Merrill Lynch Q3 2007 Earnings Call Transcript

Oct.24.07 | About: Merrill Lynch (MER)

Merrill Lynch & Co., Inc. (MER)

Q3 2007 Earnings Call

October 24, 200710:00 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 AmericaSecurities

Jeff Harte - Sandler O’Neill

Douglas Sipkin – Wachovia

Meredith Whitney -CIBC World Markets

Presentation

Operator

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

Sarah Furber

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

The following live broadcast is copyright to Merrill Lynch.Statements made today may contain forward-looking information. While thisinformation reflects management’s current expectations or beliefs, you shouldnot place undue reliance on such statements, as our future results may beaffected by a variety of factors we cannot control.

I would direct you to read the forward-looking disclaimer inour quarterly earnings release as it contains additional important disclosureson this topic. You should also consult our reports filed with the SEC for anyadditional information, including risk factors specific to our business and theinformation on the calculation of non-GAAP financial measures that is posted onour investor relations website, www.ir.ml.comwhere an online rebroadcast of this conference call will be available today atapproximately 1:00 pm Eastern time.

Unless otherwise indicated, comments will exclude the impactof one-time compensation expenses related to adopting FAS 123-R in the firstquarter of 2006, as well as the one-time net gain from the closing of thecombination of Merrill Lynch Investment Managers or MLIM with Black Rock in thethird 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, areavailable in the attachments to Merrill Lynch earnings release, as areschedules 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 ourteam. 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, ourperformance and our focus going forward, and then Jeff Edwards will brieflytake you through our operating results. After that, Jeff, Ahmass Fakahany andGregory Fleming and I will be happy to answer your questions.

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

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

The bottom line is we got it wrong by being overexposed tosub-prime, and we suffered as a result of an unprecedented liquidity squeezeand deterioration in that market. No one -- no one -- is more disappointed thanI am in that result. As the market for these securities began to deteriorate inthe first quarter, we began substantially reducing our warehouse risk byconstructing CDOs and retaining the highest parts of the capital structure,which we expected then to be more resistant to market disruptions in terms ofboth liquidity and price. We sold and hedged our exposures to the lower-rated traunchesof these securities but our hedging of the higher-rated traunches was notsufficiently aggressive, nor was it fast enough.

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

We were left with a position difficult to manage andsuffered significant value erosion as a result. During the quarter andthroughout the year, we have substantially reduced our net exposures andcontinue to work to do more, but our exposures remain subject to marketvaluations.

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

As a result of completing this process, we recorded a moresignificant loss for the quarter than we had initially estimated on October 5. I am not going to talk around the fact thatthere were some mistakes that were made. I am accountable for these mistakes justas 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 werenecessary 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 newrole 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 basedon risk management. I am looking to himto bring that same orientation to the rest of the FICC organization.

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

Given the current and expected market environment, we arecontinuing to resize our balance sheet, including rescaling our CDO, mortgagesand First Franklin businesses. We're optimizing our capital allocation acrossbusinesses firm-wide where we see higher growth and higher returnopportunities.

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

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

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

In other areas of FICC, we continue to actively increaserisk-taking capabilities. Rates and currenciesare running at record levels and we continue to invest in these businesses. Incredit trading, our businesses away from CDOs has performed well. We'recapitalizing on the explosive growth in emerging markets and products such ascredit derivatives. Our performance in equity markets demonstrates that we arealso managing our risk well and earning appropriate returns on the risks thatwe're taking.

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

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

We remain confident in our business capabilities in riskmanagement, but we recognize we still have exposure in specific areas where themarkets remain illiquid. We continue to manage our remaining positions byreducing risk at prudent transaction values wherever possible.

On the other hand, we expect our other businesses tocontinue 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 businessesincluding FICC, where revenues excluding sub-prime mortgages and CDOs were up11% 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 worldand continues to get stronger. For the firm as a whole, our non-U.S. revenueswere up 25% for the first nine months of the year.

