S&P Downgrades Merrill Lynch after "Startling" Loss

The ratings agency cites concerns about the Wall Street giant's risk management practices and business strategy

From Standard & Poor's RatingsDirect

On Oct. 24, 2007, Standard & Poor's Ratings Services lowered its ratings on Merrill Lynch & Co. Inc. (MER) to A+/A-1 from AA-/A-1+, as well as the ratings on Merrill Lynch's related entities. The outlook is negative.

The downgrade follows the company's startling announcement that it incurred a massive $2.3 billion net loss from continuing operations for the quarter ended Sept. 29, 2007 (equivalent to a loss per share of $2.85), which compares to management's prior expectation of a loss per share of up to 50 cents, as disclosed on Oct. 5, 2007 (whereupon we revised the outlook to negative from stable). The significantly greater-than-anticipated loss primarily reflects a reconsideration of the marks used as the basis for the valuation of the company's outsized positions in CDOs and subprime mortgages. The actual write-down recorded related to these positions was a staggering $7.9 billion, which compares to the $4.5 billion that management previously indicated.

Merrill Lynch's total pretax loss of $3.5 billion in the third quarter would have been approximately $600 million higher, were it not for the accounting effect of a widening of the company's credit spreads on the valuation of certain of its own long-term debt liabilities. The absolute size of the loss related to CDOs and subprime mortgages, and management's miscues regarding the valuation of its positions, further heighten our concerns regarding the company's risk management practices and business strategy. We expect management to initiate a major retrenchment in the mortgage and CDO sectors.

We continue to view Merrill Lynch's overall business franchise as solid, given its leading positions in investment banking, securities trading, and wealth management. Partly mitigating the losses incurred in the third quarter were the substantial contributions of the firm's other businesses. Although we believe certain sectors of the capital markets will likely remain depressed for an extended period, and the potential for further market turmoil during the near term cannot be ruled out, we consider it likely that Merrill Lynch's financial performance will recover significantly in the current quarter, compared with the very weak third-quarter result. In addition, Merrill Lynch has maintained a large liquidity position, and the company has not experienced any funding difficulties amid recent extraordinary capital market volatility.

Outlook

During the next few quarters, we will assess changes that emerge in Merrill Lynch's business strategy, as well as the effectiveness of measures taken to address risk-management shortcomings. There is some potential for the ratings to be lowered based on the outcome of this review. The ratings could also be lowered if, contrary to our current expectations, Merrill Lynch encounters further setbacks that hamper a rebound in profitability, and/or that impinged on liquidity and funding.