Merrill could face big subprime write down

By @ibtimes on

Profit at Merrill Lynch & Co. Inc. could take a big hit if the U.S. brokerage heavyweight cuts the value on nearly $1 billion in subprime lender assets it bought just eight months ago.

Analysts said they would expect Merrill Lynch to write down at least some of the goodwill-related assets from its $1.3 billion purchase of First Franklin Financial Corp, the No. 5 U.S. subprime originator in the first quarter, according to Inside Mortgage Finance.

The possibility of write-downs related to ill-timed acquisitions of mortgage lenders shows that the Wall Street fallout from the subprime mortgage meltdown, which caused two Bear Stearns & Co hedge funds to collapse and Lehman Brothers to shutter a unit, is far from over.

Since the First Franklin deal closed in late December, the decline in loans to home buyers with poor credit histories has accelerated, forcing dozens of U.S. lenders to slash jobs, close or seek bankruptcy. Investors lost their appetite for risky mortgages packaged into securities, undercutting Wall Street's rationale for buying these lenders in the first place.

I expect some of those assets to be written down to some extent, said Matthew Albrecht, a brokerage and equities analyst at Standard & Poor's. Whether or not they reduce their operations, we'll see case by case.

A hit to Merrill's goodwill related to misplaced subprime bets may not be the only one among Wall Street firms, analysts said. Morgan Stanley, which last year paid $706 million for subprime lender Saxon Mortgage, also could face a write-down, though on a smaller scale, they said.

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Merrill Lynch and Morgan Stanley both declined comment.

Goodwill represents the premium companies pay over the value of a target company's tangible assets such as cash, buildings and equipment. A write-down of goodwill indicates a company overpaid for an acquisition and that it has not performed as expected.

Regardless of any write-down, Morgan and Merrill are being questioned for the timing of their plunge into subprime.

The criticism is that if they had waited six months, it would have been a lot cheaper (to buy these lenders), Bernstein Research analyst Brad Hintz added. The question is how long will it take for the more aggressive parts of mortgage market to come back. It may be 12 to 24 months or more.

The fate of Wall Street's mortgage lending was thrown into doubt this week after Lehman Brothers Holdings, the pioneer whose strategy of buying up mortgage originators was emulated by Morgan Stanley and Merrill Lynch, said it will close a subprime lending unit, BNC Mortgage. The decision triggered $42 million in charges, including a goodwill write-down of $27 million.

Hintz said Lehman would not have shut down BNC unless it expected the subprime business to be impaired for a long period of time.

If this was going to turn around in a quarter or two, you'd leave the infrastructure in place, Hintz said. I'm not certain you'll see a shutdown at the other firms. But what I'd say is investors may question the wisdom of making subprime acquisitions just prior to the market going into a nose dive.

Executives earlier this year backed away from their original forecast that First Franklin would add to profits in 2007.

Merrill declined to provide any detailed information about First Franklin's performance.

But recently filed reports with U.S. banking regulators show that Merrill Lynch Bank & Trust Co., where much of the First Franklin franchise is housed, lost $111 million through the first half of 2007. In the fourth quarter, before First Franklin's impact was felt, the unit made money, records show.

U.S. accounting rules require companies to evaluate goodwill for impairment at least once a year. If the goodwill is impaired, its carrying value on the balance sheet is cut and companies record a loss, reflected on income statements. One effect of the rules is that they provide investors with insight into management's success on past acquisitions.

Merrill Lynch put $999 million worth of goodwill on its balance sheet, primarily from the First Franklin acquisition, the company's financial statements show.

The timing for a write-down on the First Franklin deal might be good because investors and analysts would expect it and Merrill Lynch may be able to offset the impairment.

Earlier this month, Merrill Lynch said it would sell life insurance businesses to Dutch insurer Aegon NV for $1.3 billion, which happens to be the same amount it paid for First Franklin.

Meanwhile, Morgan Stanley carries $348 million of goodwill on its balance sheet related to the purchase of Saxon and Moscow-based lender CityMortgage, its financial statements show.

Morgan Stanley does not plan to close Saxon. Indeed, the company says it is expanding Saxon's loan-servicing business amid turmoil in the market.

Spokesman Mark Lake declined to comment on whether Morgan Stanley would record a charge or impairment related to Saxon.

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