April 17, 2008 11:32AM

Merrill Lynch’s Neat End-Run

By Elizabeth MacDonald

Merrill Lynch’s latest earnings report, which disclosed its third quarterly consecutive loss, saw wildly different ranges reported in the business media as to the size of its actual, total writedown.Merrill booked a $1.96b loss, but you may be confused seeing reports of anywhere from $6.6b to $9.7b in writedowns. My finance sources at Merrill walked me through the numbers, so did a PR staffer at the firm.

The writedown is $6.5b. Merrill got there with a neat, perfectly legit move, more on that in a minute.

A separate item: Merrill is laying off 2,900 workers, not 4,000 as you may be seeing. That 2,900 is on top of the 1,100 Merrill already announced and let go last quarter, most of which came from its disastrous purchase of First Franklin. That brings the cumulative total let go to date to 4,000, which is 10% of Merrill’s 40,000 headcount which excludes investment advisors who work on commission. My sources at Merrill tell me the 4,000 is likely much bigger, as retirement packages are increasingly handed out, with execs on the level of managing directors walking out the door.

Back to the writedown, here’s how Merrill kept it to $6.5b.

Merrill sluiced $3.1b in net pretax writedowns for securities backed by shaky Alt-a residential mortgages held at its US banks through an obscure financial statement line item called “other comprehensive income.” That $3.1b would have brought the $6.5b up to $9.6b, but here’s the thing. By slotting that amount in this line item, Merrill doesn’t have to book the writedown in earnings. Instead it goes to the balance sheet and hurts book value.

Don’t be thrown by this. What’s going on is, Merrill is saying its units are going to sit tight and they are not going to sell these securities just yet. The firm is saying that it will sit on these assets until the markets turn around.

If it did sell these securities now, Merrill is essentially saying it would have to recognize that $3.1b writedown on its income statement. Translation: Again, Merrill is waiting for the markets to calm down because there could be value in these securities. And it doesn’t need the hit to profits now, as Merrill’s $14b in net losses over the past nine months erased what the brokerage earned in 2005 and 2006.

Watch other banks and firms mimic this perfectly legit accounting maneuver in coming days, to rebel against rigid accounting rules. The move is a neat-end run around stiff “fair market value” accounting rules that I’ve repeatedly warned you about that is causing massive writedowns that could be as inflated as the profit figures they tossed off during the bubble (”What’s Really Rocking the Stock Market,” “The Answer to Who’s Next on Wall Street,” “What the Fed Chairman Really Said“).

The accounting rules are the subject of so much controversy here and around the globe, that you’ve got the likes of the IMF, Federal Reserve Chairman Ben Bernanke, US Senator Charles Schumer (D-NY), France’s finance minister Christine Lagarde, George Soros, and economists far and wide getting into heated debates over them. 

So here’s the breakdown of Merrill Lynch’s writedown, according to my guys at Merrill:

The first-quarter writedowns included $2.6b to account for the plunging value of Merrill’s mortgage-related bonds, including collateralized debt obligations. Merrill also cut the value of bond insurance contracts by $3 billion, and reduced the value of leveraged loans by $925 million. Again, it stuck $3.1b in losses from securities backed by Alt-A mortgages in that line item that doesn’t affect its earnings.

Ok, back to the reason for the big heated controversy over the writedowns plaguing the markets. Here’s the deal. Because there is no market for these securities right now, the writedowns so far are based on guesswork. And auditors are being pretty tough because they are fearful of another post-Enron, Arthur Andersen-type takedown by the government and because they are increasingly being criticized for sanctioning sizable profit figures during the housing bubble.

Even though the credit market has largely frozen over, the rules say the banks must book prices on these bonds as if they were being sold today. You can’t get a price tag when there is no market. You can’t mark to market when there is no market to mark to.

This is starting to sound like an Abbot and Costello routine. This isn’t mark to market. It’s mark to madness.

Again, companies must price tag any securities they have on their books by getting a value for them as if they were going to sell them today. When they can’t get a price tag on this junk, they must use internal models to come up with their own numbers, which is essentially the equivalent of sticking up a wet finger in the wind.

The problem is, because management can use their own “mark to myth” accounting to price these zombie securities, they often rely on the ABX index, which is comprised of credit default swaps, again, which are essentially bets backed by any trader’s best guess of what these Frankenstein securities are really worth.

The ABX does not reflect the fair or true value of these assets, since panic has taken hold of it, and so it does not realistically take into account that the risk of default may be much lower than the index implies. Still it’s used, and still, it has led to billions of dollars in writedowns.

The ABX is stuck on a hamster wheel that’s turning into a death spiral. Announcements of writedowns cause the ABX index to fall further, which in turns means that other firms need to make writedowns.

Those values arising from using things like the ABX index are dumped into a bucket on the balance sheet called “level 3″ assets.  Merrill Lynch did not disclose its level 3 assets in its most recent earnings release, opting to disclose them when it has to file its earnings report to the Securities & Exchange Commission, at least a month away. Stinks, yes, that we are kept in the dark. Goldman Sachs’ level 3 assets surged 39% to $96.4b at the end of February from $69.2b in November. Morgan Stanley’s level 3 assets rose 6.1% to $78.2b last quarter. Lehman’s level 3 assets rose 1.3% to $42.5b.   

Enough is enough. Move away from reporting date based measurements of market price and start measuring the average market price for these zombie securities over a period of time, six or 12 months.

Using an average price will increase confidence, since the price will not be affected by short-term, choppy day to day events.

And this mess ought to settle once and for all an important regulatory debate. The market cops ought to force these firms to list these derivatives on a market exchange once and for all and stop these quarterly shenanigans.

Yes easier said than done, I get it. But these geniuses can cook up these Frankenstein securities, there’s got to be a way they can come up with a regulated exchange for them. Sunlight is the best disinfectant.

It’s not enough to leave it like this, that, if investors believe these underlying assets are going to rise in value, they can bid up the banks’ stocks.

Time for common sense. Until then expect to see more firms mimic Merrill’s accounting move, and watch them sit on these zombie securities until the market gets its head on straight.