Executives
Sara Furber - Investor Relations
John A. Thain - Chairman of the Board, Chief Executive Officer
Nelson Chai - Chief Financial Officer, Executive VicePresident
Eric Heaton - Treasurer
Analysts
Glenn Schorr - UBS
Roger Freeman - Lehman Brothers
Mike Mayo - Deutsche Bank
Prashant Bhatia - Citigroup
Jeffery Harte - Sandler O'Neill
William Tanona - Goldman Sachs
Michael Hecht - Banc of America Securities
Meredith Whitney - Oppenheimer
Merrill Lynch & Co., Inc. (MER) Q4 2007 Earnings Call January 17, 2008 8:00 AM ET
Operator
Good morning and welcome to the Merrill Lynch fourth quarterand year-end 2007 earnings conference call. (Operator Instructions) I’d nowlike to turn the call over to Sara Furber, head ofInvestor Relations. Please go ahead.
Sara Furber
Good morning and welcome to MerrillLynch's conference call to review the 2007 fourth quarter and full yearresults. The following live broadcast is copyrighted 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 that we cannot control.
You should read the forward-lookingdisclaimer in our quarterly earnings release as it contains additionalimportant disclosures on this topic. You should also consult our reports filedwith the SEC for any additional information, including risk factors specific toour business and the information on calculation of non-GAAP financial measuresthat is posted on our investor relations website, www.ir.ml.com, where anonline rebroadcast of this conference call will be available later today atapproximately 11:00 a.m. Eastern Time.
Unless otherwise indicated,comments will exclude the impact of the one-time compensation expenses relatedto adopting FAS-123R in the first quarter of 2006, as well as the one-time netgains from the closing of the combination of Merrill Lynch Investment Managers,or MLIM, with BlackRock in the third quarter of last year.
In addition, comments will excludethe operations of both Merrill Lynch Insurance Group, MLIG, and Merrill LynchCapital, which are now reported under discontinued operations.
Full GAAP financials which includethese items are available in the attachments to the Merrill Lynch earningsrelease, as are schedules reconciling those data to the numbers that will bediscussed.
Today I am joined by MerrillLynch's senior management team, including Chairman and Chief Executive Officer,John Thain; Chief Financial Officer, Nelson Chai; and Treasurer, Eric Heaton.
And now I will turn the call overto John Thain.
John A. Thain
Thank you, Sara and good morning,everyone and thank you for being on the call. This morning I would like tostart our call by making some comments on the firm’s results and the actionsthat the senior management team and I have taken since my arrival here aboutsix weeks ago.
Nelson Chai, our new ChiefFinancial Officer, will briefly take you through our operating results.Afterwards, Nelson, Eric, and I are happy to answer your questions.
Today, as you know, we reported anet loss of $8.6 billion for the full 2007 year and a net loss of $10.3 billionfor the fourth quarter. This quarter’s losses were primarily driven bywrite-downs of $11.5 billion related to CDOs and sub-prime mortgages, and $3.1billion related to increased credit reserves against financial guarantorcounter parties.
With these write-downs, the firm’sremaining net exposures to CDOs are $4.8 billion and to sub-prime mortgages are$2.7 billion respectively. And I want to emphasize the fact that theperformance of the vast majority of Merrill’s businesses were very strong in2007 and in particular, global private client equity markets and investmentbanking all had record revenues in 2007.
So let me first talk about what ourfocus has been for the first six weeks and then we’ll get into some moredetails on the results.
The first focus for the managementteam was on liquidity and remember the concern, particularly as we got to theend of the calendar year, was on how much of a liquidity squeeze there would be.And I am very pleased to say that we ended our fiscal year with $80 billion ofcash and liquidity available to us at the holding company. That number was morethan what we had targeted and we were very comfortable with our liquidityposition, both at the end of the year and going forward. We also finished theyear with over $100 billion of deposits in our banks.
We have been actively working tobring down the size of our balance sheet. We are reducing positions,particularly illiquid assets and freeing up liquidity, and we will continue todo that into the first quarter, particularly reducing carry type trades andilliquid assets within our fixed income areas.
The second main focus was oncapital and as you already know, we raised $6.2 billion of common from Temasekand Davis Advisors, and we announced on Tuesday anadditional $6.6 billion of mandatory convertible securities primarily from aKorean investment corp, Kuwait Investment Authority, and a Mizuho corporatebank and several other important investors. With those two capital raisestotaling $12.8 billion we have, significantly greater than the losses, replacedour equity base and we have put ourselves in a position that we are wellcapitalized, both at the parent level and at our regulated subsidiary level,and we are very confident that we have the capital base now that we need to goforward into 2008 and beyond.
In addition to the capital raise,we also freed up capital. We freed up about $2 billion of additional capitalthrough the sale of the vast majority of the assets of Merrill Lynch Capitaland MLIG. And so we have the ability to continue to rationalize and redeployour equity and our balance sheet and you’ll see us continue to focus on balancesheet management and allocation of capital as we go into 2008.
The other important piece of this,which is either already out or is in the process of coming out today, will beour rating and I do expect -- and I know some of them are already out thismorning -- I do expect that all of our rating agencies will in fact reconfirmour ratings and that was one of the major focuses of the capital raise. And ofcourse, we did the capital raise in advance of our earnings because we wantedto comfortably be in excess of the capital we had lost and be well capitalizedand maintain our ratings.
The third focus is on people andorganizational structure. I am committed to flattening out the organizationalstructure to broadening out the senior management team and to reduce what Iperceive as some of the siloing that has taking place at Merrill Lynch over thecourse of the last few years.
Just in terms of the strengtheningand bonding of the senior management team, as you already know, Nelson Chai isour new Chief Financial Officer. We’ve also brought back Jeff [Cronthal], whois a veteran of the mortgage area and he is helping us work through our CDO andmortgage related positions and I believe, I hope, later today we will alsoannounce an addition to our risk management team. This is a senior experiencedrisk management person who will co-head our risk functions with Ed Moriarty. Weare combining all of risk, both market and credit risk, in this new person andEd will report directly to me, which is also a change in terms of theorganizational structure.
