Hoping Rock Bottom is Near: Merrill Lynch Reports Largest Quarterly Loss in its 93-year History

On October 24th, Merrill Lynch & Co. reported the largest loss in its 93-year history due to the unprecedented write-down of $8.4 billion worth of assets. The write-down is due largely in part to the credit crisis that burst the housing bubble this past summer. This enormous figure, coupled with poor managerial foresight as to the stability of the credit markets, led to the staggering reevaluation of the firm’s assets. The news is just another astonishing blow to an industry that has been beaten relentlessly throughout the third quarter of this year. In just over two months time, it has seen thousands of layoffs (CIT, Bank of America, and UBS), multiple firings of major CEOs (UBS and Bear Stearns & Cos), the write-down of billions of dollars worth of assets (UBS and Merrill Lynch), and the exposure of hundreds of thousands of sub-prime mortgages that will likely default and further exacerbate the tragic state of the market.

There are two critical problems with Merrill Lynch’s recent announcement to reassess and lower the value of its collateralized debt on its balance sheet by writing off the difference as a loss for the quarter. First of all, the fact that the company lost $8.4 billion worth of investors’ money raises questions about its investment policies and its ability to assess risk. Merrill’s credit took a hit by reputable rating agencies due to the irresponsible and negligent amount of its balance sheet that was tied up in risky fixed income securities. Agencies such as Standard & Poor’s, Fitch Ratings and Moody’s Investors Service all lowered their assessments of Merrill’s credit. According to Bloomberg, Standard & Poor’s lowered its rating on Merrill’s senior unsecured debt from AA- to A+, describing the quarter’s performance as “startling” and referencing “management miscues” as the reason behind the losses.

The second problem regards a press release by Merrill Lynch on October 5th of this year that declared that its asset write-downs for the quarter would total $5 billion, a jarring number in its own right, but barely half of the figure released later this month. This gives an insight into seriously questionable management and severe analysis and communication issues. Merrill’s Chief Executive Office, Stanley O’Neal, defended the write-down as a “conservative” analysis of Merrill’s holdings after “misjudging the severity of the decline in debt markets since July.” The excuse has not bolstered investor confidence, as Merrill’s stocks have decreased significantly since the announcement, falling 5.8% on the day to $63.22. Rose Grant, who manages about $2 billion including shares in Merrill, describes its performance as “disappointing.” She adds that she does not “think Stan O’Neal will step down, but you do have to look at top management and wonder why they didn’t know the extent of this loss.” It is certainly no surprise, however, that, given the decline in share value due to the massive discrepancy between estimates less than a month ago and the most recent figures, Merrill Lynch did, in fact, ask Mr. O'Neal to step down.

The terrain is definitely unstable for the large American financial institutions that specialize in underwriting asset-backed securities (selling these mortgages to both public and private investors). On top of Merrill’s stock’s decline, major competitors like Lehman Brothers Holdings (down 1.5%) and Bear Stearns & Cos (down 2.3%) have all seen their stocks decline as the bad news keeps rising. Merrill’s, which has been called “the largest write-down by a U.S. securities firm,” according to Charles Geisst, author of 100 Years of Wall Street, exceeds Citigroup Inc.’s $6.5 billion revaluation this period and pushes the industry-total for the period up North of $30 billion.

As estimates continue to be defied it might be appropriate to ponder the near future of the market. Opinions vary from quasi-optimistic to severely pessimistic. International investor-celebrity Warren Buffet hypothesized that “problems in the U.S. subprime mortgage market will likely be a drag on the U.S. consumer’s buying power for up to two years, but that the U.S. economy will weather the storm.” Nigel Gault, chief domestic economist at Global Insight, said that he expects “consumers [will] reduce their spending by about 6 cents for every dollar of lost wealth.” In other words, if prices drop 5% next year, there would be a $60 billion decline in spending. This would be a significant slowdown but, according to Gault, “not enough to cause a recession.” On the other hand, highly regarded investor and co-founder of the Quantum Fund, Jim Rogers reported to Britain’s Daily Telegraph that the United States has “undoubtedly entered a recession,” citing that “Many parts of [the American] industry are actually in a state worse than recession. If it were not for [Federal Reserve Chairman Ben] Bernanke putting huge amounts of money into the market, the stock market would probably be down much more than it is.”

