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Tickers in this Article: MER, MS, GS, LEH, XLF
Merrill Lynch (NYSE: MER) kicked off earnings season for the brokers last week, and unlike its large cap brethren in the banking industry, the company did not surprise the market with a better report. Investors didn't seem to mind, and bid up the stock with the rest of the financial sector. However, while investors may seem optimistic, lower leverage and more regulation may make it difficult for the banking industry to return to previous levels of profitability.

More Losses, Negative Revenues
Merrill Lynch reported a net loss from continuing operations for the second quarter of 2008 of $4.6 billion, or $4.95 per diluted share compared to average analyst expectations of $1.91 a share. The company even reported negative revenues on a GAAP basis of $2.1 billion. Negative revenues are possible after losses and credit valuation adjustments are deducted from total revenues. (Find out more on analyzing reports in Advanced Financial Statement Analysis.)

Merrill Lynch took a number of write-downs and credit adjustments in the quarter:

  • Losses totaling $3.5 billion related to U.S. super senior asset-backed securities (ABS) and collateralized debt obligations (CDO)
  • Adjustments to credit valuation of -$2.9 billion related to hedges
  • $1.7 billion loss in the investment portfolio of U.S. banks owned by Merrill Lynch
  • $1.3 billion loss from residential mortgage exposures
  • Merrill Lynch also noted that it sold its 20% ownership stake in Bloomberg L.P. back to Bloomberg Inc. for $4.43 billion; it was also in negotiations to sell a controlling interest in Financial Data Services Inc. for approximately $3.5 billion.

Other brokers joined the rally, with Goldman Sachs (NYSE: GS), Lehman Brothers (NYSE: LEH) and Morgan Stanley (NYSE: MS) all showing strong gains for the week. The brokers have all bounced off the bottoms reached on July 16. The gains range from 48% for Lehman Brothers to 14% for Goldman Sachs.

Company Close
July 14
July 21
Merrill Lynch
Lehman Brothers
Morgan Stanley
Goldman Sachs

A Second Leg?
It is doubtful that the brokers will rally much more without significant new news. The rally already has begun to peter out, with the Financial Select Sector SPDR (AMEX: XLF) starting to flatten out as strong buying interest stagnates.

Goldman Sachs, Lehman Brothers and Morgan Stanley reported their second quarter results last month, and the smaller brokers, if they surprise on the upside, may not provide enough lift to power the sector.

Will the Good Times Return?
Another factor that investors should consider is what the brokers will do to generate growth in earnings once the bulk of the write-offs have passed. The brokers made significant amounts of profit from securitization, and it is difficult to believe that this business will reconstitute itself in a form that will be as lucrative as before.

The brokers also used high leverage to generate profits, and again it seems unlikely that they will attempt that kind of leverage in the future. If the lessons of the last 12 months haven't convinced them, then reduced levels of capital will make it impractical to attempt the leverage levels of previous years.

There are also many legislative and regulatory proposals on the table involving the brokerage industry. It's a bitter pill for these companies to swallow, but a price that may have to be paid to get access to borrowing from the Federal Reserve and reduced collateral requirements for that borrowing. (Discover how the Federal Reserve moves the market, in An Introduction To The Federal Reserve.)

As with the large cap banks, sentiment is swinging toward the brokers, but investors should proceed with caution, as the sector may have difficulty returning to the leverage and lucrative business of previous years.

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