I think it is very important thatwe emphasize to the organization going forward the importance of riskmanagement. In the leveraged finance area, we actually did a very good job in risk management and as youhave seen, we are -- our portfolio on the leverage finance side is in very goodshape, but on the trading side, in particular as it relates to CDOs, we did notdo a good job. And that really begins at the very first line of defense, whichare the trade invests themselves.
So one of the other changes that Iam going to make is I will bring in a new global head of trading and that is anewly created position, will also report directly to me. So we will be addingtalent and emphasis on trading and we’ll be adding talent and emphasis on therisk management functions. And going forward, and this is a philosophicalpoint, in our trading businesses, both equities and FICC, we will continue totake risk. Trading businesses don’t make money if they don’t take risk. But therisks that they take will be sized appropriately to the businesses. None of thetrading businesses should be taking risks, either single positions or singletrades, that wipe out the entire year’s earnings of their own business and ofcourse certainly shouldn’t be taking a risk or wipe out the earnings of theentire firm.
We will be reducing the type ofcarry trades that are very balance sheet intensive. We will also move more ofour illiquid assets type of investing into third-party funds. We are actuallyin the process of doing that already in the case of our Pacific rim real estatefund. So you’ll see us be more conservative in terms of the use of the balancesheet for illiquid assets but we are still in the risk-taking business.
We also have reinstituted a riskcommittee. That committee will meet weekly. It will include the heads of all ofthe trading businesses and it will include, of course, our risk management teamand myself. And we’ve also added Bill McDonough, who’s a great resource to us.As you probably know, Bill has been at the scene of pretty much every majorfinancial crisis over the last 25 years and so he will also be a great additionto that risk management function.
I also just want to comment oncompensation philosophy because this gets to the broader topic of broadeningout the management team and reducing the silos. We will change, and we are inthe process of doing that now with this comp year, the compensation philosophyso that the first and most important thing is how well does the firm as a wholedo and then the second impact will be how does the individual business area doand how do individuals do. And the other change this year has been an increasein the equity component of comp, and I think those two things will also helpthe development of a more team oriented atmosphere and focusing on the firm asa whole.
Now, before I turn it over toNelson, I want to just make a couple of comments about why I chose to come toMerrill. I came here because I believe this is a world-class franchise. It hasa tremendous brand. It has a unique set of businesses with a global footprintand it has a great culture. And I have been very impressed by how many of theMerrill employees talk about their commitment to the company, their long tenurewith the company.
I was actually down in Arizona at aconference for the top managers of the global wealth area and the culture andthe strength of the culture here is terrific. In spite of the difficult marketenvironment and in spite of the changes at the top of the firm, I just want toreiterate how strong most of the businesses have done this year and of course,we are very optimistic as we look out into 2008.
But just to give you a couple ofideas, for the full year within FICC, rates and currencies, two business areas,set new revenue records, grew more than 60% year over year. Equity markets, asI said, had a record. Their revenues were $8.3 billion, up 23% year over year.Investment banking had record revenues, up 22%. And global wealth managementreported revenues up 18% and pretax earnings up 41%. So the growthopportunities in our mix of businesses are very strong.
I also want to comment that at current prices, our BlackRockinvestment is worth more than $13 billion and it remains a core strategic assetfrom my perspective. It is not something that we would look to sell.
And I also believe that we have a great opportunity outsideto the United States. Although the U.S. economy, and I guess we’ll see what Mr.Bernacki has to say today, but the U.S. economy is likely to be slower in 2008.
We continue to see great growth opportunities outside theU.S. and particularly in India, China, Latin America, Brazil, Russia, andreally across the entire Pacific Rim. So I believe that the performance of ourcore businesses provides clear evidence that our business strategy is a goodone, that we have great long-term prospects, and as I look out into 2008, I amvery optimistic about our ability to perform for our shareholders.
So with that, I will turn the call over to Nelson.
Nelson Chai
Thank you, John. Let me reiterate John’s comments about howimpressed I’ve been with the people I’ve met here and the strength of theMerrill franchise.
With that, let me briefly review our results. Fourth quarternet revenues were a negative $8.2 billion. Diluted earnings per share netearnings were also negatively impacted with Merrill Lynch reporting a net lossof $10.3 billion and a net loss per diluted share of $12.57.
Let me now review each of our major segments. GMI fourthquarter revenues of negative $11.8 billion were down substantially from priorperiods, although our non-FICC businesses performed well. GMI revenues for thefull year were negative $2.7 billion. GMI’s pretax loss for the quarter was$15.8 billion.
Turning to the revenue detail by business line, FICC resultsare dominated by write-downs of $11.5 billion related to U.S. ABS, CDOs, andsub-prime. In addition, FICC was negatively impacted by credit valuationadjustments of $3.1 billion related to the firm’s financial guarantor exposuresand additional write-downs related to other residential mortgages, commercialreal estate, and leverage finance.
Let me walk you through the major buckets.
On the CDO front, the vast majority of our losses in thisquarter are related to U.S. ABS CDOs and the net exposure related to thesepositions is currently $4.8 billion. As you can see in our release, netexposure at the end of the third quarter was $15.8 billion, which was reducedby $9.9 billion of net write-downs and $1.1 billion of other net changes, whichincludes interest amortization and the impact of hedging activity.
Our super senior ABS CDO long exposure, which excludes theimpact of the hedges and short positions, is $30 billion at year-end postwrite-downs. At the end of the fourth quarter, our high grade net exposure wasapproximately $4.4 billion, our mezzanine net exposure was approximately $2.2billion, our CDO squared net exposure was approximately $270 million, and ourCDO secondary trading positions were net short, or negative approximately $2billion.
Our valuation of these exposures takes into considerationthe deteriorating market conditions for these securities, as evidenced bydeclining indices, such as the ABX remittance and cumulative loss data.