Regardless of these highly regarded investors’ opinions, it seems safe to say that once again the American economy is in a terrible downward spiral and the proverbial “rock bottom” is nowhere in sight. Millions of Americans will be forced to vacate their homes due to their unaffordable mortgages over the next year and the U.S. housing market will continue to decline. Therefore, it is imperative, someone must take action now. Whether it be President Bush locking in interest rates for adjustable rate mortgage (“ARMs”) borrowers or Ben Bernanke stimulating the economy with a more progressive monetary policy, something needs to happen. This is a cry for action, and the action needs to be now.

The Exodus: Investors Abandon U.S. Stocks and Dollars for Safer Government Securities

It appears the recession has begun. Whether it be the Euro-Dollar conversion ratio or the high probability that the Federal Reserve Bank will lower interest rates for the second month in the row, all signs point to the conclusion that the Untied States’ benign economy of the past several years is long gone. And it gets worse. As American and international investors’ views of the U.S. economy worsen, the credit crunch will continue to tighten the liquid markets of the economy. Most notably, investors are increasingly opting for the “safe-bet” investment–U.S. Treasuries–and pulling their cash out of illiquid and more risky securities. As reported by Bloomberg, Thomas Roth, head of U.S. government bond trading at Dresdner Kleinwort said, “The fear is back… Where there’s smoke there’s fire, and people are just running back into Treasuries.” But can investors really be blamed for lacking confidence in the economy when its chief financial advisor–Mr. Ben Bernanke-describes his job of assessing the U.S. economy as “a formidable challenge”? Surely one’s confidence might fritter.

As bad news keeps rolling in, including the increased speculation that the Fed will lower interest rates again, only one word can describe the condition of the U.S. securities market: chaotic. The stock market took a big hit last week with the untimely increase in the price of crude oil to just over $90 per barrel for the first time ever. The news sent investors scurrying to liquidate their commercial paper and stock certificates in exchange for lower-yield Treasury securities. Meanwhile, U.S. Treasury bonds gained for a fifth day in a row and two-year notes headed for their biggest weekly increase in more than five years. The emigration of people into the government-issued securities market has caused yields to decrease while prices soar. According to Carl Lantz, an interest rate strategist at Credit Suisse Group, the yields have decreased due to the “flight [of investors] to quality [securities], people gravitate to the front end as they seek the most liquid securities" (yield curve on left). Speculation casts light on what may lie ahead in the near future, as futures traded on the Chicago Board of Trade suggests with 92% certainty that the Federal Reserve will reduce "the target rate for overnight lending between banks by a quarter of a percent to 4.5% on October 31st," cites Bloomberg.

The negative trend and the resulting fear of the U.S. economy are as prevalent in the global markets as they are at home. Ironically, the International Monetary Fund (IMF) and The World Bank just completed their annual meeting with a concluding emphasis on the uncertainty of the U.S. markets. In a public statement made Monday, October 22nd, Rodrigo Rato-head of the IMF-spoke to the risks of an "abrupt fall" in the U.S. dollar linked to "a loss of confidence in dollar assets," reports Breitbart. "The uncertainty comes from the downside risks that are much larger than they appeared six months ago," said Rato. And indeed he is correct; the recent fall of the U.S. dollar amidst foreign currencies serves as clear proof that the market has changed. The most glaring example of such change comes in the sharp contrast between the success of the Euro in the face of the U.S. dollar's demise. While the dollar is suffering in foreign exchange rates across the board, the Euro rose to an all time high (worth $.14738) as of November 3rd. Yahoo Finance reported "the dollar has been under pressure over concerns about the health of the U.S. economy, which have encouraged speculation that the Federal Reserve will soon cut interest rates again." This coming at the same time that Mr. Rato is declaring the Euro might want to "temper its strong appreciation." Curiously, while the Fed may feel pressure to lower interest rates in order to spark the U.S. economy, the decision will also continue to deflate the value of the dollar relative to foreign currencies.

A month ago, when the Fed cut interest rates for the first time in response to the housing crisis, it was speculated that the U.S. economy would be entering a recession, if it had not already. According to Mr. Bernanke, the economy is sending “mixed” signals, as there is “continued weakness in the home sales and construction alongside a solid labor market...". Now, a month later, the situation is still deteriorating: the Fed is on the verge of cutting interest rates by another quarter percentage point, the U.S. dollar and economy are simultaneously going down the drain, and our elected leader is having a tough time "analyzing" the American economy. God help us.