Merrill now in shorts' sights as Lehman crumbles

By Elinor Comlay

NEW YORK (Reuters) - The crisis of confidence in Lehman Brothers LEH.N has led to fallout throughout the financial sector -- especially for larger rival Merrill Lynch & Co Inc MER.N.

The problem for Merrill is that short-sellers regard it as the next weakest investment bank after the crumbling Lehman and the crumbled Bear Stearns, which was sold at a firesale price in March.

"People are saying, 'Who's next on the list?'" said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor in Cincinnati.

The result in the market was clear. Merrill Lynch shares lost about a third of their value this week, while peers Citigroup Co (C.N) and Morgan Stanley (MS.N) only lost 2 percent and 4 percent, respectively.

A Merrill Lynch spokesman declined to comment.

Like Lehman and Bear, Merrill has holdings of structured debt that are triggering write-downs and calling into question its overall capital position.

Merrill Lynch has been one of the hardest hit firms over the course of the year-old credit crisis, posting well over $40 billion in write-downs and credit losses and selling valuable assets to raise capital.

In the second quarter, Chief Executive John Thain sold the bank's prized 20 percent stake in news company Bloomberg LLP and arranged to sell a banking administrator company to balance out $9.4 billion in losses and write-downs.

Investors are bracing for more bad news in the third quarter, after Thain arranged to sell $30 billion in complex debt securities to a private equity firm in July, taking more than $5 billion in write-downs at the same time.

Merrill also provided financing to Dallas-based private equity firm Lone Star Funds and sold those securities at 22 cents on the dollar. While the Lone Star deal removed a large, toxic weight from Thain's shoulders, there are still problem assets on Merrill's books, according to analysts.

"There's concerns they still have commercial mortgage exposure and people feel that's worsening," said Albert Yu, portfolio manager and analyst at Clover Capital Management, which does not have a position in Merrill.

Looming large among investors' worries about Merrill are mortgage-backed securities and other structured debt held at two of its banking subsidiaries -- Merrill Lynch Bank USA and Merrill Lynch Bank & Trust Co.

In the second quarter, structured debt held by these subsidiaries was responsible for losses of $1.7 billion. That could worsen in the third quarter as sales of these securities has set a low market price.

One hedge fund manager who is short Merrill said he sees these banks, which hold loans and deposits made through Merrill's network of financial brokers, needing more capital, which will have to be provided by the parent.

"Merrill's in a box, but people don't realize it," he said.