By Bradley Keoun
Oct. 16 (Bloomberg) -- When Merrill Lynch & Co. paid $1.3 billion for subprime lender First Franklin Financial Corp. 10 months ago, Chief Executive Officer Stanley O'Neal promised ``revenue velocity.'' What he got is a dead weight with decelerating earnings.
Dwindling income from First Franklin and the $5 billion writedown Merrill incurred for the third quarter mean Wall Street's biggest brokerage has no chance of fulfilling Chief Financial Officer Jeffrey Edwards's April estimate of as much as $700 million in annual revenue from underwriting subprime mortgages and repackaging them into bonds.
Investors who lauded the 56-year-old O'Neal for pushing New York-based Merrill to make higher returns now question whether he adequately policed the risks. They're also second-guessing his self-described ``disciplined and selective'' track record for takeovers.
Confidence in O'Neal is ``certainly shaken,'' said Adam Compton, an analyst who helps manage $150 billion at RCM Capital Management in San Francisco, which owned about 800,000 Merrill shares at the end of June.
Merrill's stock is the third-worst performer in 2007 among securities firms after E*Trade Financial Corp., which had home- loan losses at its online bank, and Bear Stearns Cos., where two hedge funds lost $1.6 billion of clients' money. Merrill is down 21 percent in New York trading. Goldman Sachs Group Inc., the biggest securities firm by market value, has gained 15 percent. No. 2 Morgan Stanley is down 2.2 percent. All the companies are based in New York.
Not since Russia defaulted on its debt and the collapse of hedge fund Long Term Capital Management in 1998 have the credit markets suffered so many dislocations. The world's largest financial institutions have written down more than $21 billion of mortgages, securities and corporate loans whose value plummeted during the third quarter.
Merrill said Oct. 5 that it lost as much as 50 cents a share in the quarter ended Sept. 28, the firm's first loss in almost six years. The complete financial report is scheduled for release next week.
The loss is O'Neal's biggest misstep since he became CEO in 2002. He has criticized acquisitions made under his predecessor, David Komansky, whose expansion culminated in a $1.7 billion charge in the fourth quarter of 2001, a record in the firm's nine-decade history. That's now dwarfed by O'Neal's third- quarter subprime-induced blunder.
O'Neal declined to comment. He said in a statement earlier this month that he was ``disappointed in our performance'' and promised to ``do a better job in managing this risk.''
Loan brokers at 1st Metropolitan Mortgage, a division of Montvale, New Jersey-based Empire Equity Group Inc., attest to how slow it's gotten at First Franklin. For the past five years, they've turned to First Franklin whenever they had a client who recently emerged from bankruptcy, said Brenda Jarvis, director of lender relations in 1st Metropolitan's Charlotte headquarters.
``They were definitely the go-to lender for that type of borrower,'' Jarvis said. Her company has 1,600 employees and 250 offices in 49 states.
First Franklin was the 10th-biggest subprime lender in 2006, with $27.7 billion of loans, according to data compiled by industry publication Inside Mortgage Finance. The San Jose, California-based firm had 2,800 employees when Merrill bought it.
Now, 1st Metropolitan sends less than $1 million of loans to First Franklin a month, down from $10 million six months ago, Jarvis said. First Franklin barely offers subprime loans anymore. Instead, it's competing for less-risky borrowers or those willing to make bigger down-payments. On these safer ``prime'' or ``near-prime'' loan offerings, First Franklin's prices are often undercut by banks with bigger-scale operations, she said.
``First Franklin has basically changed the way they do business,'' Jarvis said. ``They're pretty much non- competitive.''
William Dallas, who co-founded First Franklin in 1981 before selling it in the 1990s, said his friends at the company are virtually idle. Merrill spokesman Bill Halldin declined to comment on First Franklin, which announced an unspecified number of job cuts last month.
More than 110 mortgage companies, many of them subprime lenders, have closed, filed for bankruptcy or put themselves up for sale since the start of 2006. Investors are refusing to buy bonds backed by subprime loans.
``First Franklin was a business that was bought at almost precisely the wrong time,'' said Brad Hintz, a New York-based analyst at Sanford C. Bernstein & Co.
The slowdown flows through to Merrill's business of packaging loans, bonds and other types of assets into securities and other debt instruments known as collateralized debt obligations, or CDOs.
Slowdown in Underwriting
After Merrill announced the First Franklin deal, O'Neal said at an investor conference last November that the takeover ``will help provide an additional attractive source of origination for our mortgage-backed securitization and trading platform, enhancing revenue velocity relative to assets and thereby increasing returns.''
Edwards told investors in April after Merrill reported first-quarter earnings that First Franklin's sales and fees from underwriting bonds linked to subprime mortgages accounted for as much as $170 million of revenue per quarter on average.
Merrill underwrote $8.1 billion of asset-backed securities in the third quarter, down from $15.6 billion a year earlier and $17.3 billion in the third quarter of 2005, according to data compiled by Bloomberg. The figure was far short of the $28.6 billion Merrill sold in the second quarter of 2007.
