Merrill strategy threatened by bad loan market

Some on Wall Street fear Merrill Lynch's exposure to the troubled subprime lending market threatens its acquisition plans.

By Shaheen Pasha, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Analysts may be hailing Merrill Lynch's appetite for acquisition, but new fears are rising on Wall Street that Merrill's foray into the subprime mortgage lending market could put the kibosh on its plans to continue to target more companies aggressively.

Merrill Lynch (Charts) has been no stranger to acquisition in its recent quest to expand into high-growth areas like private equity and high-net-worth retail banking. The company has promised that it will continue to shop around for profitable businesses as strong global markets and a healthy backlog of M&A deals portend another profitable year for investment banks.

But its purchase of subprime mortgage lender First Franklin in September is raising concerns that the troubled mortgage space could be the wrench that slows down Merrill's momentum.

Since 2004, Merrill Lynch has spent almost $3 billion, snapping up around 18 different businesses, including First Franklin at a price tag of $1.3 billion. The company's most recent buy of retail bank First Republic last month for $1.8 billion - its largest deal in a decade - earned it kudos from Wall Street as analysts said Merrill was on the right track toward plugging gaps in its business lines and expanding its base of high-net-worth clients.

But the First Franklin acquisition has received mixed reviews and caused some analysts to worrying that Merrill's investment into the subprime mortgage space - a hot market for banks in recent years - could have come too late.

"First Franklin is going to be more of an integration and absorption issue than it seemed at first blush," said David Hendler, senior analyst at CreditSights. "[Merrill Lynch] rushed to fill in a need but that market may have peaked, creating less revenue opportunities and more loss exposure than they expected."

Hendler added that the headache of trying to navigate the subprime mortgage market at a time when delinquent borrowers are defaulting on loans in droves could slow down the company's acquisition plans.

It's against this backdrop that Merrill bought First Franklin last September. Now the company is going to have to spend its resources and energy making sure that underwriting standards are up to snuff and that Merrill has enough reserves to cover potential losses, Hendler said.

That may leave it little time to ponder acquisitions in other areas, he added.

But Dick Bove, financial strategist at Punk, Ziegel & Co., said that Merrill's acquisition strategy is broad and not wholly focused on subprime mortgages. By expanding into more profitable areas such as trading, retail banking for affluent customers and private equity through small, bolt-on acquisitions, the company is putting its capital to good use.

He added that subprime mortgages, while troublesome for the industry, were nonetheless just one part of its overall growth plans.

And, if done right, Merrill Lynch could stand to make money.

Banks like Merrill, Bear Stearns (Charts), Lehman Brothers (Charts) and JPMorgan Chase (Charts) have long been attracted to buying subprime loans from lenders because they can convert them into mortgage-backed securities and sell those bonds to hedge funds and other institutional investors. It's been a profitable endeavor in the past few years for those companies that got into the market at the right time.

But with defaults on subprime mortgages rising rapidly, mortgage lenders have been pushed into bankruptcy. And big banks, like HSBC (Charts), that bought those now troubled loans found themselves putting aside massive amounts of money in provisions to cover defaults. HSBC set aside $10.6 billion in 2006, while New Century Financial (Charts) reported its first quarterly loss since 2001 because of the deteriorating market.

"Brokerage houses are probably overpaying for these assets currently when they buy them off lenders," said Steve Roukis, managing director and portfolio manager at Matrix Asset Advisors, which owns shares of Merrill Lynch. "There are other ways Merrill Lynch can make money."

By acquiring First Franklin from National City (Charts), Merrill took on the responsibility for underwriting the loans, rather than simply buying the loans from other lenders. That way, the company could ensure that the mortgage-backed securities it created were less likely to default, he added.

"And even if for some reason they did get it wrong, First Franklin is a small enough deal that it's not a big financial impact to them," Roukis said.

Roukis and Bove added that there's little chance that Merrill Lynch will abandon or slow down its acquisition strategy over troubles in one area.

Analysts said the company is still working to play catch up with its peers like Goldman Sachs (Charts) in areas like commodities trading and structured finances - areas that were slashed after current Chief Executive Stan O'Neal took over the company in 2002 and set about reorganizing its businesses and cutting costs.

"Merrill has a tremendous amount of excess capital at hand and is using that that capital to build out its businesses in sectors where it has been weak," Bove said.

Analysts said the company's stake in money manager BlackRock Inc. last year and the acquisition of the boutique investment banking Petrie Parkman & Co. were among Merrill's smart buys to increase its foothold in high-growth areas like investment banking and asset management. Its purchase of First Republic gave the company access to high-end luxury lending as well as a more affluent customer base, with which it can cross-sell other products.

And the company is looking to increase its revenue from abroad, which could open the door for more overseas acquisitions regardless of troubles at home.

In a recent research note, Bank of America analyst Michael Hecht said Merrill's co-heads of global markets and investment banking expect non-U.S. revenues to grow to 75 percent of its total revenue over time. Merrill's overseas revenue accounted for 50 percent of its total investment banking revenue in 2006.

Analysts said with such lofty goals, Merrill is going to have to pursue its aggressive acquisition strategy.

"There's lots of opportunity for Merrill," said Matrix Asset Advisors' Roukis. "By pursuing these small tuck and fill acquisitions, they're reducing risk to smaller amounts and stringing together pearls to make the franchise better."

A representative from Merrill Lynch was unavailable for comment.

None of the analysts quoted in the story, with the exception of Matrix Asset Advisors' Roukis, own shares of Merrill Lynch.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.