May 11 (Bloomberg) -- Merrill Lynch & Co., preparing for its biggest expansion since the 1990s, plans to buy a mortgage lender, triple its corporate investments and increase trading bets to boost shareholder returns that trail those of rivals.

New York-based Merrill's top managers spent the past six months determining how to spend ``excess capital,'' Chief Administrative Officer Ahmass Fakahany said in an interview last week. The firm, which has the world's biggest network of brokers, decided against expanding by buying a consumer bank, he said.

``What's new is an increased emphasis on building our institutional business,'' said Fakahany, 47. ``When I say mortgage origination will take capital, that's because it requires an acquisition.''

The biggest U.S. mortgage lenders not owned by major banks include Countrywide Financial Corp., Ameriquest Mortgage Co. and IndyMac Bancorp Inc. Fakahany declined to name potential targets.

While Merrill is benefiting from rising stocks and record commodities prices, Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. are reporting faster earnings growth. Goldman, which depends on half as many employees to produce about the same amount of profit, last month surpassed Merrill as the world's No. 1 securities firm by market value.

Chief Executive Officer Stanley O'Neal limited Merrill's growth by cutting more than 20,000 jobs after the bull market ended in 2000 and keeping acquisitions to less than $1 billion. Rivals including New York-based Goldman took bigger risks trading and investing.

Missed Market

``We just wish we had the clairvoyance to retool the company earlier so we could take advantage of a market that's quite robust,'' Fakahany said.

Merrill's return on equity, a measure of how effectively it reinvests capital, is the lowest of the five biggest Wall Street firms. Its first-quarter ROE of 19.1 percent, excluding an accounting change, was half Goldman's 38.8 percent and trailed New York-based Lehman's 26.7 percent.

Shares of Merrill rose 80 percent during the past three years, while Goldman's and Lehman's more than doubled. Merrill stock fell 74 cents to $76.51 in New York Stock Exchange composite trading yesterday.

``They're behind in some important businesses, like commodities and fixed-income trading,'' said Jeff Harte, an analyst at Sandler O'Neill & Partners LP, who recommends clients buy Merrill shares. ``They need to close the gap not only to generate returns, but to maintain themselves as a viable competitor.''

Excess Capital

Merrill hasn't been as bullish about spending since the late 1990s, when then-CEO David Komansky acquired Mercury Asset Management Plc of the U.K. for $5.3 billion and Canada's Midland Walwyn Inc. for $810 million. He opened a Japanese brokerage that eventually cost the firm hundreds of millions in losses.

Unlike Lehman and Goldman, Merrill didn't accelerate the pace of capital investments after cutting costs in 2001 and 2002, said Morgan Stanley analyst Chris Meyer. He figures Merrill has the most excess capital of any investment bank.

``I'm not dispelling the need to be compared to those two because we should and we do ourselves,'' said Fakahany, Merrill's vice chairman in charge of strategy and one of seven executives who report to O'Neal. ``We really need to keep doing what we're doing. The problem is we haven't been doing it as long as some of these other people.''

Energy Trading

Merrill made up some ground with the $800 million purchase of Entergy-Koch LP's energy-trading unit in 2004. With 280 new commodities employees, Merrill entered the markets for natural gas, fuel storage and weather derivatives. Derivatives are financial instruments derived from assets such as stocks and bonds or the outcome of an event.

Lehman's expansion into the home-loan market made it one of the top mortgage-bond underwriters and led to a 67 percent surge in fixed-income sales and trading revenue from 2003 to 2005, more than double Merrill's pace.

New York-based Lehman acquired five mortgage lenders in 2003 and 2004, adding 3,300 employees. It originated $85 billion of residential mortgage loans and bundled $133 billion into bonds during fiscal 2005, both increases of more than 30 percent from 2004. Merrill said it generated a ``cash inflow'' of $58 billion turning home mortgages into securities last year.

``Building a mortgage capability is a priority,'' said Fakahany, who was promoted from chief financial officer in March 2005. ``You can't just build it out of thin air.''

Merrill is having ``dialogues'' with companies it may buy, he said. A mortgage lender would be what Merrill considers a ``bolt-on'' acquisition, not a ``transformational deal.''

Mortgage Stocks

Shares of Countrywide, the biggest U.S. mortgage originator, have gained 18 percent in the past year. That gives the Calabasas, California-based company a market value of $25 billion -- more than one-third of Merrill's.

IndyMac, based in Pasadena, California, has gained 19 percent. Closely held Ameriquest is closing all its retail branches to focus on online lending. Other independent mortgage lenders include New Century Financial Corp. of Irvine, California, and Melville, New York-based American Home Mortgage Investment Corp.

Merrill also plans to dedicate more capital to trading, with the majority going to proprietary bets in fixed income, Fakahany said. Strategies for equities such as statistical arbitrage, in which banks of computers determine whether securities are cheap or expensive, also are a priority, he said.

The firm plans to triple its investments in other companies within two years, either by partnering with clients or leveraged-buyout firms, Fakahany said. Merrill's purchases in the past 14 months include stakes of about $500 million each in Hertz Corp., Rexel SA and Bank of China.

`A Misperception'

``There's a misperception out there that because of our capital strength there's a need for capital to go somewhere, to be used in some transformational transaction,'' Fakahany said. ``That's not the case.''

One deal Merrill explored was a takeover of North Fork Bancorp of Melville, New York. O'Neal, 54, met with North Fork CEO John Kanas last year. Fakahany said Merrill was interested in North Fork's GreenPoint mortgage unit. The talks broke off and Capital One Financial Corp. agreed to buy the bank for $14.6 billion.

In addition to a mortgage lender, Merrill is looking for brokerages similar to Advest Group Inc., a Hartford, Connecticut-based firm with 500 financial advisers, Fakahany said. Merrill acquired it last year for $400 million. He said Merrill also is interested in teams of traders and specialized companies with ``bank-like'' products.

International Expansion

Expanding investment banking in Europe and Asia, where Merrill's revenue is growing faster than in the U.S., is another priority, Fakahany said.

Merrill's latest deal was the February agreement to swap its money-management unit for 49.8 percent of New York-based BlackRock Inc. to form the biggest manager of bond funds.

If Merrill can't find suitable investments, it can always increase dividends or stock buybacks.

``We just renewed our buyback program by another $6 billion and we haven't even finished the first one,'' Fakahany said. ``We're not shy to do it again.''

Last Updated: May 11, 2006 00:12 EDT