Merrill Writedown Mushrooms

Updated from 7:40 a.m.

Merrill Lynch (MER) stunned Wall Street for the second time this month Wednesday with the disclosure that it was forced into a $7.9 billion writedown of bad debt tied to risky mortgages and so-called structured paper.

The announcement marks a turning point in the credit crisis that has consumed investors in recent months and has observers wondering how much more pain will be felt by Merrill's rivals in the brokerage industry. Shares in Wall Street firms fell 1%-2% in early trading as investors braced for Merrill's 10 a.m. EDT conference call.

The announcement comes three weeks after Merrill surprised investors by estimating that its third quarter would swing to a loss under the weight of $4.5 billion in writedowns on certain securities. That was by far the largest hit taken by a Wall Street firm after a summer of turmoil locked up the credit markets and left many financial institutions sitting on hefty losses.

Merrill said the writedown increased after the firm took a second look at its valuation of collateralized debt obligations and subprime mortgage backed securities.

The writedown amounts to a huge black eye for Merrill chief Stanley O'Neal, whose firm pushed into the subprime lending market just last November with its $1.3 billion acquisition of First Franklin. Since then defaults by homebuyers with poor credit histories have spiked, sending investors fleeing from the once-robust market for mortgage-backed securities. Merrill and its rivals at firms such as Lehman Brothers (LEH) and Bear Stearns (BSC) have been hit hard by losses tied to those markets

Earlier Wednesday, news reports had put Merrill's revised writedown as high as $10 billion.

Merrill's third-quarter report has to rank among the worst in modern Wall Street history. The firm swung to a loss of $2.24 billion, or $2.85 a share, from continuing operations from a year-ago profit of $3.05 billion, or $3.14 a share.

Revenue plunged 94% from a year ago to $577 million, as the firm took a $5.9 billion loss on its in-house trading operation.

"In light of difficult credit markets and additional analysis by management during our quarter-end closing process, we re-examined our remaining CDO positions with more conservative assumptions. The result is a larger write-down of these assets than initially anticipated," said O'Neal. "We expect market conditions for sub-prime mortgage-related assets to continue to be uncertain and we are working to resolve the remaining impact from our positions."

Merrill said $6.9 billion of the third-quarter writedown was related to its CDO positions and $1 billion to its subprime holdings. The firm said its net exposure to those securities dropped from second-quarter levels, but it continues to have $15 billion worth of CDO exposure and nearly $6 billion worth of subprime exposure.

Merrill's shares, which were off 28% for the year heading into Wednesday's trading, dropped $2.25 to $64.87 in early action.

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