Merrill writes off $5.5bn in largest credit loss so far

Merrill Lynch, one of the mightiest banks on Wall Street, warned yesterday that it will plunge into the red, after it admitted $5.5bn (£2.7bn) of losses in its debt business.

The write-downs make Merrill the biggest Wall Street casualty of the credit crisis so far, and prompted an apology to shareholders from the company's chief executive, Stan O'Neal.

"While market conditions were extremely difficult and the degree of sustained dislocation unprecedented, we are disappointed in our performance in structured finance and mortgages," Mr O'Neal said. "We can do a better job in managing this risk, as we have done with other asset classes."

The company said it will have to write off $4.5bn from the value of its portfolio of mortgage-backed securities, which have become impossible to sell because of rising defaults on the underlying mortgages. And on top of this, the resale value of Merrill's loans to private equity buyout vehicles is being written down by $967m, although half of this will be offset by underwriting fees.

Merrill is the largest underwriter of collateralised debt obligations, CDOs, which are created by parceling together mortgages and other debts and selling them on in tranches to outside investors.

This week, the investment bank removed its global head of fixed income, Osman Semerci, and the co-head of fixed income in the Americas, Dale Lattanzio, and also punished Dow Kim, the former co-head of institutional securities, who had announ-ced his intention to leave to set up a hedge fund and will now exit earlier than planned.

The figure of $4.5bn in write-downs from the mortgage securities business was much worse than even the most bearish rumours that have been circulating on Wall Street for the past week, and some analysts expressed frustration that they will have to wait for the full third-quarter results statement on 24 October for more details about how the losses have come about.

In a report suggesting it may cut its credit rating on the company, the rating agency Fitch said Merrill had invested heavily to expand its fixed-income business but appears to have "overestimated its capacity". It said: "Our rating thesis was based on a belief that the company had sufficiently robust risk management and limits around these businesses to address any incremental risks. However, the size of the loss and sudden departure of key fixed-income executives indicates that this may not be the case."

Mike Mayo, analyst at Deutsche Bank, told clients: "We are somewhat frustrated for not having the total exposure for either CDOs or sub-prime mortgages and, therefore, can't give context to the write-downs. We also wonder why Merrill (and others) terminated the head of CDOs if such moves are so unprecedented. They can't have it both ways."

Merrill will report a third-quarter loss of up to 50 cents per share, more than $400m, which is likely to be the worst performance by a big Wall Street bank over the period. Its profit warning came at the end of a week when several banks have totted up the losses suffered on exotic debt products on their books. In aggregate, the losses announced this week mean more than $10bn of value has been wiped out.

Also yesterday, Washington Mutual, the largest savings and loans company in the US, said it was setting aside $975m to cover mortgage defaults and that it now expects a 75 per cent drop in quarterly earnings.

Nonetheless, banking shares have risen through the week. Investors believe the write-downs are one-time events and that the worst of the dislocations in the credit markets may be over.

What the big banks have lost

Write-offs announced so far for third quarter linked to sub-prime mortgage crisis:

Merrill Lynch $5.5bn

UBS $3.4bn

Citigroup $3.3bn

Deutsche Bank $3.1bn

Bear Stearns $1bn

Lehman Brothers $700m