The Merrill Lynch "Surprise" Fuels More Subprime Uncertainty

By Jason Simpkins
Associate Editor

Just one day after Merrill Lynch & Co. Inc. (MER) wrote off billions in bad mortgage loans and reported its biggest quarterly loss in 93 years, Wall Street analysts yesterday (Thursday) predicted there was still more bad news to come.

Although it wrote off $8.4 billion of subprime mortgages and others debts in the third quarter, experts say Merrill failed to accurately predict the size of its quarterly loss and also didn't outline how it has reduced its overall debt exposure. The upshot: The company has lost a lot of credibility on Wall Street and analysts now fear it may be looking at $4 billion in additional write-offs in the fourth quarter, according to Forbes.com.
Merrill's shares dropped as much as 7% yesterday, finally closing at $60.90, down $2.32 a share, or 3.67%.

But most importantly for investors, the revelations of the past two days served as sobering reminders that the subprime-mortgage debacle has a long and miserable tail. 

Two of the world's biggest banks, Citigroup Inc. (C) and UBS AG (UBS), announced multibillion-dollar third-quarter writedowns three weeks ago, and their stock prices actually jumped.  After announcing a $5.9 billion writedown, Citigroup's stock gained 2%.  Likewise, UBS climbed 3.2% after announcing its $3.4 billion. The reason: Analysts believed the write-offs defined the extent of the mortgage mess, meaning the end was in sight.

"These writedowns just lulled the market into a false sense of security, that the subprime problem had been defined and written off and we could all move on. However, it wasn't as simple as that," says Martin Hutchinson, our Money Morning banking and financial expert.

But Money Morning predicted there was more pain to come.

Merrill Lynch is now a case in point. The investment bank's $8.4 billion hit nearly doubled the firm's prediction of three weeks ago. The writedowns on subprime mortgages, asset-backed bonds and leveraged loans combined to generate a third quarter loss of $2.24 billion, six times the company's initial estimate

What's astonishing isn't just the magnitude of the writedowns and the dent in quarterly profits, but Merrill's inability to anticipate the losses.

Dick Bove, bank analyst at Punk Ziegel, was one of the first to point out that the fat lady hadn't quite sung for the subprime mortgage meltdown. In an interview with USA Today, he alluded to the 1987 credit crisis and pointed out that the Federal Reserve wasn't able to fix that problem with rate cuts. It took several years for that debt crisis to work its way through the system.

In 1987, Citigroup's then-CEO John Reed also announced a major charge against earnings - a $1 billion write-off related to problems with loans to Latin America.

"John Reed said exactly what [current Citigroup CEO] Chuck Prince said," according to Bove. "We've figured out the problem, isolated it and eliminated it. Stocks went up, and everybody was happy. However, we know from hindsight that in 1991, Citi was still writing off its Latin American debt because they hadn't isolated the problem and they had no idea what the depth of the problem was."

Bove recently took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53. Wall Street analysts rarely rate a stock as an outright "Sell," instead using such well-understood code words as "Hold." By listing Citi's shares as a "Sell," Bove made clear his disenchantment with the company's performance.
Just a few weeks ago, industry executives warned that the housing market might not recover until 2010.

"It's going to be a long time before we see [the housing market] bottom out and recover," David Lowman, chief executive of JPMorgan Chase & Co. (JPM) said at the Mortgage Banker's Association's annual convention. 

And here are a few more facts to consider:

  • In the next few years, more than 75% of the nation's housing markets will suffer an overall price decline - some by double-digit amounts.
  • A few weeks ago, Peter Orszag, director of the Congressional Budget Office (CBO), told a Senate panel that if home prices drop as much as experts have projected, U.S. households could lose $3 trillion in wealth.
  • Adjustable-rate mortgages to subprime borrowers accounted for 7.3% of all home loans and 44% of all new foreclosures, according to the Mortgage Bankers Association. An estimated 2 million to 2.5 million adjustable-rate mortgages (ARMs) are scheduled to reset this year and next, jumping from low "teaser" rates to much steeper rates that in some cases could cost borrowers their homes.

 

Merrill Lynch just paid a heavy price for underestimating the extent of the subprime crisis. Don't be fooled into thinking the worst is over, there could be plenty more fallout on the way.

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