Merrill takes $7.9B mortgage hit

CEO Stanley O'Neal in the hot seat after firm reveals huge loss on bad mortgage bets and swings to first quarterly loss since 2001.

By Grace Wong, staff writer

LONDON ( -- Merrill Lynch & Co. Inc. took a $7.9 billion writedown in the third quarter due to bad mortgage bets, well exceeding its initial estimates and raising questions about whether the worst is over for the Wall Street firm.

Writedowns on home loans given to borrowers with poor credit and collateralized debt obligations - pools of bonds sold off in slices of varying credit risk - hurt performance and resulted in the company reporting on Wednesday its first quarterly net loss since 2001.

The mortgage hit was well above the writedown Merrill (Charts, Fortune 500) estimated it would take earlier this month. The blow has put the bank's risk management practices under more scrutiny and turned up the heat on Merrill Chief Executive Stanley O'Neal.

"The bottom line is we got it wrong by being overexposed to subprime," O'Neal told analysts during a conference call.

Merrill has been reducing its exposure to mortgage debt. During the quarter ended in September, the bank scaled back its CDO exposure by 53 percent to $15.2 billion and reduced its subprime exposure by 35 percent to $5.7 billion.

But Merrill executives offered few details on how the firm lowered its exposure, and analysts expressed concern the bank would have to take more markdowns.

When pressed by an analyst, O'Neal stopped short of saying the firm wouldn't have to take further writedowns. He said he could not predict the market's trajectory but was comfortable the firm had marked its positions conservatively.

As a result of those more conservative assumptions, Merrill's loss on mortgage-related securities came in $3.4 billion higher than the bank had originally estimated.

For the quarter, Merrill posted a net loss from continuing operations of $2.3 billion, or $2.85 a share. In the year-ago period, Merrill reported a net profit of $3 billion, or $3.47 a share, on the same basis.

Net revenue dwindled to $577 million, down 94 percent from $9.8 billion in the same period last year.

The news drove shares in the company down nearly 6 percent on Wednesday.

On Oct. 5, Merrill warned investors and analysts that it would take a $5 billion third-quarter writedown, including a $463 million writedown related to loans extended for corporate buyouts. At that time, it also said it expected to post a net loss of up to 50 cents a share.

The additional writedown the company has taken in the little more than two weeks since that estimate has raised questions about risk management at the firm.

Credit rating agency Standard & Poor's lowered its rating on Merrill Lynch by one notch to "A+/A-1" after the results were released.

"The absolute size of the loss related to CDOs and subprime mortgages, and management's miscues regarding the valuation of its positions, further heighten our concerns regarding the company's risk management practices and business strategy," S&P analyst Scott Sprinzen said in a note.

During the conference call, O'Neal conceded that the firm didn't hedge some of its CDO exposure aggressively enough. Merrill's assessment of the potential risk and its mitigation strategies were "inadequate," and "errors of judgment" were made, he said.

But he said efforts were already underway to put the company back on track, referring to recent leadership changes. Earlier this month, Merrill promoted David Sobotka, head of global commodities, to lead the firm's fixed-income business and appointed Ed Moriarty to the position of chief risk officer.

Executives said mortgage-related revenue would be severely constrained for quite some time, but said they were upbeat about other businesses.

The company said it was also considering unloading some non-core assets. Merrill did not specify which investments this could involve, but said it would not affect its investment banking unit or wealth management business.

Global wealth management, which includes earnings from the company's investment in BlackRock, was one of the few strong points for Merrill in the quarter. Revenue rose 29 percent to $3.5 billion.

Merrill's writedown is the biggest of all the Wall Street firms, far exceeding the $3 billion hit Citigroup Inc. (Charts, Fortune 500) suffered. Financial services companies worldwide have reported more than $20 billion in losses related to the mortgage meltdown, although all the other major Wall Street banks managed to post a profit despite their exposure to mortgage-backed securities.

Fears about rising defaults on risky home loans have scared investors away from mortgage-backed securities, resulting in a decline in their value. A group of banks led by Citigroup has announced plans to launch a "superfund" to revive the market, although doubts are growing about whether the fund will be able to get off the ground. Top of page