NEW YORK (AP) — Wall Street turned on itself Friday, as one widely watched analyst said investment banks face $10 billion or more in writedowns this quarter from bad mortgage debt, and another downgraded much of the banking sector on similar fears.
The downgrades and the commentary renewed fears of a repeat of August, when stocks sank, credit markets locked up and banks slashed the value of their investment portfolios.
Deutsche Bank analyst Mike Mayo predicted late Thursday night that the investment banks will need to take another $10 billion in writedowns in the fourth quarter, with hits of $4 billion each at Citigroup and Merrill Lynch and a total of $2 billion at places like Wachovia and Bank of America.
But after a Wall Street Journal article Friday morning suggested Merrill Lynch could be under investigation over its handling of mortgage debt, Mayo issued a new note, downgrading Merrill to “Hold” from “Buy” and saying it could face $10 billion in writedowns on its own.
Meanwhile, Standard & Poor's equities analyst Matthew Albrecht also cut his rating on Merrill Lynch, dropping the company to “Hold” from “Buy.” S&P downgraded Wachovia Corp. to a “Buy” from a “Strong Buy” and Citigroup to “Hold” from “Strong Buy” as well.
The problem at the banks stems from their exposure to complex instruments known as collateralized debt obligations. So-called CDOs combine slices of different kind of risk; many include pieces of bonds backed by subprime mortgages. As those mortgages have gone into default at rising rates, the bonds have lost value and the CDOs have as well.
That trend has shown no signs of abating, which has meant fresh rounds of charges by banks to recognize the decreased value. Writedowns related to declining mortgage debt values have already exceeded $25 billion this year, and any more could cause serious damage, Mayo said.
“If there are much higher CDO writedowns, Merrill may have additional credit rating downgrades and may need to find a partner to give it new credibility and financial strength,” Mayo wrote in a research note Friday.
The trigger for Mayo's pessimism was the Journal story. The Journal reported Merrill Lynch struck deals with hedge funds to take certain positions that did not transfer risk, but merely delayed when Merrill Lynch would have to disclose its exposure to that risk. That practice, the paper reported, is under investigation by the Securities and Exchange Commission.
Merrill Lynch said in a statement that it has “no reason to believe that any such inappropriate transactions occurred,” adding they would violate the company's policy. SEC spokesman John Nester in Washington declined to comment, and would neither confirm nor deny that the agency was investigating Merrill Lynch.
Merrill Lynch was hit the hardest in the third quarter by the deteriorating subprime mortgage market. The investment bank took $7.9 billion in writedowns — less than three weeks after it told investors that its mortgage losses would only amount to $4.5 billion.
Stan O'Neal, Merrill Lynch's chief executive, was forced to retire because of the fallout over the writedowns. Mayo said the new chief executive at Merrill Lynch will likely take a more conservative route when valuing CDOs and other subprime-backed securities.
O'Neal's ouster has put other CEOs on notice that they must right the ship sooner rather than later. Citigroup's Charles Prince and Bear Stearns' James Cayne both came under fire after reporting multibillion dollar writedowns related to bad bets in the subprime mortgage market.
Merrill Lynch shares fell 8.9 percent to $56.65. The stock traded as low as $54, its lowest point since roughly mid-2005. Shares in Goldman Sachs and Morgan Stanley also fell roughly 5 percent.