Merrill’s $3.4 billion balance sheet bomb

In three short weeks, the Wall Street giant’s losses grew from $4.5 billion to nearly $8 billion. Fortune’s Peter Eavis shows what went wrong.

Peter Eavis, Fortune senior writer

October 24 2007: 5:33 PM EDT

NEW YORK (Fortune) — What is the balance sheet of Merrill Lynch really worth? Depends to a large extent on who’s in charge of valuing the company’s large holdings of risky securities.

Wednesday, Merrill (Charts, Fortune 500) reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations (CDOs), which are complex debt securities, and junk mortgages. What shocked the market was that only three weeks ago Merrill estimated losses of $4.5 billion on these sorts of assets. What on earth happened that caused the brokerage to suddenly find another $3.4 billion of losses? One cause was that Merrill gave the job of valuing these securities to a group of people who turned out to have a much more conservative view on these assets’ true worth.

Merrill Lynch CEO Stanley O’Neal

The revelation of extra losses clobbered Merrill’s stock, which fell $3.76, or 5.6%, to $63.36 Wednesday.The human element in balance sheet valuation emerged during Merrill’s communications with the public about its ugly third quarter. On a conference call Wednesday, Merrill CEO Stanley O’Neal said that over the past few weeks, the brokerage’s new head of fixed income, David Sobotka, had been part of “a collective review” of the troubled securities, which resulted in “more conservative valuation assumptions” and the larger loss number.

A person familiar with how the losses were booked says that the valuation committee that included Sobotka took a more conservative stance than the people that previously had responsibility for valuing CDOs and junk mortgages. The fixed income business was previously headed by Osman Semerci, who has left Merrill.

Attempts to contact Semerci were unsuccessful at publication time.The market may never hear Semerci’s view of what happened and how assets were valued under his charge, and it is important to remember that it is in a brokerage’s interest to blame problems on a former executive, rather than those still running the show, like O’Neal himself.

When asked whether Merrill’s valuation methods gave substantial leeway for executives to reach markedly different conclusions, company spokeswoman Selena Morris pointed out that O’Neal had said that the loss increase was part of a collective review, indicating that it wasn’t driven by one person or a small number of people.

While blame may never be properly apportioned at Merrill, one thing is clear: the brokerage’s problems have reignited the debate over whether Wall Street’s balance sheets can be trusted.

Compared with 10 years ago, Wall Street firms hold far more securities and financial instruments that don’t trade regularly, which means they are valued according to in-house estimates and not so much by market prices. The extra $3.4 billion of losses at Merrill will only deepen fears that brokerages and banks have been overvaluing their assets to avoid taking the correct amount of losses at the appropriate time.

To be sure, Merrill was more exposed than its peers like Goldman Sachs (Charts, Fortune 500) and Bear Stearns (Charts, Fortune 500) to CDOs, which have been hit particularly hard. And many banks and brokerages that have reported third quarter earnings have said they feel their valuations are correct.

But the extra $3.4 billion of losses at Merrill shows how easy it is for valuations to change. The Merrill loss adjustment thus flies in the face of the view, presented by most banks, that their valuations rely less on subjective human contributions and far more on the results of rigorous computer models.

Indeed, on the conference call, the Merrill CFO, Jeff Edwards, gave a helpful insight into the valuation process, and it shows how large the human factor can be.

He said that Merrill didn’t change the methodology it used to value the securities that took the big losses. Edwards noted that Merrill’s methodology produced a range of valuations for the assets in question. So, what actually changed after Oct. 5, when the bank estimated that it would report the lower $4.5 billion of losses on CDOs and junk mortgages? After Oct. 5, Merrill chose to opt for valuations that were at the “significantly more conservative end of the range,” according to Edwards.

This is big. It shows that executives had enough leeway under Merrill’s approach to choose a very different end result. Different to the tune of $3.4 billion.

Sobotka, the new head of fixed income, has good reason to go for a more conservative set of valuations. It makes it easier for his business to show improvement in the coming quarters, though Merrill execs didn’t sound that confident on the Wednesday call that there wouldn’t be more losses on CDOs and junk mortgages.

Yes, Merrill has stumbled more than others — it wasn’t prepared for the credit crunch, its internal loss estimates were too low, and to cap it off its credit rating was cut Wednesday by Moody’s and Standard and Poor’s.

But it did the market a great service: It showed just how dependent Wall Street balance sheets can be on arbitrary human judgments.

THE ECB is …indecisive now. They give out mixed signals whether they gonna make some change to the rate or not.

In SEP they said they would raise.
In Oct they said they would keep it steady.
And prospect is to have a RISE.

