Mystery: How Could Merrill Have Lost That Much?


Merrill Lynch’s losses in the fourth quarter of last year were an epic $15.5 billion. Everyone knew that Q4 was rough, but Merrill’s losses exceeded even the most dire predictions. And no one seems to be able to figure out how.

Perhaps most mysteriously, Merrill said that half of its Q4 losses occurred in December, which was widely viewed as a much calmer month in the markets than the previous couple of months. What happened in December that crushed Merrill so badly?

Fortune tries to dissect the losses. It explains two sources of big losses: corporate bonds and an attempt to arbitrage the spreads between bonds and credit default swaps. But even the disasters in these two areas don’t come close to explaining the huge losses at Merrill.

Here’s Fortune:

The write-downs on the “legacy” leveraged loans and CDOs from the O’Neal era – around $7 billion after tax – were expected. The shock was the enormous losses on fixed-income trading, specifically the credit positions that were part of Merrill’s proprietary trading book. (The information on Merrill’s fourth-quarter losses comes from ex–Merrill board members and current and former executives, none of whom would speak on the record.) In the fourth quarter the U.S. suffered the worst credit meltdown in memory. The spread between Treasury yields and those on high-grade corporate bonds jumped to 3.4 points – two points is the usual margin – while the spread between junk bonds and Treasury yields soared to 19 points. Merrill’s plain-vanilla portfolio of about $50 billion in corporate bonds was pummelled.

Merrill also had another $50 billion or so in “correlation trades.” In a correlation trade, investors seek to profit from the spread between the interest on a bond and the cost of insuring that bond, usually via credit default swaps. Such trades typically produce a reliable stream of profits. But the credit crunch was so violent that the price of the bonds fell far more than the price of the swaps rose, as panicked investors, irrationally it would seem, dumped the swaps. Merrill also bought protection from the so-called monoline insurers, such as MBIA and Ambac. But when those insurers were downgraded by the rating agencies, the protection Merrill had paid for was less valuable, and Merrill had to add to its reserves to make up the difference. That alone saddled Merrill with $3.2 billion in fourth-quarter losses. Even with those details, mystery still shrouds the epic write-downs: It’s not at all clear why more than half the losses occurred in December, when the credit markets were calmer than they were in October and November.

It is apparently too much to ask to have Bank of America detail these losses. So perhaps some of our readers can shed some light on this mystery. What clobbered Merrill? 

Did the firm really lose the money in December, as it claims, or is this just a cover-story to let Bank of America off the hook?  And how did it lose this much?  Did it mark its assets to reasonable levels for the first time (thus admitting that it had been way too optimistic before then?)