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Higher-Quality Loans May Trip Merrill Next

The credit crunch may soon hit an already battered Merrill Lynch (MER) in a place few have considered.

Wall Street is predicting that the nation's largest brokerage franchise may take further body blows on writedowns to mortgage-related debt and funky paper that have already hobbled it and rivals like Citigroup (C - Get Report), Bear Stearns (BSC), UBS (UBS) and many other financial firms.

Most observers have been searching the nation's largest broker's prodigious holdings in collateralized debt obligations and other esoteric mortgage securities to uncover where it might endure more pain.

But given mounting negative forecasts on delinquencies and foreclosures in higher-quality mortgages such as Alt-A, home-equity lines of credit and consumer credit cards, Merrill's little-known commercial bank subsidiary Merrill Lynch Bank USA may prove a source for worry.

Based in Salt Lake City, Utah, MLB USA collects deposits primarily via so-called cash and dividend sweeps from its retail brokerage customers, because brokers are not allowed to keep on their books cash that is derived, for example, from dividends in client accounts.

Merrill's bank arm serves as a massive source of funding, from its huge brokerage deposit base, and it offers a wide array of loans and services to its customers.

According to public filings, the bank had some $76.5 billion in total assets and a total loan base of about $38.6 billion at the end of last year.

About $20 billion of those assets are in the form of mortgage-backed securities; about $11 billion on loans secured by real estate; and a combined $25 billion in commercial and industrial loans, as well as student loans and revolving credit cards.

Standard & Poor's analyst Scott Sprinzen wrote in a recent report that MLB USA and another of Merrill's bank subsidiaries, Merrill Lynch Bank & Trust Co. FSB, suffered during the past year because the latter served as "a platform for Merrill to expand its presence in U.S. subprime mortgage origination," while MLB USA has "acted as a liquidity provider to various Merrill established asset-backed commercial paper conduits." S&P rates both Merrill subs AA-/A-1+ with an outlook negative.

"In the case of [Merrill], mostly these are provided to its own retail customers and tends to be higher quality," Sprinzen adds.

That said, the problem for banks in general is that what began last summer as a subprime crisis -- involving debt extended to borrowers with shaky credit -- has morphed into what many people now consider a full-blown recession, in which even higher credit quality assets have fallen in value and the risk of mortgage and other loan defaults are mounting.

A Merrill spokeswoman declined to comment.

"It's going to be a source of earnings pressure; no question they will face some increase in loss experience," Sprinzen adds. "We really view Merrill Lynch's banks as intricately connected with the rest of [Merrill Lynch]." He adds that Merrill Lynch might raise additional capital or buy problem assets from its banks, if a problem arises and asset quality begins to deteriorate.
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