The majority of write-downs this quarter were related to thefirm’s U.S. high grade super senior ABS CDO exposures. A significant portion ofthe underlying collateral for our super senior exposures is comprised of 2006vintage mortgages, which have been valued using cash flow analysis withcumulative loss assumptions primarily between 16% and 21% based upon multipleinputs, including market data and projections for future collateralperformance.
During the fourth quarter, we recorded substantial creditvaluation adjustments of negative $3.1 billion related to hedges we had withfinancial guarantors, which include a credit valuation adjustment to write downthe firm’s current exposure to a non-investment grade counterparty.
For U.S. super senior ABS exposures, our hedge related creditadjustments were negative $2.6 billion. While we use a range of counterparties,such as financial guarantors, insurance companies, and hedge funds to wrap andhedge a variety of products, as of year-end we had $14 billion of net notionalsuper senior ABS CD exposure that was hedged with financial guarantors, ofwhich the vast majority was against high grade exposures with high attachments.
On the sub-prime and other residential mortgages, within oursub-prime mortgage business, our exposure is $2.7 billion and in aggregate, ournet write-downs related to these exposures totaled $1.6 billion during thequarter. These enabled to meaningfully reduce our exposure to the completion ofwhole loan sales and securitization transactions during the quarter.
In addition to our sub-prime related exposures, we also tookmarks of approximately $400 million on our U.S. Alt-A exposures and $500million on our mortgage exposures outside the U.S., as sub-prime contagionspread to other residential markets.
On the commercial real estate and leveraged finance front,within our commercial real estate business our aggregate net write-downstotaled approximately $230 million for the fourth quarter and were the resultof spread widening and market illiquidity.
Within leveraged finance, net write-downs of approximately$126 million were recorded with respect to these financing commitments.
Finally, within our U.S. bank and related investmentsecurities portfolio, we recognized a $1.3 billion of net write-downs through othercomprehensive income, or OCI, and $869 million of net write-downs through theincome statement. These adjustment primarily relate to U.S. sub-prime and ABSCDO securities and are in line with adjustments we have made to comparablesecurities outside our bank’s investment securities portfolio.
Apart from those areas discussed above, the challengingbusiness environment affected all of our major FICC business in the fourthquarter. Rates and currencies both generated record revenues for the full year butwere down substantially during the fourth quarter from record third quarterlevels as the benefit of increased volatility was offset by substantiallyweaker client flows and decreased trading opportunities, particularly inDecember versus September.
During the quarter, our MUNI business also experiencedsequential declines as issuance slowed amid mono-line credit fears. Offsettingthese declines was a net benefit of approximately $800 million during thequarter related to changes in the carrying value of certain long-term debtliability.
Turning to equity markets, fourth quarter net revenues of$2.2 billion were up 23% compared to the year-ago quarter. Equity markets fullyear net revenues reached a record $8.3 billion, up 23% from the prior-year period.For the fourth quarter, we reported significant year-on-year revenue increasesin our equity-linked, cash and financing and services businesses, with ourprime brokerage client balances up over 50% year over year.
These revenue increases were partially offset by declines inproprietary trading. Sequentially, prop trading rebounded off a weak thirdquarter while the prime brokerage business experienced declines, reflecting theseasonality of yield enhancement business I Europe. This quarter’s results alsoincluded approximately $500 million in fair value adjustments related tocertain long debt liabilities.
In investment banking, we continue to demonstrate globalstrength and generated solid revenues, despite slower market activity levels inNovember and December, with revenues of $1.2 billion in the fourth quarter, up15% on a sequential basis.
Revenues for the full year increased 22% over 2006 to arecord $4.9 billion. This quarter, our advisory revenue set a new record and we’reup significantly, both sequentially and year over year, while debt originationrevenues were down in both comparable periods due to continued weakness inleveraged finance origination revenue. Equity origination was mixed, upslightly from the third quarter but down from the prior year period.
During the quarter, Merrill Lynch ranked first in globalequity and equity linked transactions and number two in global debt and equityfees. And for the full year, we finished in a top five ranking across globaldebt, global equity and equity-linked, and global completed M&A.
Our investment banking fee pipeline remains strong. We endedthe year down from peak levels in 2007 but higher than the 2006 year end, withparticular strength in advisory and equity under-writing mandates.
Turning to GWM, GWM had again another strong quarter, withrecord revenues of $3.6 billion, up 12% year-on-year and 2% sequentially. Evenin this challenging period which included significant market volatility, pretaxearnings of $914 million were up 30% year over year and pretax margin was25.4%.
For the full year, GWM generated significant revenue andpretax earnings growth of 18% and 41% respectively, while achieving a pretaxmargin just under 26%. This year, we continued to make significant strategicprogress in our global wealth management business. In the third quarter, weclosed our acquisition of First Republic and in the fourth quarter, wecompleted our planned sell of MLIG, which resulted in an after-tax gain of $316million, which is being reported under discontinued operations.
GPC net revenues in the fourth quarter were $3.3 billion,the second-highest achieved in any quarter, up 10% from the prior year period.Fourth quarter revenue growth was driven by record fee-based revenue, whichreflected higher market values and fee-based assets. Transaction andorigination revenues were up slightly from the prior year quarter but downsequentially from the third quarter of 2007, which included revenues of $128million related to a sizable transaction.
For the full year, GPC’s record revenues of $12.9 billionwere up 14%. We achieved the strongest annual net new money in over seven yearsof $80 billion. Client assets reached $1.7 trillion, just 1% off the recordreached at the end of the third quarter.
Success in retaining our industry-leading team of financialadvisors in 2007, representing the fourth consecutive year we have grown our FA[headcount] by at least 5% while maintaining an annualized revenue per FA of$860,000. This is even more impressive considering that our industry-leadingtrading program, from which we derive significant future benefits, actuallydilutes this metric in the near term until trainees become fully productive.
