October 25, 2007 | posted by Michael Baxter in IABN |

Only one word can do justice to the latest set of results revealed by US banking giant Merrill Lynch yesterday: disastrous.

The bank made a net loss of $2.3 billion in its third quarter - that was the biggest loss ever announced by the bank. So that was pretty disastrous.

The bank also announced write-down of $7.9 billion, after it wrongly called the market for Collateralized Debt Obligations (CDOs). As you no doubt know, CDOs are the financial instruments behind the credit crisis. These CDOs are little more than a brew of simmering debt. Banks slice up the loans they make, and these slices are then stirred in with slices of other debt, then sold in chunks on the open market. Merrill was a great advocate of CDOs, pushing these financial instruments hard.

For a while, it seemed the strategy of aggressively moving into CDOs was working, and the US bank enjoyed $800 million in CDO underwriting fees - more than any other bank, or so says data from Thomson Financial/Freeman. But then, with the credit crisis, this policy backfired, and the brew of CDOs turned out to be poison, with the bank forced to make this massive write-down.

So while the loss was bad, the write-down seems even more troubling.

But, be warned, there’s worse to follow. When the writing appeared there on the wall in massive letters, Merrill was looking the other way. According to Reuters, as recently as last December the bank was busy forking out $1.3 billion for subprime lender First Franklin Financial Corp.

This tale of woe should have the hairs standing on the back of your neck by now, but here is the real blow, we haven’t even told the worst bit yet.

The truly awful news is this. Just three weeks ago the bank was projecting a write-down of $4.5 billion. In just 20 days, the company found another $3.4 billion in losses. How could it have got the sums so wrong?

Well, there has been a change in personnel. The man in charge of fixed income has changed. And with the new regime, came a new more conservative way of valuing assets - hence the further write-down. But, let us remind you, this happened in just three weeks - imagine what must have been going on behind closed doors at the bank over the last few weeks.

But, and this is the truly worrying bit, what emerged from the Merrill Lynch press conference held yesterday is how subjective the valuation of these assets is. The bank isn’t saying the previous projections are wrong - as such, rather that they have now adopted a more conservative valuation methodology.

When a bank changes its mind on the size of its write-downs to the tune of $3.4 billion, it makes you wonder how accurate the figures are. Is this loss really the product of finger-in-the-air valuation?

And what about the methodology employed by other banks to value their write-downs? Is it more or less conservative?

The truly worrying implication of this Merrill Lynch change in methodology seen in the last three weeks, and that was so publicly aired - is that it leaves you wondering how much you can trust results stated by other banks. And when analysts lose that faith in reporting, uncertainty can take on a life of its own.

That’s why the results from Merrill Lynch are not just disastrous for the bank and its shareholders - maybe they are disastrous for the entire banking sector too - don’t be surprised if this story returns to haunt the markets over the next few weeks.

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