Will Merrill remain independent?

Even if embattled CEO Stanley O'Neal departs the company, the road forward for Merrill Lynch is far from clear, argues Fortune's Peter Eavis.

By Peter Eavis, Fortune senior writer

NEW YORK (Forrtune) -- Could Merrill Lynch (Charts, Fortune 500), wounded by huge bond losses in its just-reported third quarter, remain independent with a new chief executive to replace Stanley O'Neal, who is reportedly close to exiting the giant brokerage?

O'Neal, according to the New York Times, explored the possibility of selling Merrill to Wachovia (Charts, Fortune 500), but O'Neal reportedly did that without getting approval from Merrill's board of directors, a move that prompted the board to think about removing O'Neal. Candidates for the top stop could include Larry Fink, the CEO of asset management firm BlackRock, which Merrill partially owns, and John Thain, CEO of the New York Stock Exchange.

A quick sale to Wachovia is unlikely, according to analysts, because the two banks would make a poor fit. However, because of Merrill's size - a market capitalization of $57 billion and some $1.8 trillion in client assets - and storied history, any new CEO would probably want to at least try and maintain the independence of the company. Would someone like Fink or Thain be able to do that?

Much depends on how strong - or weak - Merrill really is. It doesn't look good that O'Neal was allegedly raising the possibility of a sale at a time when the brokerage was about to report over $8.3 billion of losses in its fixed income business. It doesn't make sense to sell out in the midst of bad news. Unless, of course, more bad news is on the way.

And analysts believe Merrill could report more large losses in its fourth quarter, especially on collateralized debt obligations (CDOs), the complex debt securities that have become worth a lot less because they are backed with junk mortgages, many of which are going into default. For example, Meredith Whitney, analyst at CIBC World Markets, estimates that Merrill could report another $4 billion of write-downs on securities like CDOs in the fourth quarter.

Clearly, if a new CEO wanted to keep Merrill independent, he or she would have to quickly convince investors that the company had executives in place who had a much better idea of how to value Merrill's balance sheet and manage its risks. The $8.3 billion of losses in the third quarter show that Merrill, unlike some other banks, had not insured itself sufficiently against market downturns. And the $7.9 billion of losses Merrill took specifically on its CDOs and junk mortgages was far higher than the $4.5 billion estimated three weeks earlier, which strongly suggests losses were originally underestimated, damaging the credibility of management.

It's hard to exaggerate how important it is for a brokerage to show that it can manage risk and value its balance sheet properly. Failure to do so can lead to clients pulling business and creditors charging more. Theoretically, this is an area BlackRock's Fink might be able to help Merrill. Fink has had a lot of experience in dealing with distressed debt securities. He, for instance, helped manage a large batch of stricken mortgage-backed securities offloaded by General Electric in the mid-90s that had been held by a brokerage GE owned. (BlackRock didn't respond to a request to make Fink available.)

The only problem is that he would likely have a big clean out -- involving large sales of ailing assets -- that could lead to even larger losses than analysts are expecting. That's because a new broom might sell more assets more quickly than predecessors in a bid to thoroughly decontaminate the balance sheet. But more losses would in turn eat away at Merrill's capital - the amount by which assets exceed liabilities - and make the firm even more vulnerable to a takeover.

So a new CEO wanting to maintain Merrill's independence might have to sell assets to increase cash - a tactic O'Neal has already raised - and possibly strengthen capital through some sort of issue of new stock. However, any attempts to shore up Merrill's balance sheet would have to be done quickly and convincingly, not only to win over investors in Merrill stock and creditors, but also to prevent a large exodus of money-making and capable employees during a shake-up.

In other words, Merrill's board isn't going to want to see just a plan for restoring the company, but one that can be implemented very quickly. Of course, the board may decide the best thing for Merrill shareholders is selling out. But there aren't that many institutions that could absorb Merrill, or even want to.

Take O'Neal's alleged choice of Wachovia. That bank isn't likely to have the management expertise to restore and get the most out of a brokerage like Merrill. Large commercial banks often find it hard to make money over time from investment banks. For example, Wachovia rival Bank of America has spent huge sums to become a big player in investment banking, but after big losses in the third quarter from that business, bank execs now say they are going to pull back sharply in their investment bank.

For similar reasons, Bank of America and Citigroup, which is also struggling, are unlikely Merill suitors. That effectively leaves JP Morgan Chase in the U.S. and a handful of large foreign banks. And even these might want to make sure they navigate their ways through the credit crunch before making a big purchase, like Merrill.

There's a smaller chance that Merrill could be taken over by another investment bank, but the culture clashes could be immense and other brokerages may show more big losses in the fourth quarter, which would raise questions about their strength.

Still, price is everything, and if Merrill's stock - down more than 30% from its 52-week high - stays weak, acquirers could start to get interested, especially if they feel they have the strength to handle Merrill and any remaining toxicity on its balance sheet. If Merrill makes $7 per share next year, its stock is currently trading at nine times those earnings. Merrill is valued on the stock market at 1.4 times its $39 billion of book value (another term for assets minus liabilities), as stated on the balance sheet. That ratio is also quite low by historical comparisons.

And an influential banks analyst, Mike Mayo of Deutsche Bank, estimates that Merrill is even cheaper when you factor in other assets not fully reflected on the balance sheet. He reckons Merrill trades at 0.7 times his adjusted book value. If potential buyers share Mayo's view, they could swoop in soon.

But selling out would be a massive step for the board to take. This is, after all, Merrill Lynch -- a huge firm with an extensive franchise that has been part of the American financial fabric for decades. The brokerage's troubles were brought about by a small number of employees who clearly had too much of the firm's capital to play with -- something O'Neal is ultimately responsible for.

As things look now, Merrill will have a new CEO by early next week. And the board will give the new boss free reign to resuscitate Mother Merrill. But he or she won't have forever.  Top of page