Mike Mayo: More misery for Merrill

The veteran banking analyst talks to Fortune's Katie Benner about the subprime mortgage mess, the lessons from Wall Street's miscues, and stocks he likes now.

By Katie Benner, Fortune writer-reporter

Merrill Lynch CEO Stanley O'Neal lost his job after the bank took a surprise $8 billion write-down.

(Fortune Magazine) -- Deutsche Bank analyst Michael Mayo is known for his prescient pronouncements on the financial sector.

Famously, while working for Credit Suisse First Boston in 1999, he told investors to dump regional banks. He was fired for that call, but the sector subsequently suffered its worst year relative to the market since 1945.

In October of this year he downgraded Citigroup (Charts, Fortune 500) to a sell; the price has since fallen sharply.

Luckily for Mayo, times have changed. "I think investors thought I helped their cause," he says. "I was amazed the reaction was so favorable."

Investors also applauded when he took former Merrill Lynch chief Stan O'Neal to task after the company's unexpected $8 billion write-down in the third quarter, a loss that cost O'Neal his job.

Mayo talked to Fortune's Katie Benner about the sector.

Q. How long will it take for the sub-prime crisis to play out?

A. It could take two to three years. The question is whether other issues will appear. There have been auto loan problems and problems in real estate construction.

Q. Should investors avoid all financial stocks for now?

A. No. Whenever you invest in financials, you're investing in a blind pool of assets, and you're paying for a management team that can handle risk. Among the investment banks, Goldman Sachs (Charts, Fortune 500) management has done an excellent job. They are in a position to expand structured products when others must retreat. They're making LBO loans more aggressively than others but on better terms than before the summer meltdown.

We've also been recommending processing and trust banks like Bank of New York (Charts, Fortune 500), State Street (Charts, Fortune 500), and Northern Trust (Charts, Fortune 500). These firms benefit from growth in capital markets without the big lending risk and from having 30% to 40% of their revenues generated outside the U.S.

Q. What happens to Merrill now?

A. The good news is that seven-eighths of the firm is performing well. Only 100 or so employees out of 64,000 caused the lion's share of the write-downs. Having said that, this one-eighth of the company, especially the CDO portion, seems much more exposed to additional problems. There could be $5 billion to $10 billion in additional write-downs in the fourth quarter. That could trigger ratings downgrades and possible regulatory involvement.

There is an outside chance that Merrill (Charts, Fortune 500) will be taken over. The value of its brokerage business, its Bloomberg stake, and its BlackRock (Charts) holdings is almost equal to its current stock market value, so an investor gets the investment-banking business for free. A takeover isn't likely, but there is an unusually large disconnect between the stock price relative to the sum of its parts.

Q. What can we learn from the Merrill and Citigroup meltdowns?

A. There are five lessons. One is that CEOs and directors need succession plans. Citi and Merrill are in limbo in part because there is no clear plan. Compensation needs to be reevaluated. O'Neal increased risk and got paid based on the good times, but losses related to his decisions didn't become apparent until this year. And we need better disclosure. In a period of just three weeks, Merrill disclosed $3 billion in additional write-downs, and Citigroup disclosed at least $8 billion.

The events at Citi and Merrill also raise questions about risk management. It's not enough to say, "CEO gone. Problem solved." Risk oversight needs to be addressed at all levels of these firms.

The fifth lesson might be that companies should think about shared positions. In the case of Merrill, there were two presidents, and when things went wrong no one could say who ultimately should be held accountable.  To top of page

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