Merrill Lynch: As Bad as It Gets?

Shares of the beleaguered Wall Street giant rallied despite a weak profit report. Investors seem to be hoping the firm has finally hit bottom

by Ben Steverman

The news from Merrill Lynch (MER) was bleak Apr. 17, but the reaction from the stock market was a collective shrug.

Merrill posted a loss of $2.20 per share in the first quarter, above the $1.99 loss analysts were expecting, but by noon ET the brokerage house's stock was trading 1.5% higher.

Almost nine months after the start of the credit crisis that has decimated the finances of Wall Street firms, Merrill investors seem to have built up an immunity to bad news.

It's not as if there wasn't plenty to worry about. Merrill's revenues, of $2.934 billion in the first quarter, were off 70% from a year ago. Writedowns from bad debt, most linked to residential mortgages, totaled more than $6.5 billion. The firm is cutting 4,000 jobs this year.

John Thain, Merrill's chief executive since December, called it "probably as difficult a quarter as I've seen in my 30 years on Wall Street."

Goldman Sachs (GS) analyst William Tanona wrote of Merrill's results, "Any investor who was hoping for a silver lining will likely be disappointed."

Staying Optimistic

Still, Thain touted a few achievements. Revenue at Merrill's global wealth management division rose 6% from a year ago. Though Merrill's investment banking business suffered in the first quarter, its pipeline of deals in the works was down just 5%. "Although the deals were delayed, they're still there and so we would hope to realize those over the course of the rest of the year," Thain told analysts.

Also, Merrill said it has $82 billion in cash, up from $79 billion the previous quarter. Thain said the firm has enough capital for now. International businesses did well, with Latin American revenues up 67% and Japan up 87%.

Finally, Thain implied that he expects Merrill to actually post profits later this year. "We're…optimistic for our results for the full-year 2008," he said.

Clearly, Thain is betting that investment banking revives and that cost-cutting starts to bear fruit. Most important, Thain seems to be counting on improved conditions in credit markets and an end to the multibillion-dollar writedowns.

There's no guarantee of this, however.

The problem is that banks have incurred huge losses on mortgage debt even though mortgage defaults still don't match levels reached in previous real estate downturns, says Octavio Marenzi of financial consulting firm Celent. "There is more pain to come and pressures on earnings are going to continue," he says.

More Pain Possible

If home prices continue to plunge, and especially if the job market deteriorates, Merrill can expect more pain from mortgage losses, "as this recession starts to bite and people can't make their payments anymore," Marenzi says.

Thain acknowledged this worry. "The real risk going forward here is how much do all of the problems, [with] the financials and credit markets, seep into the real economy," Thain said.

A long, deep recession would ravage Merrill's troublesome mortgage debt, and it would also likely hurt revenues elsewhere in the firm, from investment banking to asset management.

Has Merrill seen the worst of the current mess? For now, investors may be cautiously optimistic, but the current credit crisis has had a nasty habit of offering up unpleasant surprises from Wall Street firms.

Steverman is a reporter for BusinessWeek's Investing channel.