Positive recruiting against our peer group and turnover, whichcontinues to be at historically low levels of our top two quintile, FA growthof 21% and revenue growth of 24% outside the Americas. And during the quarter,we transitioned more than $100 billion of client assets from our MLUA accounts into other platforms and virtuallyno client assets were transferred outside of Merrill Lynch. Excluding theimpact of the MLUA transition, our net annualized -- annuitized would have beenover $20 billion for the quarter.
Moving on to GIM, which generated net revenues of $286million for this quarter -- year-over-year growth of 36% was driven primarilyby BlackRock earnings growth and increased revenue from our businesses thatcreates alternative investment products for GPC clients.
Also this month, we reached an agreement to sell our 20%stake in GSO Capital to Blackstone, which we expect to result in a modest gainbut a significant return on investment. Blackstone will broaden its assetmanagement capabilities with the addition of GSO and we will be an investor anddistributor of a GSO-managed fund. This transaction demonstrates our success intaking strategic equity stakes in world-class money managers.
That concludes my discussion of the segments. Now I’ll turnbriefly to the firm as a whole and discuss expenses.
I’ll start with compensation expenses, which for the fullyear were up 6% from 2006 levels but down on a per headcount basis given ourperformance.
For the quarter, compensation expenses were $4.3 billion andreflect the results of year-end accruals made for 2007, increased headcountlevels from 2006, and increased productivity from FAs.
On the non-comp costs, they increased 25% to $2.4 billionfor the quarter, largely related to acquisitions and headcount growth, ongoinginvestment in our GMI and GWM technology platforms, and significant growth inBC&E expenses associated with strong volumes in equity markets, rates, andcurrencies in GWM.
Non-compensation expenses included $53 million fromwrite-off of First Franklin intangibles, as well as $60 million in expensesrelated to First Republic in the fourth quarter of 2007.
Managing the firm’s expenses to be better in line with thebusiness activity will be a key focus of mine as we turn into 2008.
At year-end, total capital was $36.7 billion and pro formafor the impact of all the announced offerings and the exercise of the Temasek option, it would have been $45.7 billion.
Treating the preferred securities on an if converted basis,our pro forma adjusted book value per share would have been $32.80, and oureffective tax rate was 32.7% for the full year.
Finally, in terms of the outlook, we remain cautious in thenear-term and continue to monitor the U.S. economic environment. We areparticularly focused on the residential housing market. However, we believe therecent actions we’ve taken significantly better position us to navigate thisoperating environment. Additionally, as John referenced, Merrill Lynch is trulya global firm. We continue to be optimistic regarding our long-term growthopportunities in each of our major business lines, particularly outside theU.S.
With that, John, Eric, and I are happy to take yourquestions.
Question-and-AnswerSession
Operator
(Operator Instructions) Your first question comes from the line ofGlenn Schorr with UBS.
Glenn Schorr - UBS
Thanks very much. John, a follow-on to your comment onbalance sheet rationalization; in terms of reducing the carry trades andilliquid assets on balance sheet, any numbers, guess you can throw at it interms of what percentage that might reduce the overall balance sheet? What kindof metrics are you looking at in terms of productivity?
John A. Thain
There’s two important pieces of that. One is reducing thecarry trades and we are going to do that really over time, so I think you’llsee progress -- you saw a little bit of progress at the end of the year. You’llsee more progress over the next two quarters.
The second piece of it will be to move more of the illiquidassets into third party funds. So I mentioned commercial mortgages, the PacificRim real estate fund is already in the process of being created and so we willmove some of the assets directly into that.
I think you’ll see us over the course of the next yearcreate private equity third party funds, as well as I think infrastructure andperhaps special situation types of funds. So philosophically, we will movethose types of illiquid assets into third party fund structures. And sooverall, you will see our balance sheet shrink and then you saw with the sale ofML Capital, we’ll reduce those assets. The first sale was about $10 billion andthere’s another $4-odd billion to go.
So we will in fact be shrinking it without giving youspecific target levels.
Glenn Schorr - UBS
And it’s fair to assume that you feel you’ve written downyour illiquids to a point where you could transfer them into a third party fundat fair value?
John A. Thain
Yes, although most of the write-downs are in CDOs andsub-prime, so those unfortunately won’t go into third-party funds. But we’revery comfortable that given where we’ve written down those assets, that theseare at levels at which we believe they are either saleable or actuallyrepresent good value.
Glenn Schorr - UBS
I think you touched on private equity and infrastructurefunds, but can you maybe talk about your thoughts around Merrill’s presence inother areas that were being built over the last couple of years, likestructured credit leverage, finance? In terms of do you think that obviouslythese markets are slower so you’ll right-size your infrastructure, or is theremore of a sea change in terms of Merrill’s attitude towards those?
John A. Thain
Those are two different areas. On the structured creditside, that will be dramatically reduced. On the leveraged finance area, wethink we are already in a very good spot and I would expect us to continue tomanage it but we will add where it makes sense exposure to the leverage financearea. So actually we’re happy with our leveraged finance position.
Glenn Schorr - UBS
Okay. Thank you.
Operator
Your next question comes from the line of Roger Freeman withLehman Brothers.
Roger Freeman -Lehman Brothers
Nelson, did I hear you right that you’ve got $30 billion ofgross exposures still on in CDOs, ABS CDOs?
Nelson Chai
Yes.
Roger Freeman -Lehman Brothers
Can you talk a little bit to the hedges that you do havearound that? Obviously the big difference between that and the $5 billion netand basis risk around that?
Nelson Chai
Well, I guess what I would say, Roger, is that I think wherethe book is marked right now reflects as of 12/31 as best we could where wethink those positions were. And as you know, under FAS-157, everything waslevel three. We triangulated around a bunch of different modeling assumptionsand a lot of obviously external metrics to come up with what we thought was theright range, if you will.
As you know, I spent some time both internally here but alsoexternally going around the street and getting a sense as well, so we felt wecame up with the most -- a very comfortable range where we though the bookshould be marked and within that range, I would say that we took a prettyprudent view, if you will, about where we should put those marks.