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

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

Let me just wrap up by touching on what we see as theseopportunities. The first is globalization. Today, Merrill Lynch is truly aglobal firm. Business outside of the U.S.contributed 55% of the firm's total net revenues for the first nine months of2007. This percentage was 60% for our GMI business when you exclude the sub-primemortgages and CDOs.

In the Pacific Rim, for example, our pretax earnings are up100% year-to-date, and we're continuing to leverage both strong market growthand our on the ground presence in the region.

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

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

Finally, we believe Merrill Lynch is uniquely positioned tobenefit from the industry-wide growth of alternative investment products forboth institutions and private clients. We have made a series of investments inbest in class hedge funds such as Sterling Stamos and GSO Capital. The additionof First Republichas added to GPC's already unique service distribution capabilities in theultra 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 whoare committed to the success of this firm, as am I. Accordingly we're focusedon ensuring we can retain and reward these people, despite short-term events, becausethe long-term value of this firm is paramount and is greater than currently reflectedin the market and has yet to be fully realized.

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

Jeff Edwards

Thank you, Stan.Third quarter net revenues were $577 million, a substantial decline from both thethird quarter of last year and our very strong second quarter. Diluted earningsper share and net earnings were also negatively impacted with Merrill Lynchreporting 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 downsubstantially from prior periods, although away from CDOs and mortgages, ourbusinesses performed well. GMI revenues for the nine-month period were $9.7billion, down 28% from the prior year period. GMI's pretax loss for the quarterwas$4.4 billion.

Turning to the revenue detailed by business line. Total netlosses for the third quarter across our CDO and sub-prime mortgage businessesequaled $7.9 billion. The vast majority of these losses were related to CDOsand 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 ourremaining CDO exposure is in the form of super senior positions and nearly 100%is rated AAA although our current valuations are substantially less than theseratings would indicate.

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

Within our sub-prime mortgage business, our exposure wasless than $6 billion, down approximately 35% from the second quarter andapproximately 75% from year end. This exposure consists of residential whole loans,warehouse lending, residential mortgage-backed security positions andresiduals. At the end of the third quarter, our sub-prime residential wholeloan exposure was approximately $3 billion, down nearly 80% from year end; ourfunded and unfunded warehouse lines totaled approximately $737 million, down90% from year end; our RMBS net positions outside of the CDO business were lessthan $350 million net, down over 65% from year end and our residual positionswere approximately $1.6 billion at quarter end. In aggregate, our netwritedowns 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 liquidpositions, we utilized various quantitative valuation techniques, employingrelevant market-based parameters and indices. We also recorded $463 million ofnet writedowns related to our non-investment grade lending commitments, net offees, or $967 million on a gross basis. In aggregate, these losses resulted inFICC third quarter revenues of negative $5.6 billion. Revenues for the firstnine months of 2007 were negative $153 million, down significantly from theprior year period.

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

Turning to equity markets, where third quarter net revenuesof $1.6 billion were up 4% compared to the year ago quarter, notably, excludingprivate equity, third quarter revenues actually increased 40% year on year.Third quarter net revenues from private equity were negative $61 million, downfrom a positive $342 million in the prior year period and $125 million in thesecond quarter. However, even including this quarter's losses in privateequity, 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-linkedbusinesses generated significant year-on-year increases and performed well,despite hedge funding deleveraging during the quarter. In fact, our primebrokerage client balances are back to near peak levels after dipping in August.Equity markets results also included sequential declines from the strategicrisk group, as well as equity-linked trading which had set a revenue record inthe second quarter.

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

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

Our investment banking fee pipeline remains strong. We endedthe third quarter down from peak levels in the second quarter, but higher thanat this time last year with particular strength in advisory and equityunderwriting mandates.

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

Aggregate GWM third quarter revenues of $3.5 billion were up29% year on year, and down less than 1% sequentially, even in the seasonallyslow 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 andwere a record $9.6 billion for the first nine months of 2007. Revenues were thehighest achieved in any third fiscal quarter, up 23% from the prior-yearperiod. Year on year, revenues rose across all major categories, led by recordfee-based revenues, which reflected higher asset values and continued strengthin flows from the annuitized product. Transaction and origination revenuesincreased substantially. Nearly half of the growth in transactional revenueswas driven by regions outside of the U.S.and origination revenues were driven by a few particularly large deals. Record net interest revenues also contributedto the overall increase.

