Merrill Lynch Charges Ahead

Big profits from the financial giant suggest the problems from subprime and other debt issues might just be contained

A strong second quarter profit from Merrill Lynch (MER) on July 17 helped ease some worries about subprime mortgages and other problems in debt markets.

Earnings of $2.24 per share were 22 cents above analysts' expectations. The firm earned $1.63 per share a year ago. Revenues were up 19% from a year ago.

"These results should alleviate most investor concerns that [Merrill Lynch] is overly exposed to deteriorating subprime mortgage markets and challenging [collateralized debt obligation and collateralized loan obligation] markets," wrote Goldman Sachs analyst William Tanona. (Goldman Sachs owns Merrill Lynch stock and the two firms do various business with each other.)

Recently investment bank stocks have been hit by worries about rising defaults in subprime mortgages. Investors have also worried about markets that were rejecting other forms of risky debt.

"Hopefully results like these soothe investor nerves," says Matthew Albrecht, a Standard & Poor's equity analyst. "A slight correction in the debt markets isn't going to cause all these investment banks to lose half their value."

Merrill Lynch disclose few financial details of its exposure to subprime loans. But, the firm reiterated its previous statement that subprime debt makes up just 2% of its overall business. "We think our net exposure in the situation is both limited and well under control," chief financial officer Jeff Edwards told analysts Tuesday. He trumpeted his firm's "proactive, aggressive risk management," and said it had reduced its exposure to risk in the second quarter.

A statement from chairman and chief executive Stan O'Neal reflected the view that risky debt is just a small part of a huge investment banking business. "We delivered another strong quarter in a volatile and, at times, hostile market environment," O'Neal said. "These results reflect our revenue diversification, which makes possible strong performance despite uneven market conditions."

In fact, many parts of Merrill Lynch's market is booming. Investment banking revenues were up 41%, reflecting strong growth in mergers, acquisitions and debt origination, the firm says. Equity traders boosted revenues 15%.

The biggest surprise may be the firm's fixed income, currencies and commodities unit, which handles subprime and other debt. Despite the worries about those areas, revenues were up 55%. The company cited weakness in mortgages, but attributed the gain to commodities, credit and interest rate products.

Merrill Lynch also benefited from an investment in BlackRock BTZ.

S&P's Albrecht says the biggest risk from subprime problems is not being taken on by investment banks like Merrill Lynch but by other funds and investors who are much more highly exposed to the issue.

That's not to say that Merrill, or the rest of the economy, are out of the woods yet. The problem could get worse as defaults on subprime mortgages continue to increase, and markets gage the full effects of subprime loans made more recently.

"We won't know the full impact for some time I believe," Albrecht says. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.)

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