We have dug in to look at some of the hedges we have againstit. You’ve seen us take a little bit on the credit side on some of thecounterparties. We obviously continue to watch closely those counterparties butagain, I think that we feel comfortable with where the book is marked as of theend of December.
Roger Freeman -Lehman Brothers
What is the game plan for reducing these exposures overtime? And were there any assets sold off during the quarter? I don’t know ifyou can quantify that or not. And just maybe just any sort of thoughts you haveabout what it’s going to take to get some sort of secondary market going here.There’s a lot of growth exposure here over time that you need to wind down.
John A. Thain
In terms of actual sales in the fourth quarter, there were afew but very small, although the ones that we did sell were right around wherethey were marked, so that was a good thing.
I would hope that the market becomes more liquid as we getinto the first quarter so we can actually sell more of them but I would saythat these -- focusing on the gross number without giving credit to the hedgesis really not the right way to look at it because we do have $23 billion ofshorts, plus we also have a short in our trading book. And the net exposure isstill dramatically reduced from where it was at the third quarter.
So the hedges are not perfect, that’s certainly true, andthey do create some credit exposures to the mono-lines. But we still think thatgiven the reduction in net exposure, it’s pretty dramatic.
Roger Freeman -Lehman Brothers
Okay, and just on the hedge counterparties, as I look atthis table in the back of the release, the hedge that you have with AC, which Iguess is a non-investment grade one mainly here, is that -- what are youactually carrying any ACA hedges at at this point? Is it anything above zero?
John A. Thain
We are reserving against ACA dollar for dollar, so it’s 100%reserved.
Roger Freeman -Lehman Brothers
One-hundred percent reserved, okay. I guess lastly and I’lljump back in the queue, the compensation expense seemed a bit high and I’mwondering, is there a charge in there related to the acceleration of the stockvesting? And how much is that?
Nelson Chai
Well, we did accelerate, as I think --- some one-timeacceleration but again, that would have been pretty small, about $183 millionin the fourth quarter, Roger. A lot of it had to do with if you look at thethird quarter comp number, it looked a little bit out of line and again, it wasa true-up, if you will, on the September year-to-date basis, based on compratios. And so in the fourth quarter, we had to take the accrual based on wherewe were going to pay people and as John mentioned earlier, across the businessfranchises, with the exception of parts of our fixed income business, the businesseshad record years and so we needed to compensate people for a lot of reasons,including retention accordingly.
So that has a lot to do with it, of where it came out.
Roger Freeman -Lehman Brothers
How much was the stock/cash mix this year compared to lastyear in bonuses?
John A. Thain
The mix on the bonus part was approximately 60-40.
Roger Freeman -Lehman Brothers
And what was it last year?
John A. Thain
I wasn’t here last year, but it’s more -- it’s certainlymore stock and that’s the direction we’re going.
Roger Freeman -Lehman Brothers
Got it. Okay, thanks.
Operator
Your next question comes from the line of Mike Mayo withDeutsche Bank.
Mike Mayo - DeutscheBank
Could you elaborate on the diluted share count ahead with thenew equity issuance?
Nelson Chai
Sure. As of the end of the year, the common sharesoutstanding was 939.1 million. If you do the adjustment for the common shareround, that gets you up to 988.3, and then if you look forward and adjust forthe mandatory, it gets you up to 114.2.
Mike Mayo - DeutscheBank
I’m sorry, the last number was?
Nelson Chai
1114.2, sorry.
Mike Mayo - DeutscheBank
Okay, and so fully diluted shares, just for our models for2008, should be --
Nelson Chai
The 988.
Mike Mayo - DeutscheBank
Okay and with regard to -- more back on the strategic level,John, any thoughts about further changes in the business mix? You announced afew asset sales. What’s the thought about more?
John A. Thain
In terms of asset sales, there’s really no other assetsales. The only other big asset that we have, I was specific about BlackRock,which I said we would not sell. The only other specific asset that we have isour stake in Bloomberg. You all know we have about a 20% stake in Bloomberg,which we carry basically at zero and we are not looking to sell that.
Mike Mayo - DeutscheBank
Okay. And then lastly, you itemized some exposures in otherareas and one of those areas was commercial real estate. I guess you had $230million of write-downs. How comfortable are you with that $18 billionportfolio?
John A. Thain
We have spent a lot of time on that portfolio. We’ve gonethrough that really almost name by name and both Nelson and I, Jeff, the guyswho run that, and actually we are very comfortable with that portfolio and howit is marked.
Any commercial real estate portfolio is somewhat sensitiveto overall economic environment but given where we are, given the types ofproperties that they are, given the structure of those deals, we’re verycomfortable that these things are conservatively marked.
And given the size of the portfolio and given the size ofthe mark, you can see that it’s a pretty high quality portfolio.
Mike Mayo - DeutscheBank
Thank you.
Operator
Your next question comes from the line of Prashant Bhatiawith Citigroup.
Prashant Bhatia -Citigroup
Just in terms of the philosophy of balancing ROE versusearning, I guess what is the philosophy there and what is your view of asustainable ROE of the firm once you make some of the changes that you’ve gotplanned?
John A. Thain
Well, as you know, there is always a trade-off between ROEand dollars of earnings and whenever you put things into fund forms, you canincrease your ROE at the expense of dollars of earnings.
Let me give you this type of guidance -- if you look in2006, or if you looked at what 2007 would have been ex the losses, which wouldhave been comparable to 2006, the ROE was around 20%.
Prashant Bhatia -Citigroup
Okay, so you can generate over time sustainable ROEs inexcess of 20% as you make some of the changes that you are planning on?
John A. Thain
We believe so.
Prashant Bhatia -Citigroup
Okay. And then, can you give any sensitivity to thecumulative loss assumptions? I think you said 16% to 21%. It’s clearly notlinear so if it ends up being higher or lower, can you give any kind ofsensitivity there on the impact?
