Wall Street continued to struggle with the aftermath of the mortgage market collapse on Friday, with a well-known analyst cutting Merrill Lynch & Co. (MER) to a sell rating over mortgage-led concerns, while battered Lehman Brothers Holdings Inc. (LEH) saw the latest rumors around the firm center on a possible creation of a 1980s-style “bad bank” to absorb nearly all commercial mortgage holdings. Goldman Sachs Group Inc. (GS) analyst William Tanona added Merrill to Goldman’s “conviction sell” list on Thursday, citing “exposure to troubled assets,” and lowered his share price estimate by 23 percent. Tanona is one of only two major analyst groups to sour on Merrill thus far; in late May, Ladenburg Thalmann downgraded Merrill to sell (a rating it still holds on the firm). Others, including Fox-Pitt and HSBC Securities, actualy upgraded Merrill to the equivalent of “neutral” ratings at the end of July, according to a review of available data by HousingWire. “Merrill currently trades at the highest price-to-book multiple in our large-cap brokerage universe, despite having some of the most significant exposures to troubled assets such as CDOs, mortgages and leveraged loans,” the Goldman report read in part, according to Bloomberg News. On July 29, Merrill said it had reached a deal to sell $30.6 billion in gross notational amount of ABS CDOs to an affiliate of Lone Star Funds; the deal was 75 percent financed by Merrill itself, however, leading to skepticism over whether the deal amounted to a true clearing of the balance sheet (including a heaping dose of it from HW, a sentiment that has since been tacked onto by other analysts). Despite ongoing mortgage-led troubles, Merrill has been beefing up its mortgage trading operations, poaching key senior execs from JP Morgan Chase & Co. (JPM) and Citigroup Inc. (C). Sources tell HW that Merrill is eying the RMBS and related securities markets on three distinct fronts: disposing of the distressed assets already on its balance sheet, trading in the expanding agency securities space, and possibly looking to trade in distressed RMBS/CDO/etc. paper once that high-yield market begins to move. Our sources suggest that Street expectations for trading in that “junk bond” space is likely to pick up in the middle of next year. Lehman brings 80s into fashion? Rumors are strong this morning, based on numerous published reports, that Lehman — facing its own mortgage-led problems — will look to officially resurrect a 1980’s-style trend of creating a “bad bank” to clear troubled assets off of its own balance sheet. HW first noted the rumors on Aug. 28, citing earlier coverage at Bloomberg News. Since then, more details have emerged about Lehman’s plan to take part of the playbook from Merrill — funding its own “bad bank,” which will hold as much as $32 billion of the firm’s commercial mortgage interests. Perhaps the most interesting part of the news is the idea that Lehman might actually call the bad bank Spinco. “What to do with bad assets when you have a good business to run? Elementary, put them in a big pile, wave the magic wand and make them into a bank,” editors at Dealmaker Daily noted Friday morning. “Then, give it a new, confidence-inspiring name like Spinco.” Bloomberg reported Friday morning that Lehman would contribute $8 billion in equity to Spinco, with the remaining $24 billion borrowed from outsiders or financed by Lehman itself. The report did not specify which investors might be interested in a Spinco stake, but did note that Lehman has been in discussions with Korea Development Bank to replace any capital it would place into the “bad bank.” KDB is rumored to be exploring a 25 percent interest in the Wall Street firm. Lehman is also rumored to be planning to lay off as many as 1,500 employees around its Q3 earnings report, in the latest effort to “right-size” its business as the credit crunch has frozen large chunks of the ABS/MBS market. Disclosure: The author held no positions in firms mentioned herein when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.