Merrill Lynch's


massive write-off leaves a black cloud hovering over Wall Street.

Merrill stunned the market Wednesday morning by taking a $7.9 billion write-off of its holdings of subprime-related debt. The move was doubly eyebrow-raising because it came just three weeks after Merrill said the charge would be more like $4.5 billion.

The switch had analysts on Merrill's third-quarter earnings conference call Wednesday morning asking over and over how the firm got to the larger number from the smaller one. The firm disclosed that $6.9 billion of the writedown came from marking down the value of senior portions of collateralized debt obligations, and $1 billion came from subprime revaluations.

But beyond that, there was little useful information from the firm. CEO Stan O'Neal and CFO Jeff Edwards said repeatedly that the increased losses were attributable to the firm's shift to more conservative valuation assumptions. But they didn't specify what the assumptions were, frustrating some listeners -- and giving investors little help in sizing up possible losses at Merrill's Wall Street rivals.

"The level of disclosure is not sufficient to understand how the ABS CDOs have been written down," said Mike Mayo, banking analyst at Deutsche Bank, referring to collateralized debt obligations that hold asset-backed securities. "This is the key question in the marketplace. What is the next shoe to drop?"

If Edwards knows, he didn't say.

"Let me just observe that we took substantial markdowns here," he replied. "We think that reflects conservative assumptions, again. And that we incorporated the trajectory of the environment as we took this into account."

Merrill's bad news had investors assuming that more writedowns may well be on the way from the firm's peers, particularly big debt market players such as

Lehman Brothers



Bear Stearns



The problem is that without knowing how Merrill arrived at its numbers, there's no way of assessing the prospects of a writedown at another firm -- particularly given the scant information the others have provided about their subprime and CDO holdings.

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Nonetheless, at least one analyst feels sure Merrill's news means more writedowns.

"What we're talking about is loans," says Richard Bove, analyst at Punk Ziegel & Co. "They are loans to people on houses, cars, home equity, and credit quality in the U.S. is clearly eroding, as evidenced by bank earnings last week."

Mayo and others wanted to know whether Merrill valued its asset-backed securities exposure on the value of hedges, or on its judgment of where the real underlying debt would trade if the market for it were liquid.

Knowing this would help investors and analysts determine if the other brokerage houses are likely to write down more in the fourth quarter. But Merrill declined to specify on the call, and some observers say it's not an easy picture to sketch out.

"Everyone is trying to determine this same thing, and there are a lot of moving parts," says Joe Capone, managing member and founder of SMaRT Financial Partners, a fund specializing in financial services equities. Capone is also a contributor to's

investment ideas Web site


He notes that Merrill based its valuations on more recent market developments. This is notable because its quarter ended Sept. 30. Bear and Lehman, for instance, both posted much smaller writedowns when they reported earnings last month -- but then, their fiscal third quarters ended in August.

Even adjusting for variances in timing, Capone says arcane accounting differences could bear on each firm's findings. "The method may be different," he says, "and that is really the key."

Indeed, market participants say that pre-earnings speculation that Merrill would have a $10 billion writedown came about in part because Standard & Poor's slashed ratings last week on structured products -- putting a wrench in Merrill's plans to use marks based on derivatives.

Some say the difference in how the marks are arrived at could make a huge difference. A firm could arrive at a mark of 90 cents on the dollar by looking at the derivative, vs. 50 cents on the dollar for the underlying debt.

"The difference between marking a derivative, or the market rate where one might hedge asset backed exposure, and the underlying paper, where there is no bid at all, is very different," says Capone.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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