade net exposure was approximately $8 billion. Our mezzanine net exposure was approximately $5 billion and our CDO squared net exposure was approximately $600 million.

Within our sub-prime mortgage business, our exposure was less than $6 billion, down approximately 35% from the second quarter and approximately 75% from year end. This exposure consists of residential whole loans, warehouse lending, residential mortgage-backed security positions and residuals. At the end of the third quarter, our sub-prime residential whole loan exposure was approximately $3 billion, down nearly 80% from year end; our funded and unfunded warehouse lines totaled approximately $737 million, down 90% from year end; our RMBS net positions outside of the CDO business were less than $350 million net, down over 65% from year end and our residual positions were approximately $1.6 billion at quarter end. In aggregate, our net writedowns related to these exposures totaled $1 billion during the quarter.

Across our CDO and sub-prime positions, wherever possible, we mark to observable prices and other transparent market data. For less liquid positions, we utilized various quantitative valuation techniques, employing relevant market-based parameters and indices. We also recorded $463 million of net writedowns related to our non-investment grade lending commitments, net of fees, or $967 million on a gross basis. In aggregate, these losses resulted in FICC third quarter revenues of negative $5.6 billion. Revenues for the first nine months of 2007 were negative $153 million, down significantly from the prior year period.

Apart from those areas discussed above, rates and currencies both generated record revenues on the strength of client volumes and trading results for the quarter. Real estate and commodities remained steady, although commodities revenues were lower than in the comparable 2006 period. FICC revenues were also positively impacted by a net benefit of approximately $400 million related to changes in the carrying value of certain long-term debt liability.

Turning to equity markets, where third quarter net revenues of $1.6 billion were up 4% compared to the year ago quarter, notably, excluding private equity, third quarter revenues actually increased 40% year on year. Third quarter net revenues from private equity were negative $61 million, down from a positive $342 million in the prior year period and $125 million in the second quarter. However, even including this quarter's losses in private equity, equity markets year-to-date net revenues reached a record $6.1 billion, up 23% from the prior year period.

Our cash equities, financing and services and equity-linked businesses generated significant year-on-year increases and performed well, despite hedge funding deleveraging during the quarter. In fact, our prime brokerage client balances are back to near peak levels after dipping in August. Equity markets results also included sequential declines from the strategic risk group, as well as equity-linked trading which had set a revenue record in the second quarter.

In investment banking, we have demonstrated global strength and are leading new groundbreaking transactions such the successful $101 billion acquisition of ABN AMRO by our clients RBS, Santander and Fortis, where we acted as exclusive financial advisor to the consortium.

In investment banking, we generated solid revenue despite seasonally slower market activity levels with $1 billion in total, up 23% year on year. Revenues for the first nine months increased 38% over the 2006 period to a record $3.8 billion. This quarter, our advisory and equity underwriting revenues were up significantly year over year, while debt origination revenues were down from both comparable periods due to weakness in leverage finance origination revenues.

Our investment banking fee pipeline remains strong. We ended the third quarter down from peak levels in the second quarter, but higher than at this time last year with particular strength in advisory and equity underwriting mandates.

Turning to GWM, this quarter we have made significant strategic progress and achieved record results in our global wealth management business. On the strategic front, we closed our acquisition of First Republic and announced the sale of our insurance manufacturing operations Aegon, as part of the creation of a broader strategic relationship between our two firms.

Aggregate GWM third quarter revenues of $3.5 billion were up 29% year on year, and down less than 1% sequentially, even in the seasonally slow period which included significant market volatility. Pretax profits were $953 million and the pretax margin of 26.9% is near historical highs.

GPC net revenues for the third quarter were $3.3 billion and were a record $9.6 billion for the first nine months of 2007. Revenues were the highest achieved in any third fiscal quarter, up 23% from the prior-year period. Year on year, revenues rose across all major categories, led by record fee-based revenues, which reflected higher asset values and continued strength in flows from the annuitized product. Transaction and origination revenues increased substantially. Nearly half of the growth in transactional revenues was driven by regions outside of the U.S. and origination revenues were driven by a few particularly large deals. Record net interest revenues also contributed to the overall increase.

