Merrill Lynch (MER) And Citigroup (C) Move To The Bottom Tier Of US Financial Firms

At the start of the year, many Wall St. analysts and much of the media give the impression that the current financial crisis would pull down all large US banks and brokerages. With the recovery, the fortunes of all would improve. It has not turned out that way. As the second quarter earnings season progresses, it is clear that there are three tiers of big financial companies. Based on Merrill Lynch’s (MER) earnings, it has been pushed down to the bottom level. Citgroup’s (C) $2.5 billion loss and threats of much worse results have pulled it under as well.

The most recent set of earnings and the forecasts coming out of companies like Merrill and JP Morgan (JPM) make it clear that decisions made at least two years ago are coming back to haunt one set of companies and saving the skins of another. Firms which bet heavily on mortgage-related paper and substantially exposed themselves to the US housing market may not have earnings recoveries until 2010 or 2011. The companies that took on less risk and leverage or hedged their positions are doing much better.

Some financial operations went so far in the wrong direction that they may not even survive as independent companies.

The top tier among banks and brokerages is an exclusive group where the members will probably have relatively modest losses and will recover from the current credit crisis fairly fast. Goldman Sachs (GS) and JP Morgan (JPM) are probably the only firms with the credentials to get into this club.

At the next level are companies including Bank of America (BAC), Morgan Stanley (MS), and probably Wells Fargo (WFC). These companies made significant mistakes in building their asset bases with too much leverage, but they had either the balance sheets or hedges to carry them though this rough period with substantial but not catastrophic losses. They may even get by without having to raise more money.

In the basement, there are financials which have seen their stocks drop by 70% to 80% this year. Their balance sheets are remarkably weak and they will almost certainly have to raise billions of dollars each, diluting shareholders and driving their stock prices down even further. Wachovia (WB), Washington Mutual (WM), and Lehman (LEH) are all bottom dwellers.

Merrill Lynch has been on the cusp. With new management and a fairly diversified set of businesses, it looked as if it would stay off the "critical" list and join those companies that were bloodied but hardy. Merrill’s second quarter earnings make it almost certain that its troubles are deep and wide. If it had not been able to sell its stake in Bloomberg for almost $4.5 billion, Merrill would have been in even worse shape.

Merrill took $9.7 billion in write-downs for the last quarter and lost $4.65 billion. “Clearly the size of the loss was a surprise" an analyst at Sandler O’Neill & Partners told Bloomberg. And, clearly no one thinks the large losses are over now. A consensus is forming that Merrill may face real write-off problems through the end of this year and into next.

Citigroup’s loss was not only disappointing, but its lack of focus on getting out of non-core businesses and cutting costs is wearing on current shareholders who expected fast action and have gotten only a cloudy plan for the way forward

Merrill and Citi may make it out of the current Wall St. troubles alive, but just barely.

Douglas A. McIntyre