John A. Thain
The problem is, as you know, that the -- it’s very dependenton the deal structure on a name-by-name basis. It’s dependent on the vintage ofthe mortgages. The 16% to 21% was intended to give you the kind of -- theaverage range that we are looking at.
It’s very hard to get much more detail to that other than --unless you actually run the individual positions. The only thing I would say iswe believe that we are being conservative on these marks and we think that atthe levels that they are marked, we will in fact be able to sell them and/orthat they represent value at where they are marked.
You know, at some point as you mark these things down, theyapproach their aisle value and they really don’t have as much downside goingforward once you get the marks low enough.
Prashant Bhatia -Citigroup
Okay, and maybe asking it another way, you’ve taken over $20billion in write-downs over the last couple of quarters. What percentage ofthat would you say is a write-down to reflect a market environment that existstoday that may not exist tomorrow? For example, how much do you think is reallya liquidity type mark based on the environment?
Nelson Chai
I think if you look at it, it’s reflective of what we thinkthe book was at the end of December, as I said earlier. And certainly inDecember, the market was a lot less liquid for these types of instruments andso I think there is a little bit of that built in. We’re not going to sit hereand predict the future. We certainly hope, and I think everybody should hope,that it brightens but again certainly our job here was as of December andfrankly, as you look at us versus some of our peers who were November, I thinkthere’s a change in timing in the quarters, both in terms of the businessenvironment in December versus what they would have had as an Augustenvironment, which at least on the equity side was very good.
And then you actually have to look at as people were takingtheir marks and again, December there was not a lot of trading going on,particularly in the back half of December.
John A. Thain
I’m not sure if you’re trying to get at whether there’s theability to recover some of the losses here.
Prashant Bhatia -Citigroup
Yeah, that’s exactly what I’m trying to get at.
John A. Thain
That’s what I thought. I think on the CDOs specifically, Ithink it’s not likely that these things are going to recover because thefundamental assumptions as to home price declines and cumulative losses, Ithink, as I said, I think we are being conservative but I don’t think thatwe’re likely to get much back on these things. So I don’t think it’s like a --just where you have an illiquid market where the liquidity comes back and yourecover a lot of it. I don’t think that’s going to be the case here.
Prashant Bhatia -Citigroup
Okay. And then, can you elaborate on the comments onBlackRock? You clearly think it’s a core, strategic asset. What drives thatview and maybe some specifics on what both firms can do together going forward?
John A. Thain
I don’t really know what more to say about it other than itis a strategic asset. It is a -- the whole strategy of separating themanufacturing from the distribution, we fundamentally agree with and so thereare -- there actually are quite good linkages. As you probably saw yesterday,[I have gone on the board] and so I think that the working relationship betweenthe companies is great and we do not intend to do anything that would changethat.
Prashant Bhatia -Citigroup
Okay, and then just finally, maybe your initial take on theretail brokerage business. I know you spent a very long time at firms that kindof stayed away from directly touching the retail consumer. I guess just someinitial takes on that business.
John A. Thain
Well, as I said, I was down in Arizona with the leadershipof the high net worth business. The wealth management business is a greatbusiness. It is -- Merrill’s wealth management business I think is the best inthe world and it is one of the great strengths of our franchise.
It is relatively immune to the ups and downs, at leastshort-term ups and downs in the marketplace. It continues to grow veryconsistently, as I think you know. The fourth quarter, in spite of being adifficult environment both for us as well as in the marketplace, we added netnew assets of $30 billion in the fourth quarter.
So it is actually is a great business and it’s a greatsource of stability.
Prashant Bhatia -Citigroup
Okay. Thank you.
Operator
Your next question comes from the line of Jeffery Harte withSandler O'Neill.
Jeffery Harte -Sandler O'Neill
You mentioned I think correctly that structure productactivities, or at least market demand for those things, is probably going to begone for a while. Looking at the size of the balance sheet marks, we have anidea how much you are exposures to those were. Can you give us any indicationas to how big a contributor to revenue those businesses that you don’t thinkare going to be coming back anytime soon were over the last year or two?
John A. Thain
We won’t be specific on that but as we are in the process ofbudgeting out 2008 now, and of course we don’t give guidance so we are notgoing to actually answer any specific questions about what we think about 2008,but from the comments I made about the return on equity, from the comments Imade about the earnings power of this franchise, whether you look at 2006 orwhether you look at what 2007 ex the marks in terms of how comparable thatwould have been to 2006, I think that that gives you at least some idea as youare thinking about this.
And our thoughts about 2008 and forward take into accountthe fact that the FICC business is going to be less balance sheet intensive andhave less structured credit components to it.
You know, if you look at the core businesses inside FICC, Italked specifically about rates and currencies and I also talked specificallyabout the commercial real estate area. The commodities business also is a verygood business and so you are going to see us focused on those parts of thefixed income area.
Jeffery Harte -Sandler O'Neill
There may not be an answer to this question, but as you talkabout trying to beef up the trading risk management side of things, relative towhat happened in leveraged finance, or fixed leveraged lending, do you have anykind of concept as to how long it may take to get things up to where they needto be from a systems or a personnel -- maybe just a culture. I mean, is itquarters, is it years, is it decades?
John A. Thain
No, no, no -- in personnel, it’s going to start todaybecause we’ve already been working on it. In terms of culture and philosophy,it’s already started a month ago. And as I said, Ed Moriarty and the new personwe are hiring will report directly to me. That’s as strong a signal to anyone.
And I think that these are changes we are in the process ofmaking now. You will see the impact right away.
Jeffery Harte -Sandler O'Neill
Okay, and finally, you mentioned BlackRock as a strategicasset. You also mentioned that Bloomberg was not for sale. In light of theamount of capital you are raising in dilution from that, did you consider sellingthe Bloomberg stake? And if you did, why didn’t you sell it?
John A. Thain
Let me answer it in the following way -- obviously theBloomberg stake generates a certain income stream and so you could -- we couldand did make the trade-off of selling the stream of income from Bloombergversus selling the stream of income from the company as a whole and we decidedthat it made more sense to market the common and mandatory conversion of thecompany as a whole.
