April 25, 2008 / 12:12 PM / 11 years ago

UPDATE 2 - Merrill at risk of credit rating downgrade- Bernstein

(Adds analyst’s comments, background and share price movement)

April 25 (Reuters) - Merrill Lynch & Co Inc MER.N faces a potential credit rating downgrade from at least one rating agency, said Sanford C. Bernstein analyst Brad Hintz, who also expects the firm to take additional writedowns in the coming quarters from its large exposures to troubled asset classes.

“With earnings depressed, the economic environment weakening, troubled collateralized debt obligations frozen on a balance sheet, hedging roll risk still high and equity stretched, we believe there is a strong chance Merrill will face a credit rating downgrade this year,” Hintz said.

A downgrade to a rating of A/A2 will impact Merrill’s cost of funds, reduce counterparty acceptance of the firm’s exposures and trading risk and trigger additional collateral posting in mark-to-market derivative deals which could hurt the company’s earnings, Hintz said.

The analyst estimates that Merrill will earn 56 cents a share this year, but said “...There is significant risk that Merrill Lynch will report its second consecutive full-year EPS loss this year.”

He maintained his “market perform” rating on the stock, but cut his price target to $45 from $50.

The analyst noted that Merrill had, on Tuesday, announced the sale of $2.55 billion of perpetual preferred equity, increasing its capital raising efforts beyond the $12.8 billion of common stock and convertible preferred stock it raised over the last five months.

“This preferred (issue) is certainly not the highest quality equity, and though we are concerned about deterioration in the quality of Merrill Lynch’s equity base, it does strengthen the firm,” Hintz said.

He, however, does not expect Merrill to receive 100 percent equity credit from the rating agencies for the new preferred issue, as credit rating firms generally do not allow more than 25 percent of the firm’s equity base to consist of preferred stock and hybrid debt.

“Unfortunately, Merrill is well over the limits,” he said.

“So the company is in the troubling situation that if Merrill’s tangible common equity base declines next quarter, its rating-agency determined equity capital base will drop more severely.”

However, Merrill’s core businesses continue to perform well in a difficult environment but its fixed income business and its legacy risk positions frozen on its balance sheet have been dragging the performance of the overall firm down, Hintz said.

“While we have faith that CEO John Thain will eventually be able to turn Merrill’s performance around, we believe it will take him some time before he can achieve his goal of an over-the-cycle 20 percent return-on-equity,” he added.

The analyst did not specify the exact size of writedowns expected in 2008 at the world’s biggest brokerage.

Merrill shares were up nearly 1 percent at $48.56 in morning trade on the New York Stock Exchange. (Reporting by Tenzin Pema in Bangalore; Editing by Jarshad Kakkrakandy)

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