Highlights for the quarter within GPC include success in retaining our industry-leading team of financial advisors who have generated over $850,000 of annualized revenues per FA for the year to date. We also continued to recruit and train FAs, adding 410 on a net basis during the quarter. Recruiting was positive against our major competitors and we also capitalized on recent industry consolidations to bring in high quality, experienced FAs. Turnover among our top two quintiles remains at historically low levels and the FA force continued to grow more rapidly outside of the U.S. We saw our strongest quarterly net new money in over six years at $26 billion. Client assets reached a record of $1.8 trillion with net new money into annuitized revenue products seeing a robust $10 billion.

Moving on to GIM, which generated net revenues of $270 million, The year-over-year growth of over 200% was driven by the inclusion of our share of BlackRock's results in the current period but not in the 2006 third quarter, as well as growth in revenues from our investments in alternative asset managers.

That concludes my discussion of the segment. Now I'll return to the firm as a whole and discuss expenses. I'll start with compensation expenses, which were $2 billion for the quarter versus $4.8 billion in the second quarter and $3.9 billion from the 2006 third quarter. The year-to-date comp ratio of 58.1% is about 9 percentage points higher than the first nine months of 2006 and reflects our focus on continuing to recruit and retain top tier talent to drive our growth initiatives forward.

We are not wedded to specific compensation ratios and do not expect to reduce overall compensation levels in line with our significantly lower revenues, given that managers and employees of other businesses are producing record performance that is critical to our plans for growth. As always, our progression toward the full year ratio will depend on the environment, but we anticipate it could remain at elevated levels in the fourth quarter.

Moving on to non-compensation costs, which increased to $2.1 billion for the quarter, driven by approximately $100 million from the write-off of First Franklin identifiable intangible assets, as well as significant growth in our BC&E expenses reflecting higher volumes.

The effective tax rate was 23.1% for the first nine months of 2007, down from 25.9% during the prior-year period. At this point, we expect that rate to increase modestly in the fourth quarter subject, of course, to the usual factors: business mix, changes in tax laws and settlements.

Finally, the company's liquidity position at quarter end includes cash and other highly liquid securities of approximately $70 billion readily available to the holding company. Additionally, we have close to $100 billion of deposits and significant additional liquidity resources across our global banking and key other regulated entities. Total equity capital was $43 billion at quarter end. As always, we closely monitor our liquidity, given that market conditions remain unsettled, we remain focused on pursuing opportunities to preserve and enhance our liquidity and capital positions, such as our recently-announced strategic transaction with our insurance group and Aegon. However, our liquidity and capital position are strong, and we are confident in our financial position and our ability to manage through turbulent markets such as those we have seen over the past quarter.

As part of its active management of equity capital, Merrill Lynch repurchased 19.9 million shares of its common stock for $1.5 billion during the third quarter of 2007, largely to offset the 11.6 million shares issued as consideration upon closing the First Republic Bank acquisition. In the near term, we do not anticipate repurchases but will balance our future pace with potential investment opportunities and our capital needs.

With that, Stan, Greg and Ahmass and I are happy to take your questions.

Question-and-Answer Session

Operator

Your first question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

As of the end of June, you noted that your ABS CDO related exposure was around $32 billion, $15 billion as of the end of September. You marked down around $6 billion. Where did the other $11 billion go? Last I checked, there were not a lot of sales on the market.

Jeff Edwards

Glenn, even in the most challenging times of the market in August, September, we were able to reduce our exposure through market transactions for a good part of the exposure.

Glenn Schorr - UBS

So most of that other $11 billion was sold? That is good. You mentioned that you planned to continue to do so if the market lets you.

Now since September 30, you know, the rating agencies have been active on the catch-up mode on marketing out some of the underlying collateral. Can you talk through how we should think about that, post these more conservative assumptions you used?

