In its Q3 results, Merrill Lynch today reported a write-down of $7.9bn across CDOs and US sub-prime, significantly greater than the $4.5bn disclosed in its earnings pre-release. Net revenues fell by 94% on Q3 2006 – as the joke goes, you can only lose 100% of your revenues, although this wasn’t far off. Both S&P and Fitch cut Merrill Lynch’s rating from AA- to A+, with S&P’s analyst describing the results as ‘startling’. Merrill Lynch’s share price was at one point 10% down, before staging a slight recovery.
If you’re an equity investor, investment banks have been a bad bet over the past few months (with the exception of Goldman Sachs). The Dow Jones is close to record highs, and yet the share prices of Bear Stearns and Merrill Lynch are 30% below the highs hit earlier this year. JP Morgan and Morgan Stanley are 15% down.
From what we’ve seen in the fixed income markets over the past few months, we think that the banks’ problems are going to get worse before they get better. In the leveraged loan market, for example, investment banks have struggled to shift loans from the jumbo LBOs off their balance sheets following the repricing of credit risk over the past few months. They have now started to have some success, but they are doing this by selling the bonds at discounts just to shift them before the end of the year and the annual reporting season.
One saving grace for investment banks is that they offer a range of services that cover different markets through the economic cycle. If M&A activity grinds to a halt, they can afford to take the hit, fire most of their M&A team, and employ a new department in, say, distressed debt. This is a luxury that companies like Northern Rock (and to a lesser extent, Alliance & Leicester and Bradford & Bingley) don’t have. As Richard argued on this blog last month, Northern Rock is in serious trouble because its entire business model is no longer valid.
Oh, and yet more terrible US housing data just out – existing home sales were -8.0% in September, way below expectations of -4.5% and the worst month since records began in 1999.