A Major Stumble at Merrill Lynch

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The results from Merrill Lynch (NYSE: MER) yesterday were enough to make you want to throw your hands up and exclaim, "What gives?"

After announcing just a few weeks ago that it would be writing down $4.5 billion worth of exposure to collateralized debt obligations (CDOs) and subprime mortgages, Merrill dropped the bomb in its earnings announcement that the writedown would actually total $7.9 billion. Whoops! Tack on top of this a net $463 million writedown on leveraged-buyout (LBO) commitments, and you're looking at a pretty mind-boggling amount of value destruction for shareholders to swallow.

While other players in the CDO, mortgage, and LBO lending markets -- including Lehman Brothers (NYSE: LEH), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), and Bank of America (NYSE: BAC) -- have taken sizable writedowns, they all pale in comparison with Merrill's flub.

Not all gloom and doom
The really sorry part is that the company saw some good performance from some of its other business groups during the quarter. Excluding its private-equity business, Merrill's equity-markets arm was up 40% from the third quarter of last year. Investment banking, which experienced good momentum in advisory services and equity underwriting, rose 23% year over year. Merrill was also the lead in the ABN AMRO (NYSE: ABN) transaction and has the bulk of those fees still ahead. The firm's global wealth-management group, which includes its investment in BlackRock (NYSE: BLK) -- a company that just announced a nice quarter -- saw net revenue increase 29% from the third quarter of 2006.

But with $8 billion of writedowns, that's all easy to skip over. After all, without adequate risk management, those stable businesses could just be building up a cushion for the next fantastic mistake like this.

Can this possibly be the right direction?
As I've discussed previously, the issues seem to stem largely from CEO Stan O'Neal's efforts to model Merrill more along the lines of Lehman Brothers or Goldman Sachs. O'Neal was on the earnings conference call -- an event that the CFOs in the investment-banking world typically handle -- and he personally apologized and shouldered the blame for the firm's mistakes. Still, he and CFO Jeff Edwards also emphasized that this performance would not mean the company will severely curtail its overall risk appetite. The apology was not typical Wall Street fare and is certainly notable, but investors still have to be wondering whether this current crew has what it takes to lead Merrill on a new course.

Frustrating, too, was Edwards' stonewalling on the conference call. Though the company did go to some lengths to provide more disclosure than others have on its current CDO and subprime exposure, it still fell well shy of ideal. Deutsche Bank's Mike Mayo, who, along with multiple other analysts, pressed Edwards for more disclosure on the call, pointed out that while Merrill did provide more disclosure than its peers, "[its] peers didn't take an $8 billion writedown."

Forward-looking statements
If Merrill were a depressed, suicidal stock, it'd be easy to tell it that it has plenty to live for. As I noted above, most of the firm's business segments turned in pretty nice results for the quarter.

That said, losses taken and apologies made don't make for instant repair of credibility. Some may trust that O'Neal & Co. have learned their lessons and will want to take advantage of the current stock price, which is down more than 25% in the past 12 months. But I'd prefer to see Merrill actually walk the walk for a few quarters first and prove that it's actually figured out -- and fixed -- what led to this awful quarter.

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