Merrill Lynch: A Bad Q3 Gets Even Worse

A couple of weeks ago Merrill Lynch (MER) announced that it would record a loss for Q3, and would write down approximately $5B in fixed income related losses. Then came the news right before their earnings announcement that things would in fact, be significantly worse:

From the NY Times:

Merrill Lynch is expected to report today that it will add about $2.5 billion more to the $5 billion worth of write-downs it has already announced, according to a person briefed on the situation.

Merrill reports its third-quarter earnings this morning. The bank announced earlier this month that it expected to write down $5 billion because of losses in its fixed-income unit. Most of the losses, the bank said, were tied to the decline in value of complex debt instruments called collateralized debt obligations, whose value has diminished in recent months as credit markets have been hit by a collapse in the subprime mortgage market.

After the “leaked info” there came the actual earnings report and to say Q3 was an earnings debacle for MER was an understatement:

• A net loss of $2.3 billion or $2.85 per share.
• Total revenue of $577 million, a 94% YoY decline due to losses within the fixed income segment. Fixed income losses were so severe that they offset revenue gains in investment banking (23%), global wealth management (29%), and other segments. In fact, if you take away fixed income the company would’ve had a good quarter; fixed income was literally the bad apple that spoiled the bunch.
• $7.9 billion worth of subprime related write-downs. Let me repeat that, $7.9 billion worth of subprime related write downs. Now other banks have written of billions as well, had significant issues of their own, etc, but they were due to a combination of things: mortgage securities, LBO loans, credit costs, fixed income trading, etc. MER had nearly $8 billion in losses just from debt securities.
• $8.4 billion worth of total write downs, the largest ever by a Wall St. firm
• Roughly $20 billion worth of exposure to subprime mortgage securities, CDOs and other debt securities.
• Only big Wall St. Firm to record a loss.

There is only one way to describe it: “financial carnage”.

During the earnings conference call, MER CEO Stanley O’Neal said the following:

From Reuters:

"The bottom line is we got it wrong by being overexposed to subprime," Merrill Lynch Chairman and Chief Executive Stan O'Neal said on a conference call.”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.

[…]

I'm not going to talk around the fact that there was some mistakes that were made," O'Neal said.”I am accountable for the mistakes as I am accountable for the performance of the firm overall and my job, our job, the leadership team's job is to address where we went wrong."

I often find myself chuckling at the banking executives who like to pretend that the credit squeeze is the sole reason behind mortgage securities related losses; as if the housing downturn and mortgage crisis weren’t the real driver. The credit crunch may have exasperated things, but banking executives should be more honest about the underlying causes. All that being said let’s not pick on Merrill Lynch too much; during the conference call they did provide more detail around their exposure to CDOs and mortgage securities than did most other banks and brokers.

Moving forward, it will be interesting to observe what the future holds for Merrill Lynch. The company hasn’t shown a lot of good judgment when it comes debt investing and the remaining CDOs and subprime mortgages could still haunt the company in future quarters. With respect to the management team, CEO Stanley O’Neal’s job is probably imperiled and the recent management shake-ups could just be the tip of the iceberg. The recent management changes may help, but “crisis related firings” are often token gestures that don’t do much to solve the underlying problem. A lot of companies address major problems by changing people, when the real solution is changing the culture, business approach and resolving the larger strategic issues that led the company down the wrong path in the first place. It’s an issue of do you change a couple of people (who are really scapegoats, even if they do bear some responsibility) or do you do you change the larger organization?

MER didn’t lose over $8 billion in one quarter because a couple of guys made bad decisions, they lost $8 billion because of the way the company (as a whole) approached debt investing.

However, let’s not throw out the baby with the bath water, take out the fixed income losses and you have a company that generated significant revenue gains in practically all of its business segments. Once the company winds down its remaining subprime positions in addition to some of the CDOs (again, we really can’t trust their judgment when it comes to debt investing right now), the company could be a buy considering its depressed stock price. However, I’d wait 1-2 quarters before buying a piece of MER.

Sources:

NY Times: “Merrill Lynch to Report $2.5 Billion in Added Loss” – Jenny Anderson, Landon Thomas Jr, October 24, 2007

Reuters: “Merrill Lynch writes down $7.9 bln of subprime bets” – Tim McLaughlin, October 24, 2007

Disclosure: the Author doesn’t own a position in Merrill Lynch.