Merrill Lynch's Counterparty Risk

Merrill Lynch posted a quarterly loss of $1.96 billion, due to $6.6 billion in write-downs related to mortgages, CDOs, and junk loans. There were also an additional $3.1 billion in mortgage-related securities that were held at its U.S. banks. Astonishingly, the losses over the past three quarters have been $14 billion, more than the bank earned in 2005 and 2006. Merrill will also let go of 4,000 employees in the capital market and trading groups, passing over the large network of financial advisers and staff. This news, while not good for Merrill employees, should temper the market's response to its recent losses.

Given the losses and on-going struggles, Moody's is warning that it could downgrade the bank's credit rating, in part because they may be forced to take another $6 billion in future write-downs. Looking at the last nine months, CDO write-downs alone have totaled over $18 billion, with $1.5 billion coming in the last quarter. While it looks like the level of CDO write-downs is decreasing, exposure isn't. In the last quarter, CDO exposure rose from $5.1 billion at the end of last year, to $6.7 billion at the end of this quarter. This of course, begs the question: "What previous risk is left on the books, and is the new risk exposure being properly managed?" As we have seen too often, it is not always the size of exposure (see Goldman), but the type and level of counter-party risk you are taking, and more importantly, the risk measures you have in place to manage such risk. Until we get more clarity, further write-downs and ratings downgrades should not really come as a surprise, and the market will certainly continue to price in this uncertainty.

Tickers: MER