Downgrade Mauls Merrill

Merrill Lynch (MER) CEO Stanley O'Neal took responsibility for the firm's pathetic third-quarter performance, but investors fled the brokerage sector anyway.

Merrill shares tumbled 5% in midmorning trading after the ratings agency Standard & Poor's downgraded Merrill. The ratings move, which echoed an outlook change on Bear Stearns (BSC) back in August just as that firm was trying to muddle through a liquidity crisis, sent brokerage stocks tumbling just after 10:45 a.m. EDT.

After earlier posting modest losses of 1%-2%, Bear was off 4%, Morgan Stanley (MS) was down 5%, and Lehman Brothers (LEH) was sliding 6% in late morning action.

The selloff came after Merrill posted a huge third-quarter loss tied to massive writedowns in its holdings of subprime mortgage securities and the structured paper known as collateralized debt obligations.

"I'm not going to talk around the fact that there were some mistakes that were made," O'Neal said in introductory remarks on the call. "We got it wrong by being overexposed to subprime."

O'Neal said on a conference call with analysts and investors that the New York-based firm would explore the divestiture of certain assets as part of its plan to recover from an embarrassing $7.9 billion in asset writedowns.

Merrill had said three weeks ago that it expected to lose 50 cents a share for the quarter ended Sept. 30 after $4.5 billion in writedowns tied to bad bets on subprime mortgages and CDOs.

Merrill's chief said that the company took a much larger hit because it continued to evaluate its position and mark down assets after its earnings preannouncement. He said the firm had reduced its exposure but "remained subject to market valuations."

The bad news at Merrill comes as a part of the fallout from a summer credit crunch that saw financial institutions including UBS(UBS), Citigroup(C) and Bear take billion-dollar writedowns linked to mortgage-related securities.

Merrill's aggressive push into the CDO market and its relatively recent $1.3 billion acquisition in First Franklin -- a subprime-focused lender -- have been criticized by analysts following the blowup of the mortgage market.

Now, Merrill may well be evaluating those areas for firings and shutdowns, as well as possible divestitures.

Merrill continues to hold chunks of debt in areas such as triple-A rated, super-senior tranches of CDO securities. Recent downgrades by Standard & Poor's and Moody's of residential mortgage paper continues to erode valuations of those securities.

Still, Chief Financial Officer Jeff Edwards says that Merrill believes its valuations in that CDO debt will hold. "Given the environment, we believe that the valuations are conservative," he said Wednesday.

"Going forward, we will continue to take opportunities to reduce inventory but in a prudent way," Edwards added.

Troubles abound in CDOs and the structured-investment vehicle market, however. A so-called liquidity dislocation -- that is, a lack of buyers -- is making it difficult for such paper to be sold, CDO traders have told TheStreet.com.

"I cannot tell you what the market trajectory will be from here," O'Neal said. He added that he believes that Merrill has been conservative in its evaluation of marking down its debt inventory.

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