Highlights for the quarter within GPC include success inretaining our industry-leading team of financial advisors who have generatedover $850,000 of annualized revenues per FA for the year to date. We alsocontinued to recruit and train FAs, adding 410 on a net basis during thequarter. Recruiting was positive against our major competitors and we alsocapitalized on recent industry consolidations to bring in high quality,experienced FAs. Turnover among our top two quintiles remains at historicallylow 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 annuitizedrevenue products seeing a robust $10 billion.

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

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

We are not wedded to specific compensation ratios and do notexpect to reduce overall compensation levels in line with our significantlylower revenues, given that managers and employees of other businesses areproducing record performance that is critical to our plans for growth. Asalways, our progression toward the full year ratio will depend on theenvironment, but we anticipate it could remain at elevated levels in the fourthquarter.

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

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

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

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

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

Question-and-AnswerSession

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 exposurewas around $32 billion, $15 billion as of the end of September. You marked downaround $6 billion. Where did the other $11 billion go? Last I checked, therewere not a lot of sales on the market.

Jeff Edwards

Glenn, even in the most challenging times of the market inAugust, September, we were able to reduce our exposure through markettransactions 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 havebeen active on the catch-up mode on marketing out some of the underlyingcollateral. Can you talk through how we should think about that, post thesemore conservative assumptions you used?

Very importantly, given that most of the remaining of your exposureis super senior traunches, how much of those super seniors have the EOD -- eventof default language -- such that you canaccelerate the cash flows upon the markdown of the collateral?

Jeff Edwards

Let me start, Glenn, by saying you're 100% right. Theprimary exposure is in what continue to be AAA rated super senior exposures andprimarily with the highest attachment points by category. Given theenvironment, we believe that the valuations are conservative and appropriate. Goingforward, we'll continue to take opportunities to reduce inventories, but in aprudent way.

Glenn Schorr - UBS

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

Stan O’Neal

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

Jeff Edwards

I would just add that the trajectory that we saw at the endof 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. Interms of the underlying language, the event of default language, in the super seniorstructures, do the cash flows get accelerated and do you move into liquidationmode? 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 aroundhow we look at the different securities. Clearly, in some cases, that isexactly what we will be thinking. In other cases, it is different. I just don’twant to go into too much further detail on that.

Glenn Schorr - UBS

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

Jeff Edwards

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

Operator

Your next question comes from William Tanona – GoldmanSachs.

William Tanona –Goldman Sachs

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

Jeff Edwards

The answer is both, but I don’t want to get into detailsabout the breakdown. This is a market where there are both cash opportunitiesfor 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 yougive us more color and a breakdown of your total $15 billion exposure that isremaining by ratings? What is AAA, AA what might be single and BBB?

Jeff Edwards

I think we have gone to pretty substantial length here toprovide more insight into that than others have provided. As you can see, it isoverwhelmingly AAA rated super senior and other super senior levels. It isprimarily investment grade and mezzanine with a very small amount of CDOsquared, and then a very small amount of other securities remaining in ourretained warehouse inventory.

William Tanona –Goldman Sachs

Were those ratings basically at the time of the actualunderwriting of the CDO, or is that the exposure of the ratings of the currentexposure?

Jeff Edwards

At the time, they are [inaudible].

William Tanona –Goldman Sachs

And then in terms of the markdowns and your existingexposure, you had mentioned in your comments about where available, you choseobservable market prices in order to mark these things to market. Can you giveus a percentage of your markdowns that were observable market prices and whatmight 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 thatwe will get to at this point. But it reflects both cash market observablelevels as well as quantitative valuation.

Operator

Your next question comes from Roger Freeman – LehmanBrothers.