One month after it abandoned a planned increase in borrowing costs in the face of credit market chaos, the European Central Bank gave little indication of when — or if — it would resuming lifting its benchmark rate. But Mr. Trichet did make clear that the bank’s next move was more likely to be up rather than down.

Samuel Kubani/Agence France-Presse — Getty Images

Jean-Claude Trichet, president of the European Central Bank, speaks to reporters after an ECB meeting on Thursday in Vienna.

VIENNA, Oct. 4 — The European Central Bank stuck by its upbeat view of the region’s economy today, leaving interest rates steady and indicating that more time was needed to assess the fallout of the credit squeeze that has roiled financial markets for months.

The president of the bank, Jean-Claude Trichet, also declined to utter a word that might influence currency markets and hinted that politicians who have been calling for action to curb the rising euro should do the same.

“The exchange rate is a very important question that calls for verbal discipline,” Mr. Trichet said at a news conference in Vienna after one of the two meetings the bank holds each year outside its Frankfurt headquarters.

The central bank kept its main interest rate at 4 percent. In response, the euro barely budged, hovering around $1.41, just shy of the record level hit early this week.

In London, the Bank of England also kept official interest rates steady at 5.75 percent, offering no explanation. But the pound rose as some investors had worried that it might make a surprise cut after a run on Northern Rock, a mortgage bank, last month.

Recent surveys have shown shakier consumer and business confidence in Europe in the wake of the credit market turmoil, which has led to emergency rescues at two German banks and one in Britain. But Mr. Trichet focused on an economy that still seems to be expanding at a healthy, though not spectacular rate of slightly more than 2 percent a year.

“Corporate earnings and profitability have been sustained, employment growth has been robust and unemployment has fallen,” Mr. Trichet said.

Numerous European politicians, including Prime Minister Romano Prodi of Italy, the government of President Nicolas Sarkozy of France and Jean-Claude Juncker, chairman of the grouping of euro-zone finance ministers, have expressed concern that the strong euro will dampen European exports.

Mr. Sarkozy has even suggested the central bank follow the Federal Reserve’s surprise cut in interest rates last month.

Mr. Trichet only repeated the message that the Group of 7 central bankers and finance ministers made public at a meeting earlier this year, namely that the United States still has a “strong dollar” policy. With financial markets skeptical that the Bush administration wholeheartedly backs this policy, the message has barely altered the euro’s upward trend against the dollar.

One month after it abandoned a planned increase in borrowing costs in the face of credit market chaos, the European Central Bank gave little indication of when — or if — it would resuming lifting its benchmark rate. But Mr. Trichet did make clear that the bank’s next move was more likely to be up rather than down.

Under the treaties that created the euro, the bank’s chief priority is to fight inflation, which is now edging above 2 percent because of higher oil and food prices, slightly above the bank’s comfort zone. Over the last two years, the bank has steadily raised rates to ensure that accelerating growth does not lead to a spiral of rising prices as companies pass on the costs of more expensive raw materials to consumers or bid up the price of labor amid falling unemployment — dangers that Mr. Trichet said were still very much present in the euro area.

The bank did drop a reference from its monthly statement to interest rates being “on the accommodative side,” a sign that it has finished tightening credit. But Mr. Trichet repeatedly emphasized that the bank “stands ready to act” to ward off higher inflation with higher rates, even though it is clearly pausing to gather more information about the effects of the credit squeeze.

“As long as they are concerned about inflation, it doesn’t really matter how they characterize their stance on interest rates,” said Elga Bartsch, an economist with Morgan Stanley in London. “But they are on hold for now.”

One reason the bank may have altered its trajectory on interest rates is that credit markets have done the bank’s job for it over the last two months, economists said. As nervous banks and investors have curbed their lending, they have forced up the cost of borrowing, effectively creating the tighter credit conditions that central banks use to keep inflation under control.

Still, the bank has to preserve its options in case the outlook for inflation worsens — an entirely plausible scenario given escalating oil and commodity prices — while bearing in mind that higher interest rates could worsen the credit squeeze, now a preoccupation of banks and brokerage firms, and hurt manufacturers and other companies.

Mr. Trichet said the bank’s surveys showed more conservative lending to big corporations, a reflection of how merger and acquisition financing has become much more difficult in recent months, but said a fuller picture of the credit situation remained elusive.

That suggested that if the bank concludes the effect of tighter credit is minimal, it might nudge borrowing costs higher in the coming months.

“The way the bank has talked to us today, they can return to a path of higher interest rates at a later date without actually changing their minds,” said Audrey Childe-Freeman, chief Europe economist at CIBC World Markets in London.

