Why Merrill Lynch Got Burned

The bank's leadership role in underwriting risky CDOs brought in millions in fees but put it in the subprime bull's-eye

by Matthew Goldstein

The blast of criticism directed at Citigroup (C) Chief Executive Officer Charles O. Prince III, whose stewardship of the nation's biggest bank has drawn barbs, has been withering in recent weeks. Yet Prince may have caught a huge break, courtesy of Merrill Lynch CEO E. Stanley O'Neal. On Oct. 24, O'Neal's firm officially became Wall Street's biggest loser in the subprime game.

Merrill's stunning $7.9 billion third-quarter writedown—the result of a sharp drop in the value of securities backed by risky home loans—is the most painful hit taken by a Wall Street bank during the subprime housing blowout. Even worse, the size of the writedown is nearly $3 billion more than Merrill had forecast on Oct. 5. The charge is an embarrassment for O'Neal and Merrill (MER), which reported its first quarterly loss in six years on Oct. 24, and stems from Merrill's big push into collateralized debt obligations—securities backed by subprime mortgages that are sold to investors based on their risk appetite.

Merrill took a leadership role in underwriting CDOs in 2006 and 2007, when subprime mortgage lenders all but threw lending standards out the window. Over that period, Merrill was lead underwriter on 136 CDO deals with a dollar value of $93 billion, according to Thomson Financial (TOC). Merrill executives may not have realized then just how reckless things had gotten in the subprime mortgage world. They do now. "We made a mistake," O'Neal said in a conference call with analysts. "Some errors of judgment were made in the business itself and within the risk management function."

Left Holding the Pieces

Merrill sure prospered while the revelry lasted, raking in $800 million in CDO underwriting fees (more than any other firm) since the beginning of 2006, according to Thomson Financial/Freeman. Citi, which took a $1.56 billion third-quarter writedown on its CDO and subprime mortgage business on Oct. 15, earned $749 million in CDO underwriting fees.

Now that the boom has gone bust, Merrill is left holding billions of dollars in less attractive pieces of CDOs that haven't been sold to investors. These pieces—often referred to as super senior tranches—carry higher credit ratings because they are considered to be the last in line to default. But these securities are rarely traded, low-yielding, and difficult to value. Merrill was sitting on a lot of CDO tranches by virtue of its prime underwriting role, up to $32 billion in exposure as of June 29, the company says. Now, Merrill has written down the value of those hard-to-trade securities by $5.8 billion and says it has cut its overall holdings by half.

Is a future write-off looming? It's a worry, especially if ratings agencies downgrade Merrill's remaining CDO securities. However, Janet Tavakoli, a structured finance consultant and frequent critic of the Wall Street investment houses, says Merrill's huge charge means the firm is finally "biting the bullet." Another person familiar with Merrill says the firm's board told O'Neal and his team to avoid a fourth-quarter charge at all costs.

If Merrill got it right, O'Neal may ride out the storm. Shares of Merrill plunged 5.8% on the day it announced earnings. But the bigger question for Wall Street is whether the big writedown at Merrill is a sign of things to come for other investment banks that took a lead in underwriting CDOs and may be sitting on similar shaky securities.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.