July 17 (Bloomberg) -- Merrill Lynch & Co., the third- largest securities firm, said profit rose 31 percent as stock- market gains and historically low financing costs spurred more trading, share sales and takeovers.

Net income in the second quarter jumped to $2.14 billion, or $2.24 a share, from $1.63 billion, or $1.63, a year earlier, New York-based Merrill said in a statement. That exceeds the average estimate of $2.02 a share in a Bloomberg survey of 17 analysts.

Trading revenue rose a Wall Street-leading 34 percent, helping Merrill weather the deepening crisis in mortgage-backed securities and the near-collapse of two Bear Stearns Cos. hedge funds. Chief Executive Officer Stanley O'Neal, who's pushing the world's largest brokerage to generate more revenue overseas, is on track to post a fourth straight year of record earnings.

``While it's probably too early to tell for sure how the subprime issue will work itself out, Merrill appears well positioned,'' said Erin Archer, an analyst at Minneapolis-based Thrivent Financial for Lutherans, which owns about 500,000 Merrill shares. ``They're still able to get deals done, and not seeing significant contagion.''

Merrill said revenue from structured finance and investments, which include the firm's mortgage business, declined in the second quarter. O'Neal said in the statement that the market environment was ``volatile and, at times, hostile.''

Higher Returns

Total revenue rose 19 percent to $9.73 billion, and Merrill said its annualized return on equity, a measure of how well the firm reinvests earnings, climbed to 22.4 percent from 18.6 percent a year earlier.

Merrill's earnings performance compares with the 1 percent gain that Goldman Sachs Group Inc., the world's largest securities firm, posted last month. Morgan Stanley, which ranks No. 2 by market value, boosted net income by 40 percent.

Shares of Merrill fell $1.19 to $86.20 in composite trading on the New York Stock Exchange. The stock has dropped 7.4 percent this year, the second-worst performance in the Amex Securities Broker/Dealer Index after Bear Stearns. Goldman has gained 10 percent and Morgan Stanley is up 7.8 percent.

Those two New York-based firms reported earnings for the three months ended in May, before the Bear Stearns hedge funds unraveled and the firm was forced to rescue one of them with $1.6 billion in emergency funding. Merrill was among the creditors to seize collateral from the funds in the form of CDOs, fixed-income securities that repackage bonds, loans, derivatives and even other CDOs into new bonds.

Bear Stearns Collateral

Chief Financial Officer Jeff Edwards said on a conference call with analysts today that the collateral is ``appropriately marked'' to market and Merrill's ``exposure'' to the Bear Stearns funds is ``limited'' and ``contained.''

Merrill said sales and trading revenue rose 34 percent to $4.77 billion, paced by a 55 percent surge in fixed income, currencies and commodities. Gains from private-equity investments, reported as part of equity trading, fell to $125 million from $705 million a year earlier, Edwards said. Excluding those results, revenue from the equity trading unit would have risen 75 percent instead of the 15 percent that Merrill reported.

Investment-banking fees jumped 41 percent to $1.42 billion, fueled by record commissions from stock underwriting. In Merrill's brokerage unit, called global private client, revenue increased 13 percent to $3.31 billion.

Return on Equity

``The investments they've made with the capital seem to be working out pretty well,'' said Peter Zuleba, who as senior portfolio manager at Glenmede Trust Co. in Philadelphia helps oversee about $20 billion, including about 525,000 Merrill shares as of March 31. ``Relative to some of the other brokers, I would expect their return on equity to rise over the rest of 2007.''

Merrill shares have fallen 12 percent since reaching an all- time high in January, partly on concern that O'Neal pushed into mortgage lending just as the U.S. property market entered its biggest decline in a decade. The company bought First Franklin Financial, one of the largest subprime mortgage issuers, in December for $1.3 billion.

Subprime borrowers, those with the worst credit histories, fell behind on their mortgages at the fastest rate since 2002 in the first quarter, according to data compiled by the Mortgage Bankers Association. Defaults on subprime home loans triggered the trouble at Bear Stearns.

Edwards said on the conference call that the subprime market ``remains in flux and is likely to remain so for a period of time.''

CDO Underwriter

While Merrill, the No. 1 CDO underwriter, stands to lose revenue as demand wanes for structured products and regulators tighten standards on subprime home loans, the firm is getting more investment-banking business. This year, Merrill ranks as the world's top equity underwriter, with $10.3 billion in share sales. That business produced a record $547 million in second- quarter revenue.

At the same time, corporate defaults remain near historic lows, keeping borrowing costs down for high-yield borrowers. That helped boost advisory revenue by 34 percent to $397 million as Merrill was hired for deals such as the 11 billion-pound ($22.5 billion) leveraged buyout of the U.K.'s Alliance Boots Plc. by Kohlberg Kravis Roberts & Co.

On the call, Edwards said the leveraged-loan market has undergone a ``correction'' in the past few weeks and that changes in the `structure and pricing'' of deals have been ``healthy.'' Still, Merrill ended the quarter with a higher backlog of pending investment-banking deals than in March, he added.

New Advisers

The brokerage unit benefited as the Standard & Poor's 500 Index advanced 5.8 percent in the second quarter, bolstering existing investments in client accounts and spurring more trades. Merrill added 270 financial advisers, bringing the total to 16,200, and client assets rose 14 percent to $1.7 trillion.

The pretax profit margin in Merrill's Global Wealth Management division, which includes the brokerage and results from the firm's stake in money manager BlackRock Inc., was 28 percent of revenue.

Charles Schwab Corp., the biggest discount broker, reported today that second-quarter profit rose 16 percent and client assets jumped 23 percent to $1.38 trillion. The San Francisco- based company's pretax margin was 35.2 percent.

O'Neal, who took over as CEO in 2002, has expanded into markets where Merrill lagged behind Goldman or Morgan Stanley, such as private equity, commodities trading and derivatives. The firm now generates 60 percent of its investment-banking and trading revenue in Europe and Asia, home to half the world's economic output and six of every 10 millionaires.

Service for Ultra-Rich

In the Pacific Rim, Merrill is introducing a new advisory product for the ultra-rich that will combine brokerage and investment-banking services. Edwards said the firm's revenue in India was more than double the previous quarterly record.

Last month, Merrill said it plans to start new funds to invest in global real estate and infrastructure, chasing Goldman and Morgan Stanley as investors seek more alternatives to stocks and bonds. Merrill is seeking about $2 billion for an Asian real estate fund and about 750 million euros ($1 billion) for a European fund, according to an investor who has seen the offering documents.

The firm's total workforce climbed by 1,600 employees during the quarter to about 61,900, Merrill said.

Merrill is a passive minority investor in Bloomberg LP, the parent of Bloomberg News.

To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net.

Last Updated: July 17, 2007 16:47 EDT