Subprime: The Story That Just Won’t Die (KBH, PHM, TOL)

October 05, 2007 | By Mark Whistler

Ah, the subprime debacle it’s like a hydra. You chop off one head and two more spring up in its place. The story simply refuses to die.

Case in point, the recent New Home Sales report came in at a seven-year low 785,000 homes sold, versus the expected 830,000. Adding insult to injury, July sales were revised downward, coinciding with a 7.5% decline in the medium home price over the previous year.When is this story going away, and when is the bottom going to be found? I think this is what many are now wondering. I know I am sure am. (For complete coverage of the subprime meltdown, see our Subprime Mortgage Feature.)

Clichés are Clichés for a Reason
I think there is one cliché that probably holds true – it is always darkest just before dawn. Right now, things are bleak, even with the recent 50 basis point cut by the FOMC.

Adding fuel to the fire, the Borrowers Protection Act of 2007, introduced by Senator Charles Schumer, would virtually wipe out stated income loans and require every buyer to provide full documentation. However, many people cannot meet full documentation standards, even if they have a steady job and good credit.

And this is where the situation gets really dismal. Not everyone in America is a Senator with outstanding income, cash, employment history and credit. Essentially, if the credit crunch standards are not loosened, real estate markets could become even bleaker. Somewhere there is a happy medium, but it could take some time to iron out.

Making matters worse, KB Homes (NYSE:KBH) reported a $35.6 million loss for its Q3 2007, while also adding that the slump could last into next year. Specifically, CEO Jeffery Mezger said, “We expect housing industry conditions to continue to worsen through the end of the year and into 2008.”

Ouch. The state of affairs in real estate markets is nothing short of miserable right now.

Sun Rising, Maybe
Amazingly, despite KB Homes’ dismal earnings, the company’s stock closed up just over 1% on Thursday. Part of the reason was because of the company’s effort to reduce debt. See, Wall Street perceives that while the entire subprime/real estate situation is nothing short of horrible, many homebuilders have been aggressively taking charges and reducing debt, thus freeing up cash to invest if and when markets turn around. It’s the old “buy low, sell high” strategy. Arguably, many homebuilders didn’t sell enough when real estate markets were truly high, but they’ve been trying to correct themselves during the downside.

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Now, there are rumors that major players are looking into buying homebuilders. Warren Buffett, for example, buys when everyone else is selling, and given his record of accomplishment, it is certainly a strategy that works. Potential Buffett-purchase candidates could include Hovnanian Enterprises (NYSE:HOV) and Pulte Homes (NYSE:PHM).

However, for the average investor, there’s fine line between buying low and trying to catch a falling knife. After all, as the famous British economist John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.”

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By Mark Whistler, Contributor – Investopedia Advisor

Goldman Record Year Shows New Wall Street in Shakeout (Update1)

By Christine Harper and Jenny Strasburg

Oct. 8 (Bloomberg) — Somewhere in the wreckage of securities backed by subprime mortgages and the resulting seizure in the credit markets, is a new paradigm on Wall Street where Goldman Sachs Group Inc., increasingly perceived as the world’s biggest hedge fund, will report record earnings for 2007.

While Goldman, the largest securities firm by market value, insists that it caters to the needs of clients and has never been anything but customer-driven, New York-based Goldman also is considered No. 1 in proprietary trading and manages more hedge funds than anyone except JPMorgan Chase & Co.

And like Paulson & Co., Harbinger Capital Partners and Hayman Advisors LP, which are posting their highest returns when so many conventional financial institutions are reeling from subprime investments, Goldman profits substantially from allowing its traders to use the firm’s capital to speculate on whether the price of assets will fall or rise.

“The real world is much better than what we’re reading in the headlines,” said Michael Holland, who oversees more than $4 billion at Holland & Co. in New York. “Many more billions are being made on the positive side than are being lost.”

Goldman may be the most prominent example of the transformation of the securities firm that behaves more like a hedge fund. Like New York-based Goldman, Morgan Stanley and Lehman Brothers Holdings Inc. also will report record earnings this year, according to analyst estimates compiled by Bloomberg.

Summer `Carnage’

Where Paulson, Harbinger and Goldman used hedging strategies to prosper in the third quarter, Merrill Lynch & Co., Bear Stearns Cos. and UBS AG weren’t so nimble when the subprime tide ran out. The divergence, following three years when earnings at the top investment banks rose almost in lockstep, also illustrates why hedge funds exist — to take advantage of others’ distress.