Very importantly, given that most of the remaining of your exposure is super senior traunches, how much of those super seniors have the EOD -- event of default language -- such that you can accelerate the cash flows upon the markdown of the collateral?

Jeff Edwards

Let me start, Glenn, by saying you're 100% right. The primary exposure is in what continue to be AAA rated super senior exposures and primarily with the highest attachment points by category. Given the environment, we believe that the valuations are conservative and appropriate. Going forward, we'll continue to take opportunities to reduce inventories, but in a prudent way.

Glenn Schorr - UBS

But to the rating agency downgrade specifically, does that matter? In other words, when you go through and do your marks as of September 30, my gut is it's not a shock that the rating agencies needed to move some collateral positions lower.

Stan O’Neal

I think it's fair to say that the market has been ahead of where the rating agencies are and we have looked to the market wherever possible as an indicator of value.

Jeff Edwards

I would just add that the trajectory that we saw at the end of the quarter, it was clear that some of these actions were going take place.

Glenn Schorr - UBS

That is clear. That's the comment I was looking for. In terms of the underlying language, the event of default language, in the super senior structures, do the cash flows get accelerated and do you move into liquidation mode? Do the super senior traunches start to hoard all that cash flow now?

Jeff Edwards

Glenn, I don’t want to get into all of the details around how we look at the different securities. Clearly, in some cases, that is exactly what we will be thinking. In other cases, it is different. I just don’t want to go into too much further detail on that.

Glenn Schorr - UBS

Over the last couple of years, number one or two underwriter on the CDO side. How much of that paper has been sold into the wealth management organization, and do you see that as an issue?

Jeff Edwards

It is a relatively small amount and we don’t see that as an issue.

Operator

Your next question comes from William Tanona – Goldman Sachs.

William Tanona – Goldman Sachs

Good morning. Quickly a follow-up on Glenn’s question in terms of the reduction in exposure. You mentioned that you were able to reduce it through market actions. Were you actually able to sell it, or were you able to hedge it? If you could give us a breakdown of what you were able to sell versus what you might have been able to hedge?

Jeff Edwards

The answer is both, but I don’t want to get into details about the breakdown. This is a market where there are both cash opportunities for reduction, and derivative opportunities.

William Tanona – Goldman Sachs

Is it safe to say that the majority was hedging though?

Jeff Edwards

I just don’t want to get into the details behind that.

William Tanona – Goldman Sachs

In terms of looking at the super senior pieces, could you give us more color and a breakdown of your total $15 billion exposure that is remaining by ratings? What is AAA, AA what might be single and BBB?

Jeff Edwards

I think we have gone to pretty substantial length here to provide more insight into that than others have provided. As you can see, it is overwhelmingly AAA rated super senior and other super senior levels. It is primarily investment grade and mezzanine with a very small amount of CDO squared, and then a very small amount of other securities remaining in our retained warehouse inventory.

William Tanona – Goldman Sachs

Were those ratings basically at the time of the actual underwriting of the CDO, or is that the exposure of the ratings of the current exposure?

Jeff Edwards

At the time, they are [inaudible].

William Tanona – Goldman Sachs

And then in terms of the markdowns and your existing exposure, you had mentioned in your comments about where available, you chose observable market prices in order to mark these things to market. Can you give us a percentage of your markdowns that were observable market prices and what might have been your subjectivity, as well as what might be remaining with the $15.2 billion?

Jeff Edwards

The markdowns reflect both. I think that is the level that we will get to at this point. But it reflects both cash market observable levels as well as quantitative valuation.

Operator

Your next question comes from Roger Freeman – Lehman Brothers.

Roger Freeman – Lehman Brothers

I just wanted to follow up on a couple of these issues that have been raised. As you thought about the revised marks, my assumption is that you actually marked the majority of these CDOs to a model, because again, took anticipative recent rating changes on the underlying collateral, and it doesn’t seem that is necessarily reflected in the market values but rather expectations of what would happen. Is that fair to say?