`Got to Deliver'
``A recovery for Merrill's fixed-income business will be challenging,'' JPMorgan Chase & Co. analyst Kenneth Worthington wrote in an Oct. 8 report. He downgraded the stock to ``neutral'' from ``overweight.'' Credit Suisse Group analyst Susan Roth Katzke on Oct. 8 cut her estimate for Merrill's 2008 earnings by 12 percent.
Since O'Neal became CEO on Dec. 2, 2002, Merrill's stock has increased 69 percent, exceeding a 65 percent gain by the Standard & Poor's 500 Index. Goldman almost tripled during the period, while Lehman Brothers Holdings Inc. doubled, and Bear Stearns rose 89 percent. Morgan Stanley advanced 76 percent.
Some investors buy Merrill's stock because a third of its revenue comes from its network of 16,200 retail brokers whose fees are more stable than the erratic gains that come from trading and investment banking.
Such confidence may be in doubt after Merrill was the only one of its peers to post a third-quarter loss, said Ken Crawford, who helps oversee more than $900 million at St. Louis- based Argent Capital Management, including about 140,000 Merrill shares.
``If you're going to play that game, OK, but then you've got to deliver returns more similar to Goldman's,'' Crawford said.
In an e-mailed video message to employees on Oct. 5, O'Neal said the firm has to take risks if it wants to compete. ``I don't think there's a choice in the modern capital markets for firms like us not to take risks,'' he said. In the Oct. 5 statement, Merrill said each of its largest businesses except fixed-income trading had third-quarter revenue growth of at least 20 percent.
The net loss includes $100 million of costs to write off ``identifiable intangible assets'' such as customer lists associated with First Franklin. Merrill cited U.S. accounting rules in deciding not to book the rest of the investment as a loss.
The decision may make Merrill's assets look artificially high, dragging down return on equity, said Robert Willens, an accounting analyst at Lehman in New York.
``If this is an unproductive asset, it's going to wreak havoc with the return on equity,'' Willens said.
The financial ratio, a gauge of profitability, was so crucial to Merrill's board of directors that they linked O'Neal's compensation to it. Under that ``incentive program,'' O'Neal got an extra $9.4 million for his part in boosting Merrill's return on equity to 21.3 percent in 2006 from 16 percent in 2005. He has increased the measure from 7.5 percent in 2002.
Merrill's return on equity will be 14 percent this year, compared with 27 percent for Goldman and 23 percent for Morgan Stanley, Hintz estimates.
Investors may forgive O'Neal partly because so many of his rivals took writedowns in the third quarter. He's been less forgiving of subordinates who have crossed him or fallen out of favor. The list includes former rivals, such as Jeffrey Peek, now CEO of New York-based CIT Group Inc., the largest independent commercial-finance company in the U.S., as well as onetime allies, including Arshad Zakaria and Thomas Patrick.
On Oct. 3, Merrill fired Osman Semerci, the firm's fixed- income chief, who had occupied the post for just over a year, along with Dale Lattanzio, one of his top two deputies in the U.S.
O'Neal earned his way through college by spending alternate semesters working at a General Motors Corp. assembly plant in Georgia. He got a master's degree from Harvard Business School in 1978 and worked as a finance executive at General Motors before joining Merrill as an investment banker in 1986. He was promoted to president in July 2001. Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.
Komansky had used acquisitions to expand into stock- oriented businesses across the world, including the $5.2 billion purchase of London-based Mercury Asset Management Group Plc in 1997 and the $781 million takeover of Canada's Midland Walwyn Inc. in 1998. Earnings plummeted 85 percent in 2001, when the Nasdaq Composite Index fell 21 percent and terrorists attacked the U.S. on Sept. 11.
``We expanded into that bubble more than any other firm,'' O'Neal said in a 2006 interview with Euromoney.
He promised not to make the same mistake. After becoming CEO, he refrained from major acquisitions until 2004, when he bought Entergy-Koch LP's energy-trading business for $800 million. The unit, which trades oil, natural gas, electricity and metals, produced $1 billion of revenue last year. Merrill described it this month as ``perhaps the most successful acquisition in the company's history.''
``We've been disciplined and selective,'' O'Neal said at an investor conference in November 2005. ``For every deal we've done, we've probably passed on 10 or 15 others.''
Thirteen months later, Merrill bought First Franklin, plunging deeper into the business of underwriting asset-backed securities. Industrywide, fees from the securities had tripled over five years to $5.6 billion in 2006, based on estimates by Bank of America Corp. analyst Michael Hecht.
Since then, the percentage of subprime borrowers making late payments has climbed to about 15 percent from 12 percent a year earlier.
``People are going to look at O'Neal more closely,'' Argent's Crawford said. ``You only get a few mulligans, and he has spent one.''
To contact the reporter on this story: Bradley Keoun in New York at email@example.com . Last Updated: October 16, 2007 00:09 EDT