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), 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.

According to observers, Merrill requested a recent rating on its bank subsidiary -- a move that usually is a prelude to a debt offering or capital raising initiative.

Already at major shops such as JPMorgan Chase ( JPM) and Wells Fargo ( WF), loan quality in unexpected areas has begun to show cracks.

For example, JPMorgan, during an investor conference held Feb. 27, said it expects to see home-equity-related losses of about $450 million in the first quarter -- nearly double its forecast from the end of last year.

Executives at JPMorgan also were hard-pressed to predict how bad the situation might get in home equity, as the recessionary environment and tighter lending standards among the major financial institutions create a dismal outlook for consumers and homeowners, who piled on leverage during the boom.

And it's not just home equity that is giving market participants jitters. Worries about Alt-A mortgages and other presumably higher credit quality loans are growing as consumer sentiment wanes. Expectations also are that unemployment could ratchet up as the teeth of the recession sets in.

For financial institutions such as Merrill Lynch, which still have sizable debt remaining on their balance sheets that affects ability to lend, any more strain, even incrementally, can cause major pain.

"They've got a big mortgage portfolio; like anyone, they've got problems in terms of the performance of that portfolio," Brad Hintz, an analyst at Sanford Bernstein, tells TheStreet.com.

On Thursday, Oppenheimer & Co. financial analyst Meredith Whitney joined Hintz in lowering earnings targets for Merrill. They were among a chorus of pundits who have leveled increasingly negative outlooks on the hobbled firm now run by CEO John Thain.

Hintz estimates that through the end of the fourth quarter, Merrill Lynch had approximately $104 billion in mortgage-related paper on its books, including those assets from its banking arm. That number represents approximately 10% of the company's firmwide balance sheet, according to data compiled by Hintz.

According to a Bank of America report written by analyst Jeffrey Rosenberg in mid-March, Merrill's mortgage portfolio is about 12% of its overall balance sheet. Rosenberg's report puts Goldman Sachs' ( GS) mortgage assets as a percentage of total assets at about 13%; Lehman Brothers ( LEH) at 29%; and Bear Stearns, which is being acquired in a Federal Reserve-led buyout by JPMorgan, at about 33% of total assets.

In his Thursday report, Hintz notes that Merrill still has about $30.4 billion in CDOs on its balance sheet at the end of 2007, where values have continued to slip in March.

"We believe the biggest swing factor for Merrill's first-quarter 2008 results will be the severity of the writedowns," Hintz wrote. "It will take at least several years for Merrill to fully divest itself of these troubled assets."

So far, Merrill has been smacked with some $24.4 billion in writedowns in 2007, according to Bloomberg. UBS' Glenn Schorr says the firm may write down an additional $2.1 billion of subprime debt, leading to a loss in the first quarter, according to a report issued by the analyst on Tuesday. Hintz estimates a writedown of about $4.5 billion. Schorr has cut Merrill from modest first-quarter earnings of 59 cents a share to a loss of $2 a share.

JPMorgan cut its first-quarter forecast to a loss of 68 cents a share from a profit of $1.05 a share and its full-year outlook for Merrill to $2.75 a share from $5.

"We believe Merrill Lynch will go through the disruptive step of true structural reorganization or right-sizing that will dominate the bulk of 2008," she wrote. Whitney rates Merrill an underperform.

To be clear, for Merrill and Merrill Lynch Bank USA, the issue isn't about a failure of the bank, but the pressure it may place on its parent for a protracted period of time. That's especially so, because unlike investment banks, the MLB USA can hold loans to maturity without writing them down immediately, notes Hintz.

"With the bank, it's not going to be a funding run with the piano falling on your head all at once; it's going to be little pieces falling on your over time," Hintz notes.

Merrill is not the only brokerage firm with a banking subsidiary. Charles Schwab ( SCHW) and E*Trade Financial ( ETFC) also have banks. But Schwab has a tendency not to lend from its subsidiary, while E*Trade has smarted from problems in its bank arm due to writedowns from subprime loans.

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