Merrill Lynch: How Bad Is It?

Analysts think the broker's second-quarter writedowns could be as high as $6 billion, and more losses could come, given its exposure to bad loans

Poor Merrill Lynch (MER). Was it only three months ago that investors were buying shares of the nation's third-largest broker ahead of its first-quarter earnings announcement? Not this time around. Since the beginning of May, Merrill's stock has dropped 45%—and touched a nine-year low of 26.50 on July 11, as investors continued to pound the stock in the days leading up to the company's July 17 earnings release.

What has changed? Back then, optimistic investors hoped the worst was over. Now, they know it's not.

The taint of bad loans continues to linger on Merrill's balance sheet. Merrill owns some of the worst junk out there. As of Mar. 31, Merrill said it had $6.7 billion of exposure to complicated mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), which remain difficult to price. They're also nearly impossible to sell. Normally, distressed debt specialists would scoop them up on the cheap. But with many credit products damaged in one way or another, buyers are ignoring the ridiculously complicated ones and sticking with simple products like high-yield bonds. "Given the size of their exposures, some further writedowns seem inevitable," says Standard & Poor's credit analyst Scott Sprinzen.

Exacerbating the problem is Merrill's $3 billion of hedges with monoline insurers like MBIA (MBI) and Ambac Financial (ABK). The monolines had their credit ratings slashed in June, and those downgrades may force Merrill to set aside extra cash reserves to cover the inability of the bond insurers to pay its liabilities, assuming there are any. Like Lehman Brothers (LEH), which lost $600 million in the second quarter, Merrill is likely to find that the indexes used to hedge its exposure to certain assets and the actual assets no longer move together. That could force Merrill to announce even more losses.

May Be Forced to Raise More Capital

Unfortunately for CEO John Thain, the credit problems will continue to overshadow Merrill's strong asset management and retail businesses, which continue to grow, if only sluggishly, and accounted for $3.6 billion in revenues during the first quarter of 2008. Merrill is also diversified globally, with more than one-third of its sales coming from Europe and only 19% from the U.S. Unlike trading and fixed income, asset management is not capital-intensive, and Merrill would like to get to the point where it can rely on those businesses to generate a high return on equity—10% to 20%—that is its raison d'être.

But that plan could be upended if Merrill is forced to raise more capital on top of the $15.5 billion raised since the credit crunch began a year ago. That will depend on the size of the writedowns, which analysts predict could total as much as $6 billion. The per-share estimates, ranging from a loss of 70¢ to Oppenheimer (OPY) analyst Meredith Whitney's prediction of a $4.21 loss, reflect the disparity in analysts' expectations for Merrill's writedowns.

Issuing common stock would be the easiest way to raise money fast, but Thain promised investors he would not resort to diluting their holdings, a promise he probably wishes he never made. If he keeps his word, Thain may have to resort to selling Merrill's two most valuable assets: its stakes in Bloomberg and BlackRock (BLK).

Bloomberg Not Essential to Merrill's Core

Estimates vary, but Merrill's piece of Bloomberg could fetch somewhere in the ballpark of $5 billion, but cost the company $300 million in profits, according to a Deutsche Bank (DB) report. Still, it's a more palatable solution than selling a piece of Merrill's 49% stake in asset manager BlackRock. Bloomberg is profitable, but not essential to Merrill's core business. BlackRock has strategic value for Merrill and its plans to rely on asset management to improve profitability.

A fire sale would force Thain to reconsider the company's plans and delay a recovery. "It would be a real failure if they had to sell BlackRock," says Alliance Bernstein's (AB) Brad Hintz. "I hope it doesn't come to that."

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