Roger Freeman –Lehman Brothers

I just wanted to follow up on a couple of these issues thathave been raised. As you thought about the revised marks, my assumption is thatyou actually marked the majority of these CDOs to a model, because again, tookanticipative recent rating changes on the underlying collateral, and it doesn’tseem that is necessarily reflected in the market values but rather expectationsof what would happen. Is that fair to say?

Jeff Edwards

I think it is fair to say that as we looked at thosequantitative valuations, as we went through the quarter end process, in lightof the environment we felt that it was appropriate to adjust the assumptionsthat 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, inaddition to what has happened to the underlying collateral?

The other piece of that is, how do you think about thepotential liquidity dislocation that could occur as these downgrades happen andinsurance 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 whilemarkets generally, for most of our businesses, remain extremely strong, werecognize that there are potential continued elements that could challengecertain 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 wherethey are held within the broker dealer versus the bank balance sheet?

Jeff Edwards

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

Roger Freeman –Lehman Brothers

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

Stan O’Neal

All of our regulated entities are well capitalized.

Roger Freeman – LehmanBrothers

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

Jeff Edwards

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

Operator

Your next question comes from Mike Mayo – Deutsche Bank.

Mike Mayo – DeutscheBank

It is the view of our firm, or me, is the disclosure is notsufficient to completely understand how much that remaining of $15 billion ABSCDOs have been written down? Can you give us that percentage?

Jeff Edwards

No. Obviouslysubstantially.

Mike Mayo – DeutscheBank

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 issuein 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 observethat we took substantial markdowns here. We think that reflects conservativeassumptions, again. And that weincorporated the trajectory of the environment as we took this into account.

Mike Mayo – DeutscheBank

If I can ask Stan, do you feel comfortable that there is notanother 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 atthis point, in the market. The expectation for progression of these securitiesas of the date that we took the markdowns. I cannot tell you what the markettrajectory 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 generalenvironment, we are comfortable that we have marked these positionsconservatively.

Mike Mayo – DeutscheBank

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

Stan O’Neal

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

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

Mike Mayo – DeutscheBank

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

Stan O’Neal

As soon as we are able to talk about it. It would be nothingthat you would think would be poor, to our investment banking, global wealthmanagement business.

Mike Mayo – DeutscheBank

You mentioned BlackRock, the value being up $4 billion, Iguess 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 assetfor the foreseeable future. We never wanted to decrease our exposure or ourability to participate in the asset management business. We think we havecreated a way in which we can participate in a much better form and it is ourintent to continue to be a part of that and to nurture that investment as longas 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 howmuch 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 weinterpret that as the marks right now reflect where you can sell these assetsin the marketplace? I understand the markets are liquid and so called goodassets are selling at depressed prices, but have you marked them down to wherethey could clear the market, and you don’t want to sell them at these depressedprices?

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, webelieve we have been conservative in modeling the values.

Prashant Bhatia –Citigroup

Where you have been conservative, how do you think thatcompares 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 ofactually marking the inventory, and how that has changed based on what you haverun in this quarter?

Stan O’Neal

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

Prashant Bhatia –Citigroup

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

Stan O’Neal

Look, the losses here are outside the parameters of our riskappetite. There were some mistakes made in us having these results. The primarymistakes were errors of judgment and understanding the nature of the risk asthe 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 wellin the marketplace for our clients. As a consequence of being in these markets,many markets both geographically and product-wise, we have to have theexpertise for taking risk. That is just a core competency that is required tobe successful in this business. We seeno scenario under which we would move back from that idea.

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

Operator

Your next question comes from Michael Hecht – Banc ofAmerica Securities.

Michael Hecht – Bancof 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 revenuesgoing forward, and GMI's business more broadly?

Stan O’Neal

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

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

Michael Hecht – Bancof America Securities

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

Stan O’Neal

Well we have alreadyseen some liquidity return to that market, and I think a number of notabledeals have gotten priced. There are pools of capital that have formed to takeadvantage of the dislocation, and the process of repricing and resetting termsand conditions in that market have taken place in an orderly fashion, incontrast to the process in other parts of the market.