Jeff Edwards

I think it is fair to say that as we looked at those quantitative valuations, as we went through the quarter end process, in light of the environment we felt that it was appropriate to adjust the assumptions that went into those to a much more conservative level.

Roger Freeman – Lehman Brothers

Is it fair to say that in thinking about rating changes, that you are considering the likely downgrade of CDOs that are coming, in addition to what has happened to the underlying collateral?

The other piece of that is, how do you think about the potential liquidity dislocation that could occur as these downgrades happen and insurance companies and pension funds are force to liquidate in the market?

Stan O’Neal

I think part of our perspective on the markets is that while markets generally, for most of our businesses, remain extremely strong, we recognize that there are potential continued elements that could challenge certain parts of the credit and liquidity market. That is absolutely part of our planning.

Roger Freeman – Lehman Brothers

Are the CDO exposures, can you give us a breakdown of where they are held within the broker dealer versus the bank balance sheet?

Jeff Edwards

No. Let me just say that what we have provided, again, we think is an extraordinarily high level of disclosure and should be sufficient.

Roger Freeman – Lehman Brothers

With respect to regulatory capital, in the Q, some $4 billion of 15C31 capital. With these writedowns, how does that impact it? Are there any issues around regulatory capital requirements?

Stan O’Neal

All of our regulated entities are well capitalized.

Roger Freeman – Lehman Brothers

Lastly, can you comment on what your leverage position was at the end of the quarter in terms of ratios?

Jeff Edwards

We will come out with our balance sheet in our Q. You should expect it to go up, obviously, in light of the earnings results.

Operator

Your next question comes from Mike Mayo – Deutsche Bank.

Mike Mayo – Deutsche Bank

It is the view of our firm, or me, is the disclosure is not sufficient to completely understand how much that remaining of $15 billion ABS CDOs have been written down? Can you give us that percentage?

Jeff Edwards

No. Obviously substantially.

Mike Mayo – Deutsche Bank

I appreciate that the level of disclosure is so much more, but your peers didn’t take an $8 billion writedown. This is the big, lingering issue in the market. Is there another shoe to drop?

What are gross writedowns, since you gave net writedowns?

Jeff Edwards

We are not disclosing our gross amount. Let me just observe that we took substantial markdowns here. We think that reflects conservative assumptions, again. And that we incorporated the trajectory of the environment as we took this into account.

Mike Mayo – Deutsche Bank

If I can ask Stan, do you feel comfortable that there is not another shoe to drop and a lot more writedowns on the ABS CDOs?

Stan O’Neal

We have tried to capture everything that we can capture at this point, in the market. The expectation for progression of these securities as of the date that we took the markdowns. I cannot tell you what the market trajectory might be from here, but as of the date that we took these markdowns, and even looking at it as we sit here today and observing the general environment, we are comfortable that we have marked these positions conservatively.

Mike Mayo – Deutsche Bank

How did you wind up with such a large concentration in the first place? I mean the number of employees is such a small fraction of the overall firm, and it results in results like this? I guess I am asking about risk management, and what went wrong and what happened in the last three weeks to wind up with $3 billion of additional charges?

Stan O’Neal

The $3 billion in additional charges is taking a look at the methodology and going through the marking models, again, and coming to a conclusion that is still within the same range that we had before, but it was more appropriate to be at a more conservative end of the range than we had previously indicated. That is where the $3 billion comes from.

Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves, and there were some errors of judgment made within the risk management function, and that is the primary reason why those exposures exist.

Mike Mayo – Deutsche Bank

And as far as potential divesting of non-core assets, when might we hear more about that?

Stan O’Neal

As soon as we are able to talk about it. It would be nothing that you would think would be poor, to our investment banking, global wealth management business.

Mike Mayo – Deutsche Bank

You mentioned BlackRock, the value being up $4 billion, I guess you have an ownership in Bloomberg, things like that?

Stan O’Neal

We really are quite happy with our investment in BlackRock. As I said at the time we announced the transaction, we want to own this asset for the foreseeable future. We never wanted to decrease our exposure or our ability to participate in the asset management business. We think we have created a way in which we can participate in a much better form and it is our intent to continue to be a part of that and to nurture that investment as long as I can see.

