More Merrill Writedowns

This post first appeared on Minyanville.

Merrill Lynch (MER) will announce tomorrow it's still reeling from bad subprime bets.
The Wall Street Journal reports Merrill will take an additional $6 to $8 billion in writedowns on mortgage-related securities and lay off 10% to 15% of its workforce. This brings the firm's total writedowns to $30 billion, having reduced its subprime exposure to $7.5 billion, down from $40.9 billion in June. The announcement is expected during tomorrow's first quarter earnings release.

Merrill has raised $12.8 billion in capital since last fall, but its leverage remains high - at 31.9 to one. According to Professor Sedacca, this isn't a level befitting a bank supposedly going through a deleveraging cycle.

Merrill's reputation has been severely damaged. The Securities and Exchange Commission is investigating whether management should have divulged the extent of the company's subprime exposure sooner. John Thain, the new CEO, says the company won't need to raise capital again and will operate with renewed focus on risk management.

Throughout 2006 and 2007, Merrill topped The Street in issuance of collateralized debt obligations (CDO), even as demand for new deals waned. The lack of buyers forced Merrill to hold a greater number of assets on its own balance sheet. As the value of the securities began to slide, Merrill was left holding the bag.

In a last ditch effort to stem its losses, Merrill entered into agreements to hedge its CDO book. It picked the wrong counterparties. Trades with poorly capitalized bond insurers ACA Financial and XL Capital forced Merrill to take big hits when the two firms became insolvent late last year. Lehman Brothers (LEH), by contrast, took its lumps over trading losses with XL Capital in the first half of 2007. Merrill still has the principal portion of around $5 billion in CDO securities hedged with struggling bond insurer MBIA (MBI).

Investors hope Merrill is on the right track. Despite ongoing turmoil in the capital markets, many analysts remain confident investment banks have seen the worst of the credit crunch. This morning, Punk Ziegel analyst Richard Bove said many financial companies are oversold. Bove believes losses are simply accounting adjustments with little effect on cash flow. He says the long-term outlook is good for most banks.

This sentiment is gaining steam on Wall Street, as investors hope earnings season will air the last of the laundry soiled by subprime slime. But hope, as Toddo likes to say, is not a viable investment strategy.

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