Subprime Loans Still Biting

Earnings shock at Merrill Lynch shows the worst isn't yet over

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As just about any Wall Street analyst will tell you, bad earnings reports are like cockroaches: If you see one, you can be sure there are plenty more to follow. Well, right about now, the nation's financial industry seems to be completely infested with the little pests, thanks to the continuing fallout from the subprime debt mess.

Indeed, the nation's mortgage crisis chalked up two fresh earnings casualties last week, as Countrywide Financial, the nation's largest mortgage lender, and financial giant Merrill Lynch, a leading asset-backed securities player, announced large-scale losses. Countrywide posted a $1.2 billion quarterly loss—its first in 25 years—after taking a $2.2 billion hit from mortgage-related write-downs and losses. Meanwhile, Merrill's $2.3 billion loss was triggered by $7.9 billion of subprime mortgage and collateralized debt write-downs—nearly twice what Merrill had said it would incur just weeks earlier. And while this was yet another bad week for financial companies, observers expect to see additional mortgage-related hits at other companies both this quarter and in subsequent periods. "I have a sneaking suspicion that write-downs will continue," says Jonathan Golub, the chief investment strategist at Bear Stearns.

Although shares of Countrywide soared after the announcement—investors took CEO Angelo Mozilo's word that the company's aggressive action has "laid the foundation for a return to profitability in the fourth quarter"—Merrill wasn't so fortunate. Its shares tumbled 3 percent the day of its release, amid downgrades of its bonds and analysts' expectations that more bad news may be ahead. "We currently assume Merrill Lynch will take an additional $4.5 billion of write-downs" in the fourth quarter, Goldman Sachs analyst William Tanona told clients. If that wasn't bad enough, the worse-than-expected earnings have turned up the heat on Merrill CEO Stan O'Neal, putting his job in jeopardy.

And there seems little chance the industry is going to catch a break from the beleaguered housing sector. The National Association of Realtors said last week that sales of existing homes fell 8 percent in September, extending what is now a three-year recession in residential housing. And while new-home sales in September were up an unexpected 4.8 percent from the previous month, no one was suggesting the pain was at an end. "The housing market is slowly healing itself," says economist Brian Wesbury of First Trust Advisors. "[But] the light at the end of the tunnel is still one to three years off." And we all know how cockroaches love the dark.