Merrill, Citi Results Could Damp Bank Rally

After JPMorgan gave financial stocks a boost, the two subprime-battered firms set to report what are expected to be gloomier results.
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JPMorgan Chase

(JPM) - Get Report

on Wednesday boosted bank stocks with stronger-than-expected first-quarter results, but earnings for two of the hardest-hit firms in the credit crunch could soon put a damper on the party.

JPMorgan

and

Wells Fargo

(WFC) - Get Report

, which also

reported positive results

Wednesday, are prime examples of banks that have been able to navigate the credit crisis and housing meltdown better than others, but that won't be the case for

Merrill Lynch

(MER)

, which reports earnings Thursday, and

Citigroup

(C) - Get Report

, which reports Friday. Analysts, on average, are expecting Merrill Lynch to report a loss of $1.99 a share, while Citi could post a loss of 95 cents a share.

Fixed income and capital markets activities are likely to continue to be a main source of pain for both companies, as the mortgage-related and leveraged loan markets both took additional hits in the first quarter.

The

Wall Street Journal

reported on Wednesday that Merrill is set to report a fresh $6 billion to $8 billion in writedowns, bringing its total to more than $30 billion. The article, citing people familiar with the firm, also said Merrill is preparing a cost-savings plan that would eliminate 10% to 15% of the workforce in its most troubled businesses.

Citi will also have additional troubles from its retail exposure -- particularly loan losses on mortgages and credit cards, among other things. Analysts and shareholders will also be looking for any cut in dividend, as the bank seeks to shore up more capital to use against future losses.

Citi, Merrill Lynch and mortgage lender

Countrywide Financial

(CFC)

have been the most high-profile victims of the credit crisis that began last summer. Merrill and Citi ousted CEOs after initial writedowns, while Countrywide agreed in January to sell itself to

Bank of America

(BAC) - Get Report

.

Merrill posted nearly a $10 billion loss in the fourth quarter after taking approximately $14.6 billion in writedowns on soured mortgage debt and other risky loans. Citi also posted roughly a $10 billion loss after taking $18 billion in writedowns for the final quarter of the year. Both firms had also taken double-digit writedowns in the third quarter as well.

JPMorgan managed to beat first-quarter expectations, fueled by its sale of

Visa

(V) - Get Report

shares, but profit was cut in half as the banking titan showed that it is not immune to the credit crunch. The New York-banking titan recorded net income of $2.37 billion, or 68 cents a share, in the first three months of the year, beating the average analyst estimate by 4 cents.

Chairman and CEO Jamie Dimon, however, noted market conditions and the credit environment "remained challenging." In the first quarter, the bank took $2.6 billion worth of writedowns related leveraged loans as well as prime, Alt-A and subprime mortgages. It also added a $2.5 billion provision to protect itself against further loan losses -- approximately $1.1 billion of which was specifically related to its struggling home-equity portfolio, the company said.

"Our expectation is for the economic environment to continue to be weak and for the capital markets to remain under stress," Dimon said in a company statement. "These factors have affected, and are likely to continue to negatively impact, our firm's credit losses, overall business volumes and earnings -- possibly through the remainder of the year, or longer."

Wells Fargo also recorded profit of $2 billion, or 60 cents a share, beating estimates by 3 cents, despite a slip in net income from a year earlier and an increasing level of charge off loans due to poor residential real estate conditions.

Both companies, like nearly every other bank to report first-quarter results thus far, substantially profited off of the sale of a portion of their stakes in Visa, which

went public last month

, contributing to their bottom lines last quarter.

Citi also likely will reap a benefit from Visa. But since Merrill is not a commercial bank, it won't enjoy the same benefit. On the other hand, both firms were a part of the more than 40 bookrunners of the massive IPO and will benefit from underwriting fees gained as part of the deal.

But the gains made from the Visa IPO are unlikely to offset either banks' writedowns from mortgage-backed securities and leveraged loans.

Sandler O'Neill & Partners analyst Jeff Harte cut his quarterly earnings estimate on Merrill in a note last week by 40% to 95 cents a share, driven by higher mark-to-market losses, reduced investment banking activities and the need to maintain compensation levels despite soft revenue, he said.

Harte estimated the brokerage firm would take writedowns on its asset-backed collateralized debt obligations, mortgages, leveraged loans and structured notes totaling $4.3 billion -- about a 5% haircut -- for the quarter.

Oppenheimer analyst Meredith Whitney -- who has proven astute in past forecasts on Citi -- said in late March that the bank will see first-quarter writedowns of approximately $6 billion. She estimates Merrill to post a loss of $3 a share for the quarter, the lowest estimate given to the company, according to Thomson Financial.

Whitney is the venerable analyst who made a name for herself last fall when she predicted -- rightly so, and several months early -- that Citi would need to cut its dividend and sell assets, among other things, to preserve itself. Citi ended up in January obtaining $14.5 billion in capital from domestic and foreign investors and cut its dividend by 41% to 32 cents.

After raising $12.8 billion of capital since late last year, Merrill should have adequate capital going forward, according to statements made by CEO John Thain.

But Whitney says that of the $12.8 billion raised, "roughly $9 billion will be reflected" in the first quarter. The analyst worries that the firm might have to raise more capital, she writes in a March 26 note.

"Inclusive of an estimated

first quarter '08 net loss and dividend payout, we estimate that Merrill Lynch will erode at least 33% of the $9 billion capital," leaving the firm's tangible equity at roughly the same level as in the third quarter of 2007, she writes.

Susan Roth Katzke, an analyst at Credit Suisse, estimates Citi's writedowns in the range of $8 billion to $10 billion, but that a "worst case" scenario for Citi could be writedowns of around $14.5 billion, she writes in a March 28 note in which she cut her earnings estimates to a loss of 40 cents a share.

"The estimate reduction relates to marks against Citi's high-risk exposures and an increase in loss rates and reserve build in the U.S. card and home equity portfolios," she writes. "Our thesis on Citi ... this is no easy fix, even for the best of managers."

Oppenheimer's Whitney says Citi may have to cut its dividend once again.

"

We estimate that Citi will actually earn $1.43 per share shy of its dividend payment this year. In other words, Citi will pay out $1.43 per share more than it earns this year," she wrote in a separate industry note at the end of March. "How anyone, let alone Citi's management and the board, can believe that its dividend is safe given this earnings scenario is beyond our comprehension. As we understand, Citi is aggressively pursuing selling non-core assets, but we hope the capital generated from these sales goes toward its own badly needed recapitalization efforts rather than to pay dividends."