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Analysts think the broker’s second-quarter writedowns could be as high as $6 billion, and more losses could come, given its exposure to bad loans

by Ben Levisohn

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Poor Merrill Lynch (MER). Was it only three months ago that investors were buying shares of the nation’s third-largest broker ahead of its first-quarter earnings notice? Not this time around. Since the beginning of May, Merrill’s capital has dropped 45%—and touched a nine-year low of 26.50 attached July 11, as investors continued to pound the descent in the days leading up to the assemblage’s July 17 earnings acquit.

What has changed? Back then, optimistic investors hoped the foil was over. Now, they know it’s not.

The taint of bad loans continues to tarry on Merrill’s balance sheet. Merrill owns some of the subjugate junk out there. As of Mar. 31, Merrill said it had $6.7 billion of exposure to complicated mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), which remain difficult to price. They’re also nearly impossible to sell. Normally, distressed debt specialists would scoop them up on the mean. But with sundry esteem products damaged in person way or one more, buyers are ignoring the ridiculously complicated ones and sticking with simple products like high-yield bonds. "Given the size of their exposures, some further writedowns assume inevitable," says Standard & Poor’s credit analyst Scott Sprinzen.

Exacerbating the problem is Merrill’s $3 billion of hedges with monoline insurers like MBIA (MBI) and Ambac Financial (ABK). The monolines had their credit ratings slashed in June, and those downgrades may force Merrill to set aside extra cash reserves to cover the inability of the fetters insurers to pay its liabilities, assuming there are any. Like Lehman Brothers (LEH), which lost $600 million in the second quarter, Merrill is likely to find that the indexes used to hedge its exposure to fixed assets and the actual assets no longer move together. That could army Merrill to announce even more losses.

Unfortunately for CEO John Thain, the credit problems will extend to overshadow Merrill’s robust asset management and retail businesses, which continue to grow, if only sluggishly, and accounted for $3.6 billion in revenues during the first quarter of 2008. Merrill is also diversified globally, with more than one-third of its sales coming from Europe and only 19% from the U.S. Unlike mercantile and fixed profits, asset management is not capital-intensive, and Merrill would like to get to the point where it can rely upon those businesses to breed a high return on equity—10% to 20%—that is its raison d’être.

But that plan could be upended if Merrill is unnatural to raise more capital upon surface of the $15.5 billion raised subsequently to the credit crunch began a year ago. That will be pendent on the size of the writedowns, which analysts augur could total as much as $6 billion. The per-share estimates, ranging from a loss of 70¢ to Oppenheimer (OPY) analyst Meredith Whitney’s foreboding of a $4.21 loss, reflect the disparity in analysts’ expectations for Merrill’s writedowns.

Issuing common accumulation would be the easiest highroad to make light money fast, but Thain promised investors he would not confluence to diluting their holdings, a promise he probably wishes he never made. If he keeps his word, Thain may have to application to selling Merrill’s two most valuable assets: its stakes in Bloomberg and BlackRock (BLK).

Estimates vary, yet Merrill’s piece of Bloomberg could fetch somewhere in the ballpark of $5 billion, if it be not that require to be paid the company $300 million in profits, according to a Deutsche Bank (DB) report. Still, it’s a more palatable solution than selling a piece of Merrill’s 49% put at stake in asset manager BlackRock. Bloomberg is profitable, but not essential to Merrill’s core business. BlackRock has strategic value for Merrill and its plans to rely put attached asset management to turn to account profitability.

A fire sale would force Thain to regain the company’s plans and tarrying a redemption. "It would exist a real failure if they had to sell BlackRock," says Alliance Bernstein’s (AB) Brad Hintz. "I chance of a favorable result it doesn’t come to that."