We are seeing renewed discussions and activity aroundpotential 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 wehave, and I think we have done a very good job of managing our way through thistightening of liquidity in leveraged finance.

Michael Hecht – Bancof America Securities

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

Jeff Edwards

First Franklin isintegrated into our overall business and that is how we evaluate it. There isno impairment appropriate.

Michael Hecht – Bancof America Securities

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

Stan O’Neal

I think the platform is really strong and it has beengetting 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 financialadvisors and I think the best product suite and platform to support those financialadvisors. Throughout all of this period, the business has continued to performwell both in terms of revenues and profitability, but most importantly, interms of capturing new clients and bringing in new assets.

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

Michael Hecht – Bancof America Securities

As we have been on the call here, I saw S&P just cuttheir rating and change the outlook. Howshould we think about that? Implications for funding costs? Any otherimplications?

Stan O’Neal

Well in terms of ourliquidity planning, we incorporate various rating scenarios and we are comfortablewithin the parameters of our liquidity. In terms of pricing, the market will ultimatelydetermine what that price is.

Operator

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

Jeff Harte - SandlerO’Neill

Can you give us some more comfort with your understanding ofyour current risk loss exposures? I'mhaving a little trouble with how you can feel that you understand your riskexposure, when September 28 marks deteriorated an extra 75% on you after thequarter closed?

Stan O’Neal

It is because we have had some time to do a lot more workand 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 conservativeend of the range.

Jeff Harte - SandlerO’Neill

Should we read that essentially at the end of the quarteryou had certain positions or directional understandings and you were wrong, as opposedto 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'retalking about?

Jeff Harte - SandlerO’Neill

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

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

Stan O’Neal

Again, as of the date we preannounced, the amount we are indicatingwas one which was within a range of valuations that we did at the time. As welooked at it, as we have gone back and examined it in the context of where themarkets are, we believe it is now more appropriate to be at the moreconservative 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 wouldwork; it is more about just making sure that we verified all of the prices andwe came to the conclusion that we were within the range, but we should be moreappropriately at the conservative end of the range.

Jeff Harte - SandlerO’Neill

Looking back at the CDO, the underwriting franchise, can yougive us some idea of what portion of the CDOs you have underwritten have beenmore 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. Goahead.

Stan O’Neal

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

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

Jeff Harte - SandlerO’Neill

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

Stan O’Neal

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

Operator

Your next question comes from Douglas Sipkin - Wachovia.

Douglas Sipkin –Wachovia

Were you guys forced to bring assets that you didn't havepreviously on your balance sheet because of the events that transpired inAugust and September?

Stan O’Neal

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

Douglas Sipkin –Wachovia

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

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

Stan O’Neal

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

Douglas Sipkin –Wachovia

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

Stan O’Neal

Could you repeat thequestion?

Douglas Sipkin –Wachovia

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

Jeff Edwards

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

Operator

Your final question comes from Meredith Whitney - CIBC WorldMarkets.

Meredith Whitney - CIBC World Markets

Good morning. I have a general question. With respect toyour 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 toFirst Franklin acquisition, and if you could provide some color in terms ofdirectionally, obviously the revenues head down as you make a strategic betaway from that; but in terms of firm-wide then, what are the steps that we willsee over the next couple of quarters in terms of replacing those revenues,management shifts, further management shifts and an ability to match expenseswith the declines in revenues?

Stan O’Neal

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

Secondly, with regard to First Franklin. The idea behindFirst Franklin was to be able to more directly control the quality of loansthat were being taken into inventory as raw material, if you will, forsecuritization.

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

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

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

Meredith Whitney - CIBC World Markets

A nitty-gritty question, since we're talking about such bignumbers, I am going to just press on some of the issues that you have avoidedwith 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 areliquidity hedges embedded in that? Any more color, I know everyone wouldappreciate 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 SarahFurber for some final remarks.

Sarah Furber

Thank you. This concludes our earnings call. If you havefurther questions, please call investor relations at 212.449.7119. Fixed incomeinvestors should call 866.607.1234. Thanks for joining us today. We appreciateyour interest in Merrill Lynch.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!