Merrill sparks fears of soaring costs

Merrill Lynch's surprise write-down ratchets up pressure on rivals to cut the values of their own subprime assets as they grapple with mounting debts and economies weaken.

The global credit crisis, roughly a year under way, could cause total damage of around £500 billion to balance sheets of financial services companies. That's far above the more than €256 billion of write-downs taken so far.

Merrill's revelation of a €3.6 billion write-down and plans to sell €5.4 billion of stock heightened worry of more pain to come from European lenders UBS and Barclays, and from Wall Street and US commercial banks.

Citigroup, Bank of America Corp, Lehman Brothers Holdings and Wachovia, for example, each still have billions of dollars of exposure to complex debt, mortgages, or both.

About €2.8 billion of the Merrill write-down came from a sale of €19.6 billion of collateralised debt obligations - which are typically backed by mortgages - to private equity firm Lone Star Funds for €4.3 billion, or 22 cents on the dollar. Merrill had valued the CDOs at €7 billion just four weeks ago.

"It was a very aggressive markdown," said Chris Henson, a portfolio manager at MFC Global Investment Management in Toronto. "The question is, is that now the clearing price for anyone who has CDOs?"

"The current environment is not one where people are prepared to give the benefit of the doubt," said Gerry Rawcliffe, group credit officer for financial institutions at Fitch Ratings. "There's a broad loss of confidence in banks."

Merrill's sale may also offer insight into the value of rivals' so-called Level 2 and Level 3 assets. Banks value these based on prices of similar securities in the marketplace, or on their own models when there is no market for them.

It remains difficult for outsiders to assess the quality of assets on balance sheets. Some banks, such as Barclays, claim their assets are better-quality and more well-hedged. Citigroup said it ended June with €14 billion of subprime exposure. That included €11.6 billion of super-senior asset-backed securities CDOs (ABS CDOs), the kind of debt Merrill sold, including €9 billion of commercial paper.

Deutsche Bank Securities analyst Mike Mayo said Citigroup might face an €5.1 billion write-down on CDOs, as the bank has valued them at 53 cents on the dollar. Fox-Pitt Kelton analyst David Trone estimated a €2.5 billion write-down.

Citigroup spokeswoman Shannon Bell declined to comment. On July 18, Chief Financial Officer Gary Crittenden said: "There has not been a single American dollar cash flow loss against the asset-backed commercial paper ... I rush to add that that is not a forecast for the future."

According to Oppenheimer & Co analyst Meredith Whitney, Lehman ended May with about $600 million of gross ABS CDO exposure, and $29.4 billion of commercial mortgage exposure. Lehman spokesman Randy Whitestone declined to comment.

Falling asset values could also make lenders less able to lend or more skittish about extending credit.

"They become much more cautious," Citigroup strategist Hampden-Turner said. "If you are a homeowner, it is harder to refinance. If you are a company, you can't borrow money as before."