Jeffery Harte -Sandler O'Neill
Okay. Thank you.
Operator
Your next question comes from the line of William Tanonawith Goldman Sachs.
William Tanona -Goldman Sachs
Good morning. As we look at the marks on the CDOs, you guyswere fairly aggressive on the high grade stuff but not as aggressive on the CDOssquareds. I guess can you help me understand what drove that decision, justgiven the collateral underlying those structures? Was it vintage? What was itthat those write-downs weren’t as aggressive? And I guess also what type ofhome price depreciation are you factoring into your cume loss assumption?
Nelson Chai
As you get into the mezz and the CDO squared, you reallystart getting close to [IO] value, as John mentioned earlier. So as we thoughtabout pricing it down, that really was kind of the floor, if you will, in termsof how we got to it. And that’s also why you saw a less dramatic mark, if youwill, in the December period.
John A. Thain
Yeah, but I want to add one thing -- if you look at -- asyou know, you have to model out the individual positions and there’s no verygood way to look at average prices and it also does depend on the collateraland the vintage, et cetera, et cetera. So there’s a lot of caveats to it.
But still, if you look at where we carried the value of themezz divided by its principal amount, which gives you at least some idea of thechange in value, if you did that at the end of September, it was in the low60s. And if you did that at the end of December it was in the mid 20s. So it’sstill a pretty significant write-down.
William Tanona -Goldman Sachs
Okay, and then you mentioned the change in philosophy as itrelated to comp. Is that something that you envision firm wide, even in theglobal private clients group? And how would you go about changing the philosophyin that business?
John A. Thain
No, it doesn’t include the global private client group andno, I don’t intend to mess with their compensation structure.
William Tanona -Goldman Sachs
Okay, and then just lastly, you’ve obviously been there fora couple of weeks. Was it better, worse, or what you had expected as you gotinto it? And then as I think about all of this exposure, how was it that youguys ended up with so much of that exposure? Was it just the underestimation ofwhat the actual risks were? And these assets, was it a failure of reportingthis stuff into the risk management systems? How was it that you ended up withthis large of an exposure in the CDOs and sub-prime?
John A. Thain
The second part of that question is a little bit harder toanswer since I wasn’t here, but in terms of what did we find, I think as in anytime you enter into a new job or new organization, some things were better thanwe thought and some things were worse. I would say specifically the leveragelending portfolio is significantly better than I would have thought and the CDOportfolio was worse.
How did we get here? Well, I’m not sure it’s so useful totry to go back into that, rather than just saying we’re focused on goingforward. I think that where we have marked these CDOs, we are comfortable thatwe are in very good shape looking into the future. And given the capital raise,we were very deliberate in raising more capital than we lost for the year sothat we can position ourselves to look forward into 2008, that we are wellcapitalized on any different measure, that we will not be going back into theequity capital market.
So we are really going to focus on going forward rather thanexactly how did this happen. Other than, the other piece I would say is thecombination of the changes in philosophy, changes in risk management, changesin trading personnel, we’ll certainly make sure this doesn’t happen again.
William Tanona -Goldman Sachs
Okay. I guess I thought it would have been important tounderstand how you got into this situation to make sure it doesn’t necessarilyoccur in the future. Thanks.
Operator
Your next question comes from the line of Michael Hecht withBanc of America.
Michael Hecht - Bancof America Securities
I know it’s early days, but I just wanted to get a quicksense from you about where you plan to make investments in the franchise andwhere you are optimistic for growth for ’08 and beyond. Are you worried about-- I know you mentioned this in your prepared remarks, an economic growthslowdown and contagion of some of the areas in mortgage and credit spreads --you know, other areas that seem to be doing quite well, like equities andretail?
John A. Thain
I think actually as you look across our mix of businesses,we actually see pretty good opportunities across the board, but I’ll go throughspecifically. On the investment banking side, we had a record year. We continueto believe that we have a great position. I would expect that our bankingfranchise will be stronger outside the U.S. versus inside the U.S., given theexpectation of a slower U.S. economy. But if you look at our institutionalbusiness, so if you take out the high net worth business, over 60% of ourrevenues are from outside the U.S., so we are well-positioned to see furthergrowth outside the U.S.
In particular, we are strong in the Pacific Rim, so India,China, Brazil. I think outside the U.S. we’ll continue to grow.
Our equity business has done very well. You know, thetrading businesses, they are helped by the volatility in the marketplace andwe’ve seen a lot of that. And as I said before, on the fixed side the currencybusiness, the rates business, the commodities business are all good.
And then another place that I think you’ll see us grow,although as I said we’ll grow in terms of third-party fund structures, is inthe principal investing area. We do have a small principal investing business.We can certainly make it bigger. As I said, we are raising a third-party fundin the Pacific Rim on the real estate side.
And then the last area I guess I would emphasize is thewealth management business outside the United States. We have a great franchisehere in the U.S. but I think there are very strong growth opportunities outsidethe United States. Again, if you look at where wealth is being created in theworld, it’s in the Middle East and it’s in the Pacific Rim, and then to someextent in Latin America, particularly in Brazil.
So those parts of our businesses I think have greatopportunities.
Michael Hecht - Bancof America Securities
Okay, that’s helpful. And then maybe a bit more color orupdate on staffing and headcount reductions at GMI -- what areas you’ve madecuts in and I guess outlook for number of heads as you look into end of ’08versus where you ended ’07, again for GMI?
John A. Thain
Well, if you look at our overall headcount, our overallheadcount is basically flat but there are pluses and minuses in that. The FICCheadcount was down about 1,000 people and of course we bought First Republic,and that added about 1,000 people, so the net number -- and then, of course,the financial advisors continued to grow so the net number is approximatelyflat.
I think you will still see some headcount reductions in FICCbut they are not, in the scheme of things, this is not a case where we are targetingthousands and thousands and thousands of people. They will be selectivereductions in places like structured credit and probably there is still moreopportunity to do headcount reductions in our various mortgage originationplatforms. So I think those are the two places you’ll probably see but it’s notgoing to be dramatic.