“Out of this carnage of the summer, it was clear there were going to be huge opportunities because for all the managers who blew up, there were sure to be a bunch that exploited the situation,” said Bill Grayson, president of Falcon Point Capital LLC, a San Francisco-based hedge fund manager.

Goldman’s third-quarter earnings soared 79 percent to almost $2.9 billion after the New York-based firm, led by Chief Executive Officer Lloyd Blankfein, took positions that rose in value as the price of mortgage-backed securities declined.

By contrast, Merrill, the biggest U.S. brokerage, and Zurich-based UBS, Europe’s largest bank, reported their first quarterly losses in more than 4 1/2 years after mortgage-related writedowns. Bear Stearns, the No. 5 U.S. securities firm, posted its biggest earnings drop in a decade.

Northern Rock

Merrill said Oct. 5 that losses from mark-to-market accounting for subprime mortgages and collateralized debt obligations were $4.5 billion, net of hedging gains, in the third quarter. Anticipated losses on non-investment grade lending commitments were an additional $967 million, or $463 million after including underwriting fees, the firm said.

New York-based Merrill blamed “an unprecedented move in credit spreads and a lack of market liquidity in these securities, which intensified during the third quarter.”

The worst credit markets since Russia’s debt default in 1998 and the collapse of John Meriwether’s hedge fund, Long-Term Capital Management LP, was triggered by defaults on subprime mortgages in the U.S.

The tumult spread to the U.K. where mortgage lender Northern Rock Plc was bailed out last month by the Bank of England after rising short-term financing costs hampered its ability to sell new mortgages. The Newcastle, England-based company is now looking for a buyer.

ABX Indexes

“You’ve only seen the first round in the deterioration of the mortgage area,” said James Melcher, president of Balestra Capital, a New York-based hedge fund with about $270 million of assets. “The second round is just starting, and it’s going to be worse.”

Balestra Capital’s fund rose about 130 percent this year through September, according to a letter sent to investors. The fund used so-called ABX indexes to benefit from the increase in home-loan delinquencies. ABX indexes allow investors to buy into derivatives called credit-default swaps on multiple securities. Bearish investors have used ABX bets to wager against the health of mortgage lenders to people with bad credit histories.

An ABX index tied to 20 subprime mortgage bonds rated BBB- slumped 46 percent in the third quarter. The index has declined about 70 percent this year, data compiled by administrator Markit Group Ltd. show.

Homebuilding Index

Home prices in the U.S. will drop on a year-over-year basis for the first time since the Great Depression of the 1930s as an estimated 1.5 million people are in danger of losing their homes to foreclosure, according to estimates from the Fisher Center for Real Estate and Urban Economics at the University of California at Berkeley. The 16-member S&P Supercomposite Homebuilding Index has fallen 62 percent since the housing boom peaked in September 2005.

While Northern Rock, Merrill, UBS and Bear Stearns weren’t prepared for the market reversal, Harbinger’s $11 billion hedge fund, run from New York by former Barclays Capital trader Philip Falcone, climbed more than 65 percent this year. The $4.5 billion Paulson Credit Opportunities Fund rose more than 300 percent and Kyle Bass’s Dallas-based Hayman reported a 400 percent return. All the funds benefited from the slumping mortgage market.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.

Trading Risks

Like hedge funds, Goldman uses its capital to take bigger trading risks than rivals. The firm’s so-called value at risk, a measure of how much the bank estimates it could lose from trading in a single day, rose to $139 million in the third quarter, up 51 percent from a year earlier to the highest ever, according to company reports. The increase was most pronounced in interest rate-related risk, which almost doubled to account for about 40 percent of the total.

On a similar basis, New York-based Morgan Stanley, the second-biggest U.S. securities firm by market value, said its trading VaR was $87 million in the quarter, up 55 percent from a year earlier. Lehman, the fourth-biggest firm, said VaR was $96 million, citing “a combination of higher levels across a range of products for the period and a higher level of risk associated with an increase in fixed-income related assets.”

Since taking over in 2002, Merrill Chief Executive Officer Stanley O’Neal has pushed the firm to match its rivals by expanding in proprietary trading and private equity, businesses that put more of the company’s capital at risk in exchange for higher returns.

First Franklin

The 56-year-old CEO extended the strategy into subprime mortgage lending last year when Merrill purchased San Jose, California-based First Franklin for $1.3 billion. Like Bear Stearns and Lehman, Merrill planned to make money by packaging loans into bonds and selling them to investors. Buying a mortgage company helped assure a steady supply for Merrill’s debt- securities underwriting.

