Alarm Bells Startle Merrill

An ill-timed fire drill interrupts CEO Stan O'Neal's comments on a big loss.
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Risk management isn't the only area where

Merrill Lynch

(MER)

is having its troubles.

The firm held a conference call Wednesday morning to discuss its steeper-than-expected $7.9 billion writedown of mortgage-securities values. The call gave execs a chance to explain how Merrill stumbled into a massive third-quarter loss that sent the firm's shares tumbling 6% Wednesday.

But perhaps tellingly, even running a sane conference call has become a challenge for Merrill -- at least judging by Wednesday's bizarre events.

Investors tuned into the call to gather intelligence on whether future quarters might bring more bad-debt losses at the big securities firm. But what they heard was CEO Stan O'Neal being interrupted by the announcement that building management at Merrill's headquarters in the World Financial Center was conducting a test of its fire system.

The building presumably passed the test -- something that certainly can't be said about Merrill Lynch's risk management. Just three weeks ago, after all, Merrill was pegging its subprime losses at a more manageable though still eye-popping $4.5 billion.

Reporter Mark DeCambre says Merrill's move wasn't shocking

O'Neal admitted on the call that the firm's take on the markets was grossly out of whack with actual values for hard-to-parse securities like collateralized debt obligations.

The fire drill wasn't the only surprise on Wednesday's call. At another point, O'Neal was interrupted by music inadvertently broadcast by a listener who had put the conference call on hold. Not missing a beat, O'Neal said, "We're back after a brief interlude."

In truth, the subprime interlude for Merrill appears far from over. Standard & Poor's sent Merrill's shares sliding with a midcall ratings downgrade. The firm cited Merrill's massive $2.3 billion net loss from continuing operations in the third quarter.

"The significantly greater-than-anticipated loss primarily reflects a reconsideration of the marks used as the basis for the valuation of the company's outsized positions in CDOs and subprime mortgages," S&P's report stated.

Later in the morning, Fitch Ratings followed suit and downgraded Merrill.

"We've had a couple conversations with management that suggests that in addition to the losses, we see some risk management issues that have to be addressed that are above beyond the third quarter," says Leslie Bright, senior bank analyst at Fitch.

Fitch now rates Merrill below other U.S. bulge bracket firms such as

Goldman Sachs

(GS) - Get Report

,

Lehman Brothers

(LEH)

and

Morgan Stanley

(MS) - Get Report

.

Chief Financial Officer Jeff Edwards and O'Neal emphasized that they believe Merrill has taken sufficient markdowns of its loan-related inventory. But the CDO market continues to slide and many are expecting that continued battering could be ahead.musical interlude."