‘Bloodbath’ or Overreaction? When it Comes to Subprime, The Jury is Still Out

A quick scan of the Wall Street Journal today offers a glimpse into what has become a pretty confusing market. Merrill Lynch reported earnings this morning that beat analyst estimates by roughly 11 percent, booking net income of $2.14 billion in the second quarter, up 31 percent from the year-ago period.

Merrill’s strong earnings came after it paid $1.3 billion at the beginning of the year to buy First Franklin Financial Corp. from National City Corp. just as the subprime mortgage market was beginning to spiral downward. Executives repeatedly have said subprime troubles haven’t spread to other parts of Merrill’s portfolio. “Merrill continues to prove it is quite diverse in light of chronic fears around subprime mortgages,” Wachovia Securities analyst Douglas Sipkin wrote in a note to clients Tuesday morning. “We struggle with what will convince investors of this. Bottom line is, in our view, its business is still robust and the stock is quite inexpensive based on its returns.”

The WSJ’s Scott Patterson, ahead of the earnings, said that Merrill — and other Wall Street investment banks like Lehman Brothers — might have been “unfairly” hit by investor concern over the subprime mortgage market:

The company says subprime-related revenue accounts for less than 2% of its overall revenue … Merrill’s big subprime risk is the one faced by the rest of us — that it might spread to the rest of the economy and cause a stock-market selloff. That isn’t expected. If it does happen, then investors will have a lot more to worry about than Merrill Lynch shares.

Keep in mind that other investment banks, like Morgan Stanley, have also reported strong increase in quarterly profits for the second quarter — booking a similar 40 percent gain in quarterly revenue. But the problem here is that the good news just doesn’t really feel like good news — it’s as if investors and Wall Street alike are waiting to see if (when?) the other shoe will drop. Certainly, trouble in the subprime mortgage market is far from running its course, as parts of the ABX hit a record low yesterday:

The riskiest, BBB-minus slice of the subprime derivative index, known as the ABX.HE 07-1, hit a record low of 45 cents in yesterday’s trade, according to Alex Pritchartt, a trader at UBS. The index, which stood at 49 cents late Friday, edged back up to 46 cents in heavy afternoon trade, but the mood in the market remained dour. “People are panicked,” Mr. Pritchartt said, noting that there was no specific news driving the declines.

The MarketBeat Blog at the WSJ called the freefall a bloodbath, which would certainly be at odds with the notion that everything else is fine in the financial markets — after all, somebody owns these securities. And that’s not all: the MarketBeat Blog also noted that ACA Capital Holdings — which is a CDO management firm — has taken a beating in recent weeks, falling 57 percent on subprime CDO concerns. And the drop comes in spite of what appears to be small direct exposure to the troubled securities in question, which would mean that either investors aren’t paying attention or that they’re expecting that ‘bloodbath’ that was mentioned above. So, if you’re ever confused about where all of this is headed — don’t worry. You’re far from alone.

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