Operator

Your next question comes from Prashant Bhatia – Citigroup.

Prashant Bhatia – Citigroup

On the $8 billion in losses, can you give us a feel for how much of that is realized versus unrealized?

Jeff Edwards

I think we already said that we are not breaking that down.

Prashant Bhatia – Citigroup

You have talked about the marks being conservative. Can we interpret that as the marks right now reflect where you can sell these assets in the marketplace? I understand the markets are liquid and so called good assets are selling at depressed prices, but have you marked them down to where they could clear the market, and you don’t want to sell them at these depressed prices?

Stan O’Neal

I would say the markets are highly illiquid and we have, wherever we can, marked them to market prices and in other instances, we believe we have been conservative in modeling the values.

Prashant Bhatia – Citigroup

Where you have been conservative, how do you think that compares to where it would actually clear the market?

Stan O’Neal

I have no comment on that.

Prashant Bhatia – Citigroup

Can you talk about the process or the methodology of actually marking the inventory, and how that has changed based on what you have run in this quarter?

Stan O’Neal

It actually hasn’t changed, we have the same inputs and as I think I said, the range is still the range. It is just that we are at a significantly more conservative end of that range, with the same methodology.

Prashant Bhatia – Citigroup

Okay. The losses, how does that change the risk appetite near term? You have a new head of FICC that has been in the business at your firm for a couple of years, you have big losses. What does that do to the risk appetite?

Stan O’Neal

Look, the losses here are outside the parameters of our risk appetite. There were some mistakes made in us having these results. The primary mistakes were errors of judgment and understanding the nature of the risk as the markets were changing for these securities. That has nothing to do with the fundamental appetite for risk.

Our appetite for risk is driven by the need to perform well in the marketplace for our clients. As a consequence of being in these markets, many markets both geographically and product-wise, we have to have the expertise for taking risk. That is just a core competency that is required to be successful in this business. We see no scenario under which we would move back from that idea.

In other areas of the firm, as I have mentioned, we take risk on a regular basis in commodities, in our equity business, in parts of leveraged finance. There are many other areas, interest rate trading, FX trading. We will continue to have an appetite in all of those areas. We just got too big in this area.

Operator

Your next question comes from Michael Hecht – Banc of America Securities.

Michael Hecht – Banc of America Securities

A follow up on Prashant's question on diminished risk appetite. How should we think about this affecting the new run rate of FICC revenues going forward, and GMI's business more broadly?

Stan O’Neal

A couple of things. One there has been a structural change in market for these structured products, particularly those which have underlying related to mortgages. The whole structural change in the market makes it less of a market opportunity I think for everyone; for some significant timeframe and perhaps the foreseeable future.

We can generate, we believe, higher rates of return at more attractive risk/reward ratios away from this business anyway. We intend to and we are in the process of, wherever possible, reallocating balance sheet and risk capital to areas that produce better risk/reward ratios. So while it might be true that to some degree, revenues are diminished a bit, we don't see that as over time diminishing our return capability.

Michael Hecht – Banc of America Securities

Shifting over to the OBO side, the exposure that you talked about on October 5th of $31 billion, down a lot, obviously quarter of a quarter and you continue to navigate through with outsized marks there, but it is still a pretty big number relative to equity. How long do you think it will take to work that down and the implications for the high yield and leveraged finance business and the M&A business near term and longer term?

Stan O’Neal

Well we have already seen some liquidity return to that market, and I think a number of notable deals have gotten priced. There are pools of capital that have formed to take advantage of the dislocation, and the process of repricing and resetting terms and conditions in that market have taken place in an orderly fashion, in contrast to the process in other parts of the market.

We are seeing renewed discussions and activity around potential deals, I think already in the marketplace. There are, as I have said, some new sources of capital that are coming into the market as well.

We feel comfortable with the remaining exposures that we have, and I think we have done a very good job of managing our way through this tightening of liquidity in leveraged finance.

