Investors Aren't Buying Merrill's Subprime Optimism - TheStreet

Merrill Lynch's

( MER) claim that the subprime mess is "limited and contained and appropriately marked" failed to lift its shares Tuesday.

Merrill reported strong results despite investor fears that it is one of many financial institutions caught in subprime's clutches. Shares in the firm have lost 6% this year even as the New York-based brokerage continues to post big earnings gains.

The latest evidence of Merrill's profit prowess came Tuesday, when the firm posted a 31% surge in second-quarter earnings and set a record for revenue in the June quarter.

But what remains front and center in the brokerage industry is the meltdown of some subprime mortgages, and various banks' exposure to related losses. As a result, Merrill's earnings call Tuesday was dominated by talk of the firm's role as one of the major lenders to a pair of troubled hedge funds affiliated with

Bear Stearns

( BSC) -- High-Grade Structured Credit Strategies Enhanced Leverage Fund and High-Grade Structured Credit Strategies Fund.

Wall Street was waiting Tuesday for an update on the net asset values of those funds. Bear said last month it would lend $1.6 billion to the less leveraged fund in a bid to bail it out. Investors hold out little hope that any value will be retained in the so-called enhanced leveraged fund.

Merrill said on a conference call Tuesday that it believes the fallout will be contained. But the comments failed to boost the company's stock.

"At this point we remain in an active dialogue with Bear Stearns' asset management," said Merrill's CFO, Jeff Edwards, during a midyear earnings call for the No. 3 brokerage firm. He declined to disclose the full extent of Merrill's exposure to subprime but added, "We think our net exposure in the situation is limited and well under control."

The Bear funds melted down based on investments in securities tied to loans made to borrowers with questionable credit. Declines in those securities led a number of major lenders including Merrill to ask the funds to post additional collateral as the fund's investments declined in value.

Despite the subprime calamity that ensued, Merrill has been able to shrug off its involvement with Bear. It made $2.14 billion, or $2.24 a share, for the quarter ended June 29, up from the year-ago $1.63 billion, or $1.63 a share. Revenue rose to $9.72 billion from $8.17 billion a year earlier. Analysts' expectations, according to surveys by Thomson Financial, were for a profit of $2.02 a share on revenue of $9.25 billion.

"We delivered another strong quarter in a volatile and, at times, hostile market environment," said CEO Stan O'Neal. "These results reflect our revenue diversification, which makes possible strong performance despite uneven market conditions. Our focus on business and revenue growth, expense discipline, and global expansion continues to enhance the earnings power of our franchise."

Edwards during the call also played down a weakening in the credit environment. Abundant and low-priced credit has driven leveraged buyout activity over the past few years, which in turn has bolstered stock prices.

There are more than $200 billion in buyout deals that need to be completed by major investment banks, including the LBO of

First Data

(FDC) - Get Report

. Wall Street and bankers are fretting that institutions like Merrill and

J.P. Morgan

(JPM) - Get Report

might not be able to sell loans structured to help fund these buyouts into a market that has become skittish because of troubles in subprime.

"The market over the course of the last month has seen some selectivity on the part of investors in regard to structure and pricing," Edwards said, commenting on the leveraged loan market that has seen investors who buy debt tied to big LBOs push back on terms and pricing.

Still, Edwards was sanguine about the overall market outlook and Merrill's. "I would describe it as a correction in the market," he commented, adding, "What we are not seeing is a deterioration in the fundamental credits."

Merrill's performance this quarter can be pegged largely to its growth in trading, particularly in commodities and its international expansion. Strength in those businesses has emerged as a major theme over the past few quarters. Revenues generated from abroad have quadrupled, Edwards noted.

Still, analysts on the call questioned how much of an impact subprime has had on the firm. They also wondered about its decision to invest in Bear's investment vehicles, which did not have much of a history since they'd only been around for a few months prior to Merrill's reportedly putting up $800 million in the funds.

"When we undertake to make such loans we do so in ways that we believe are prudent," Edwards commented, responding to an analyst question about the firm's investment.

Edwards also trumpeted Merrill's risk management and its proactive stance in trying to sell off collateral tied to the Bear funds as evidence that the firm has been effective at limiting the damage.

All the positive spin didn't help Merrill's shares, which were down about 50 cents at $86.91.