Less than two months later, the mortgage market began to unravel as HSBC Holdings Plc, the biggest U.S. subprime lender, disclosed that bad-loan provisions increased 20 percent. By early April, New Century Financial Corp., the biggest independent subprime lender, had declared bankruptcy. About 100 mortgage companies have halted operations, declared bankruptcy or sought buyers this year.

Last week, Merrill reported its first quarterly loss since the fourth quarter of 2001, after the Sept. 11 terrorist attacks that had destroyed the World Trade Center. Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.

Market Swoon

Shares of Goldman are trading as if the market swoon of July and August never happened. They have gained 39 percent since falling to a 52-week low on Aug. 15 and now sit less than 3 percent below their all-time high. Stephen Schwarzman’s Blackstone Group LP, manager of the world’s largest leveraged buyout fund, has gained 35 percent since falling to a record low of $21.54 on Sept. 7.

Goldman’s stock rose 14.6 percent so far in 2007, the best performance of the five biggest U.S. securities firms. Morgan Stanley gained 1.9 percent, while Merrill and Lehman dropped 18 percent, and Bear Stearns fell 19 percent.

Not all of Goldman’s traders were so successful. Global Alpha, a $6 billion hedge fund run by Mark Carhart and Ray Iwanowski, lost almost 35 percent in the year through September after shedding 6 percent in 2006. Goldman raised $1 billion from investors and injected $2 billion of its own capital into another fund, Global Equity Opportunities, after it dropped 30 percent in first two weeks of August.

Higher Pay

Still, Goldman pays employees more. The company set aside $16.9 billion for compensation and benefits in the first nine months of the fiscal year, up 21 percent from a year earlier, the company reported last month. The outlay exceeded Morgan Stanley’s $13.4 billion and Lehman’s $7.3 billion. Bear Stearns was the only one to reduce compensation as its revenue declined. The firm’s costs fell 5.9 percent from a year earlier to $3.1 billion, according to company reports.

“There’s kind of a love-fest going on with Goldman right now, as they were able to weather the subprime storm much better than anyone else,” said Peter Kovalski, who helps manage more than $12 billion at Purchase, New York-based Alpine Woods Investments, which holds shares of Goldman and Merrill. “They’re one of the best-run investment banks out there.”

When Canadian Prime Minister Stephen Harper went looking for a governor for the Bank of Canada, he settled on former Goldman investment banker and finance ministry official Mark Carney.

Carney’s Ace

Craig Wright, chief economist at Royal Bank of Canada, the country’s largest bank, said Carney’s “experience in the private sector seems to have been the ace in the hole.”

Former Goldman executives including U.S. Treasury Secretary Henry Paulson and Bank of Italy Governor Mario Draghi have been named to top policy-making posts. Paulson, Goldman’s former chief executive officer, last year became the 10th senior official to join the U.S. government. Ex-Goldman leaders Robert Rubin and Stephen Friedman served as White House appointees, while Paulson’s former co-CEO Jon Corzine was elected to the Senate before becoming governor of New Jersey.

Goldman reported record fixed-income trading revenue of $4.9 billion in the third quarter, exceeding the combined tally of Morgan Stanley, Lehman and Bear Stearns. Analysts estimate Goldman will earn almost $11 billion this year, 30 percent more than its closest competitor Morgan Stanley.

Morgan Stanley will earn a record $8.4 billion in the fiscal year that ends in November and Lehman will earn a record $4.3 billion, according to a survey of analysts by Bloomberg. Bear Stearns’s net income may fall 31 percent to $1.4 billion.

The Storm

“For being an awful fixed-income year, it sure looks like a pretty good bottom-line year,” said Brad Hintz, an analyst at New York-based Sanford C. Bernstein & Co., who recommends buying shares of Merrill and Morgan Stanley.

Hintz lowered his 2007 and 2008 profit estimates for Merrill today after the company’s disclosure that it will report a third- quarter loss, though he kept an “outperform” rating on the stock. Analysts at JPMorgan Chase & Co. and Credit Suisse Group dropped their recommendations on Merrill shares to “neutral” and also cut their earnings estimates.

Bear Stearns Chief Executive Officer James Cayne, who ousted his potential successor Warren Spector in August, told shareholders on Oct. 4 that his firm will “weather the storm.”

“The businesses are much, much more global than they were seven years ago,” said Peter Goldman, who manages about $500 million, including shares of Bear Stearns and Morgan Stanley, at Chicago Asset Management. “They are more diversified and with the exception of Bear they didn’t have such a compartmentalized risk profile.”

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net ; Jenny Strasburg in New York at jstrasburg@bloomberg.net .

Last Updated: October 8, 2007 09:44 EDT