Michael Hecht – Banc of America Securities

You mentioned First Franklin in your remarks and how you had a writedown for intangibles. How should we think about the potential for a writedown of goodwill there?

Jeff Edwards

First Franklin is integrated into our overall business and that is how we evaluate it. There is no impairment appropriate.

Michael Hecht – Banc of America Securities

Shifting over to GPC really quickly, can you talk a little bit about the acceleration and retail flows you are seeing? What do you think really is driving that? Does it have more to do with the market or just retail investors becoming more active, or more about share gains on the part of Merrill and things you have been doing to reenergize the platform?

Stan O’Neal

I think the platform is really strong and it has been getting stronger year by year and it continues to separate itself from the competition. It is a well-run business, it is a great franchise. We have the best financial advisors and I think the best product suite and platform to support those financial advisors. Throughout all of this period, the business has continued to perform well both in terms of revenues and profitability, but most importantly, in terms of capturing new clients and bringing in new assets.

I think it is a function of the quality of the business we have and the fact that the issues in the marketplace generally have been severe in some cases, as we have discussed but they have been isolated.

Michael Hecht – Banc of America Securities

As we have been on the call here, I saw S&P just cut their rating and change the outlook. How should we think about that? Implications for funding costs? Any other implications?

Stan O’Neal

Well in terms of our liquidity planning, we incorporate various rating scenarios and we are comfortable within the parameters of our liquidity. In terms of pricing, the market will ultimately determine what that price is.

Operator

Your next question comes from Jeff Harte - Sandler O'Neill.

Jeff Harte - Sandler O’Neill

Can you give us some more comfort with your understanding of your current risk loss exposures? I'm having a little trouble with how you can feel that you understand your risk exposure, when September 28 marks deteriorated an extra 75% on you after the quarter closed?

Stan O’Neal

It is because we have had some time to do a lot more work and we have reviewed the methodology, we have reviewed the pricing standards, we have reviewed the inputs and we have come to the conclusion that again, within the same range it is appropriate to mark it much more towards the more conservative end of the range.

Jeff Harte - Sandler O’Neill

Should we read that essentially at the end of the quarter you had certain positions or directional understandings and you were wrong, as opposed to maybe you didn't understand the potential magnitude of the exposures?

Stan O’Neal

I'm sorry. This is at the end of the third quarter you're talking about?

Jeff Harte - Sandler O’Neill

On September 28^th, I am getting to when you preannounced the dollar values you preannounced versus what you are reporting now, I am having trouble getting my arms around or accepting how you effectively understood your risk exposures from a risk management and a hedging standpoint on September 28^th, given the retroactive changes you made.

Did the directional just go the wrong way or were you surprised by the magnitude of the exposures you wound up having?

Stan O’Neal

Again, as of the date we preannounced, the amount we are indicating was one which was within a range of valuations that we did at the time. As we looked at it, as we have gone back and examined it in the context of where the markets are, we believe it is now more appropriate to be at the more conservative end of the range. There is no change in the perspective on it. There is no change in hedging assumptions or how we think the hedging would work; it is more about just making sure that we verified all of the prices and we came to the conclusion that we were within the range, but we should be more appropriately at the conservative end of the range.

Jeff Harte - Sandler O’Neill

Looking back at the CDO, the underwriting franchise, can you give us some idea of what portion of the CDOs you have underwritten have been more to client-specific specifications versus just generally securitizing, saying you hope to spin out?

I suppose ultimately what I am getting at… I am sorry. Go ahead.

Stan O’Neal

I think I understand the question. I would say that the business was originally designed to be all specified for clients. Although it is hard to tell looking back and understanding precisely how things evolved, it would appear that we drifted away to some degree from that specification for the design of the business.

How much of that was a function of drift and focus and strategy and how much of that was just a function of competitive forces in the marketplace is unclear, but the business was originally designed to be essentially bespoked for portfolios.

