Kitchen sink approach fails Merrill

Vikram Pandit, Citi's new chief, was less candid this week about the bank's portfolio of mortgage-related securities. His reticence has spooked shareholders.

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NEW YORK (Fortune) -- Nothing has worked lately for Merrill Lynch and Citi - not even the time-honored Wall Street tradition of writing off everything but the kitchen sink.

On Thursday, Merrill (MER, Fortune 500) became the latest big financial institution to post its worst-ever quarterly loss amid sharp devaluations of mortgage-related securities. The big brokerage firm lost $10.3 billion, or $12.57 a share, from continuing operations for the quarter ended Dec. 31.

The latest quarter included a $10 billion writedown of Merrill's collateralized debt obligations, or CDOs, the risky debt tied to the mortgage meltdown that hit the credit markets this summer. Merrill's red ink follows similar bloodletting at Citi (C, Fortune 500), which posted Tuesday a quarterly loss of $9.83 billion, or $1.99 a share, reflecting an $18.1 billion writedown of mortgage-related securities holdings.

The writedowns did little to placate jittery investors who wonder if the worst isn't over. Merrill shares fell 8 percent after Thursday's report. Citi shares are down 12 percent in the three days since its losses were announced.

Are investors overreacting?

Merrill and Citi have much in common beyond their mortgage-related woes. Both firms have new chief executives - John Thain at Merrill, Vikram Pandit at Citi - who are highly regarded and seen as thoroughly understanding the complex mortgage securities business. Both men have backgrounds in Wall Street's dark arts of quantitatively carving up cash flows that would enable them to, as the saying goes, "Get the joke."

More to the point, both firms have vibrant, highly profitable businesses beyond the mortgage area that should help them ease through a painful period of adjustment. Given the steep decline in shares of both companies - Merrill stock has lost 48 percent of its value over the past year, and Citi 54 percent - you might think that investors would be inclined to give the new CEOs a bit of a grace period.

But it hasn't worked out that way. Both companies' stock declines reflect continuing unease about the firms' reeling balance sheets and the toxic legacy of five years' worth of CDO underwriting. The ongoing seizure across broad segments of the CDO and asset-backed security secondary trading markets has collapsed prices to the point where investment banks and hedge funds are practically refusing to bid for these securities.

During Tuesday's conference call with analysts, Citi's Pandit and chief financial officer Gary Crittenden declined to offer or even confirm ballpark valuations for the bank's CDO holdings. They declined to acknowledge publicly that their $14.3 billion writedown - on a balance sheet with $29 billion in CDO exposure of all stripes remaining - might not be the last.

The only insight into the valuation question came from Oppenheimer analyst Meredith Whitney. Whitney, who has been saying for months that Citi will need to raise billions of dollars of new capital to offset massive writedowns, ventured that the valuations of certain Citigroup CDO slices known as mezzanines were around 43 cents on the dollar. As it turns out, her hunch is widely shared, at least by Citi's rivals, who told Fortune that their own CDO inventories for this sort of paper are also around 40 cents on the dollar. (Merrill, meanwhile, is valuing the mezzanine parts of its CDO portfolio at 20 cents on the dollar.)

But Pandit and Crittenden refused to answer Whitney directly, missing an opportunity to illuminate the market on Citi's valuation methodology and almost certainly contributing to this week's $3-plus drop in the stock's price.

Merrill's Thain, on the other hand, was more candid on his conference call, pointing out that he assumes that the value of a large chunk of the company's $11.5 billion writedown for CDOs and sub-prime securities won't come back. "I don't think we're going to get much back on these things," Thain said. "I don't think it's just like an illiquid market where liquidity comes back and you get back these losses."

Thain made a safe assumption, but it was a breakthrough with respect to Wall Street management, which has tended to treat the issue of CDO writedowns as one would an investment that declined in value - rather than an investment that has utterly collapsed.

In other words, Thain implicitly sided with longtime housing market skeptics and bearish hedge fund managers, such as Hayman Capital's Kyle Bass, who have argued that the credit crisis represents a fundamental value collapse of a wide swath of the capital markets.

However, some CDO analysts cautioned against drawing broad distinctions between Merrill and Citi. Janet Tavakoli, of Chicago's Tavakoli Structured Finance, said that "Pandit and Thain took very different disclosure approaches because they have too pretty different sets of problems."

To Tavakoli, Citi's remaining CDO portfolio "has some problem paper to be sure, but based on the prospectuses I read, has a good chance to continue making [principal and interest] payments [on the debt] for awhile."

"Merrill's portfolio, on the other hand, does not," she said. She argued that Thain had little choice but to write down his firm's CDO portfolio into the 20-cents-on-the-dollar range. "Some of the deals are absolutely sleazy," she said. "Their 2007 vintage [CDO] paper is really problematic."

That's why for now, the joke is on Merrill.