Michael Hecht - Bancof America Securities
Okay, great. And then just to come back on retail, I mean,great year no matter how you look at it -- flows, productivity, growth inbrokers, assets -- I guess the question is, what do you really do for an encorein that business and how can you draw out the value of that franchise, which Idon’t think you get credit for in your stock price? And then, are you seeingany signs that the retail investor is going to fall out of bed here? I mean,it’s been relatively resilient.
John A. Thain
Well first of all, I hope you guys help us get credit in ourstock price because as you all know, if you simply put a multiple on theearnings out of the wealth management business, you basically get the marketvalue of the whole company, so I assume that you all will help by telling howcheap our stock is.
In terms of the U.S. wealth management business, I justthink it will continue to grow. It grows at a nice rate. I don’t see anyparticular reason for the retail investor to fall out of bed here, so I thinkthe U.S. will continue to grow at the type of rate it’s been growing.
And I think the big opportunity for us is outside the U.S.,and so if you looked at well, where is there incremental upside, it will bewith the high net worth business outside the U.S.
Michael Hecht - Bancof America Securities
Okay, that’s great, and then just two quick housekeepingthings; liquidity position, you mentioned $80 billion -- can you say what thatwas a quarter ago and a year ago?
John A. Thain
Eric can answer that.
Eric Heaton
Sure. At the end of the third quarter, that number was $73billion and at the end of last year, it was in the mid 70s as well.
Michael Hecht - Bancof America Securities
Okay, great. And just within equities, and you may have saidthis but there was a little bit of disturbance in your prepared remarks,Nelson, the equities business, how much were private equity losses in Q4? I’massuming -- and that would suggest core strength -- you saw there was evenbetter than the reported number, I think.
Nelson Chai
Private equity losses was $14 million in the fourth quarter.
Michael Hecht - Bancof America Securities
Okay, so not --
(Multiple Speakers)
Nelson Chai
Sorry, 114, sorry.
Michael Hecht - Bancof America Securities
One-hundred-and-fourteen, okay, great. Thank you.
John A. Thain
And by the way, that is really just marking to market thepositions we own in publicly traded stocks. So we don’t -- that’s just afluctuation in the market value.
Michael Hecht - Bancof America Securities
Yes, got it. Thank you.
Operator
Your final question comes from the line of Meredith Whitneywith Oppenheimer.
Meredith Whitney -Oppenheimer
Good morning. I have a few questions. I appreciate youranswer to Jeff’s question about not wanting to discuss the exposure in terms ofexposure to revenue to structured products, but could you provide -- and I’llgo back and do the math and try to do it myself, but could you provide somecolor in terms of your exposure on a revenue basis to the MUNI market?
And then the second question is with respect to the factthat on a go-forward basis, you see strong markets in the credit markets interms of rates and currencies, and then in commodities. Could you provide colorin terms of what went wrong this year with your commodities business?
And then the third question, third and final question, is ifyou guys are so comfortable with your carrying values on your CDO exposures andsub-prime exposures in aggregate, why not just dump the assets? Why not -- whydidn’t you purchase the assets in the fourth quarter?
John A. Thain
Let’s go backwards because I can do -- I can go backwards --we’ll start with the CDO. There really was very little liquidity. There wasvery little trading by anyone in the CDO market, so as I said, we sold smallpieces of them. But there’s no question that we intend to sell them goingforward. We intend to reduce the absolute position. Jeff is -- Jeff understandsthat that’s his job to do that and we are optimistic that as the market startsto open up and actually trades really occur, that we can actually sell thesethings at levels that either at or near where they are marked.
So the intention was to mark them where we could sell them,and so I hope we do in fact see some trading happen and we’ll have to see. Sofar this year, there really hasn’t been any significant amount of trades donebut our goal is to sell them.
Meredith Whitney -Oppenheimer
But isn’t that because the buyers aren’t coming to market --sorry, the sellers really aren’t coming to the market? There are bids out therebut the sellers don’t want to concede to those bids?
John A. Thain
I don’t think that’s right. I think there will be buyers.There’s a number of people raising funds to do this. I actually think thatthere will be a lot of money made in this marketplace and so I think that thepeople who are putting these distress mortgage funds together will eventuallycome in the marketplace to buy them, but it’s not really true that todaythere’s a big buyer’s market. I think there will be but it hasn’t reallyhappened yet.
Meredith Whitney -Oppenheimer
Okay, in terms of the other questions, please?
John A. Thain
Yeah, I know -- my handlers are telling me that we don’tdisclose the specific P&L items of individual business lines like MUNIs,but when I look at what that number actually is, it is -- it’s really not --it’s not going to be the driver, either positive or negatively, to our resultsgoing forward.
I mean, look, MUNIs are still a good business and we arestill committed to doing it but it’s not going to -- it’s not going to be theplace that you are going to want to spend too much time on. It’s just a good,consistent business, that’s all. But in terms of percentage of the total, it’snot that big. And look, it’s a business that’s also not going to change thatmuch going forward. I don’t see the MUNI business as a place where there’s ahuge upside in terms of changes to our P&L.
In terms of the commodity business on the other hand, Ithink there is a lot more upside to the commodity business and I think that isan area where we do in fact have a lot more upside, so I am optimistic that wecan actually do a lot better in the commodity business.
One of the places where we really didn’t -- we weren’treally positioned properly is in oil itself, so we just recently hired an oil traderand actually I think that there is -- there are opportunities for us to do muchbetter in commodities.
Operator
Ladies and gentlemen, let me now turn the call back to SaraFurber for some final remarks.
Sara Furber
Thank you. This concludes our earnings call. If you havefurther questions, please call investor relations at 212-449-7119. Fixed incomeinvestors should also call 866-607-1234. Thanks for joining us today. Weappreciate your interest in Merrill Lynch.
Operator
Thank you for participating in today’s conference call. Youmay now disconnect.
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