Jeff Harte - Sandler O’Neill

If that is the case, specifically structured for the client, at what point in time do the mortgages and whatever assets you are collecting to put into the CDO or the CDO itself get moved to a bankruptcy remote location, as opposed to being on your balance sheet? At what point in time does it become someone else’s risk as opposed to your risk?

Stan O’Neal

I think as soon as the structuring process, there's a sufficient amount of resources that have accumulated in order to make it the risk of the investor. The arrangements in many cases differ from investor to investor.

Operator

Your next question comes from Douglas Sipkin - Wachovia.

Douglas Sipkin – Wachovia

Were you guys forced to bring assets that you didn't have previously on your balance sheet because of the events that transpired in August and September?

Stan O’Neal

We did see some assets come on our balance sheet as a result of the extreme liquidity crunch in August and September. Our liquidity position that we described reflects that.

Douglas Sipkin – Wachovia

Drilling down a little bit more on the sale of non-core assets, I know there's always speculation around your stake in Bloomberg. Is it a conscious decision of you guys not to revalue it to market or is there more to it than that? Considering, I guess, the potential ratings implications and your capital position, I would think it would make sense to revalue that and improve your equity position.

I'm just wondering, is that your decision as an elective, or is that actually just something you can't do?

Stan O’Neal

We are not going to comment on any specific investments at this point, including Bloomberg.

Douglas Sipkin – Wachovia

Finally, you talked about the consortium transaction, the banking fees around that, does some of that fall into Q3 or will all of that be a Q4 event?

Stan O’Neal

Could you repeat the question?

Douglas Sipkin – Wachovia

I believe Jeff mentioned in his comments about the landmark financial transaction with ABN AMRO, and I know you guys are the lead advisor and banker on that. Are the bulk of the fees still to be recognized in the fourth quarter, or are there some that have already flowed through in the third quarter?

Jeff Edwards

The answer to that is there were some that had been recognized previously, the bulk are in the fourth quarter.

Operator

Your final question comes from Meredith Whitney - CIBC World Markets.

Meredith Whitney - CIBC World Markets

Good morning. I have a general question. With respect to your comments on sub-prime and the mistake associated with the sub-prime bet, it seems to me that the sub-prime bet was firm-wide, extending from CDOs to First Franklin acquisition, and if you could provide some color in terms of directionally, obviously the revenues head down as you make a strategic bet away from that; but in terms of firm-wide then, what are the steps that we will see over the next couple of quarters in terms of replacing those revenues, management shifts, further management shifts and an ability to match expenses with the declines in revenues?

Stan O’Neal

Sure, two things. One is I think I said earlier that while revenues related to this area will obviously be severely constrained for some foreseeable period of time, we think that despite that, we can actually earn a higher rate of return in areas away from this.

Secondly, with regard to First Franklin. The idea behind First Franklin was to be able to more directly control the quality of loans that were being taken into inventory as raw material, if you will, for securitization.

By having a high quality originator which we could directly control the parameters in which they were originating mortgages, we believed we would be able to gain more quality control over the assets as opposed to purchasing from third party mortgage brokers.

We did not buy a portfolio with First Franklin, we bought a platform and First Franklin's platform is very high quality. We have a shrunk that platform, reflecting the current state of the market. We closed some 20 branches, and we've scaled back the personnel in line with that.

So there will be an impact, obviously, in terms of revenues related to these areas, but I really don't believe over the intermediate to longer term that it will affect our ability to generate returns. It may diminish revenues, but not overall returns.

Meredith Whitney - CIBC World Markets

A nitty-gritty question, since we're talking about such big numbers, I am going to just press on some of the issues that you have avoided with respect to the hedge on the $11 billion in sales or relocation of assets.

Can you talk about what type of hedges and whether there are liquidity hedges embedded in that? Any more color, I know everyone would appreciate it. Thanks.

Stan O’Neal

Sorry, we don't have any more color. Thank you.

Operator

Ladies and gentlemen, let me now turn the call back to Sarah Furber for some final remarks.

Sarah Furber

Thank you. This concludes our 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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