Forward-Looking Statements
This report on Form 10-Q, the documents that it incorporates by reference and
the documents into which it may be incorporated by reference may contain, and
from time to time Merrill Lynch & Co., Inc. ("ML & Co. and, together with its
subsidiaries, "Merrill Lynch," the "Company," "we," "our" or "us") and its
management may make certain statements that constitute forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. When used in this report, "we," "us" and "our" may refer to ML & Co.
individually, ML & Co. and its subsidiaries, or certain of ML & Co.'s
subsidiaries or affiliates. These statements can be identified by the fact that
they do not relate strictly to historical or current facts. Forward-looking
statements often use words such as "expects," "anticipates," "believes,"
"estimates," "targets," "intends," "plans," "goal" and other similar expressions
or future or conditional verbs such as "will," "may," "might," "should," "would"
and "could." The forward-looking statements made represent the current
expectations, plans or forecasts of Merrill Lynch regarding its future results
and revenues and future business and economic conditions more generally,
including statements concerning: the expectation that we would record a charge
to income tax expense of approximately $400 million if the income tax rate were
reduced to 22 percent by 2014 as suggested in United Kingdom ("U.K.") Treasury
announcements and assuming no change in the deferred tax asset balance; that the
Merrill Lynch international wealth management sale (the "International Sale") is
expected to close in stages starting in the first quarter of 2013; the estimates
of liability and range of possible loss for various representations and
warranties claims; the resolution of representations and warranties repurchase
and other claims; the belief that the representations and warranties liability
currently has provided for a substantial portion of Merrill Lynch's
representations and warranties exposures; the possibility that future
representations and warranties losses may occur in excess of the amounts
recorded for those exposures; the estimated range of possible loss for
representations and warranties exposure as of September 30, 2012 of up to $1.2
billion over existing accruals; the expectation that unresolved repurchase
claims will continue to increase; Merrill Lynch's expected response to
repurchase requests for which it concludes that a valid basis for repurchase
does not exist; liquidity; the revenue impact resulting from, and any mitigation
actions taken in response to, the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the "Financial Reform Act"), including the impact of new
regulation of the derivatives markets, requiring certain swap dealers to
register with the U.S. Commodity Futures Trading Commission; that it is our
objective to maintain high-quality credit ratings; the estimated range of
possible loss from and the impact on Merrill Lynch of various legal proceedings
discussed in Note 14 to the Condensed Consolidated Financial Statements; our
interest rate risk management strategies and models; our trading risk management
processes; and other matters relating to Merrill Lynch. The foregoing is not an
exclusive list of all forward-looking statements we make. These statements are
not guarantees of future results or performance and involve certain risks,
uncertainties and assumptions that are difficult to predict and often are beyond
our control. Actual outcomes and results may differ materially from those
expressed in, or implied by, any of these forward-looking statements.
You should not place undue reliance on any forward-looking statement and should
consider the following uncertainties and risks, as well as the risks and
uncertainties more fully discussed elsewhere in this report, under Item 1A.
"Risk Factors" in our Annual Report on Form 10-K for the year ended December 31,
2011, and in any of ML & Co.'s subsequent Securities and Exchange Commission
("SEC") filings: assets under management at the time of the International Sale;
the satisfaction of the closing conditions of the International Sale, including
regulatory approvals; Merrill Lynch's ability to resolve representations and
warranties claims made by private-label and other investors, including as a
result of any adverse court rulings, and the chance that Merrill Lynch could
face related securities, fraud, indemnity or other claims from one or more of
the private-label and other investors; if future representations and warranties
losses occur in excess of Merrill Lynch's recorded liability and estimated range
of possible loss for representations and warranties exposures; uncertainties
about the financial stability of several countries in the European Union (the
"EU"), the increasing risk that those countries may default on their sovereign
debt or exit the EU and related stresses on financial markets, the Euro and the
EU and Merrill Lynch's exposures to such risks, including direct, indirect and
operational; the negative impact of the Financial Reform Act on Merrill Lynch's
business and earnings, including as a result of additional regulatory
interpretation
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and rulemaking and the success of Merrill Lynch's actions to mitigate such
impacts; adverse changes to Merrill Lynch's credit ratings from the major credit
rating agencies; estimates of the fair value of certain of Merrill Lynch's
assets and liabilities; and unexpected claims, damages and fines resulting from
pending or future litigation and regulatory proceedings.
Forward-looking statements speak only as of the date they are made, and Merrill
Lynch undertakes no obligation to update any forward-looking statement to
reflect the impact of circumstances or events that arise after the date the
forward-looking statement was made.
The Notes to the Condensed Consolidated Financial Statements referred to in
Management's Discussion and Analysis of Financial Condition and Results of
Operations (the "MD&A") are incorporated by reference into MD&A. Certain
prior-period amounts have been reclassified in order to conform with the current
period presentation.
Introduction
Merrill Lynch was founded in 1914 and became a publicly traded company on
June 23, 1971. In 1973, the holding company ML & Co. was created. Through our
subsidiaries, we are one of the world's leading capital markets, advisory and
wealth management companies. We are a leading global trader and underwriter of
securities and derivatives across a broad range of asset classes, and we serve
as a strategic advisor to corporations, governments, institutions and
individuals worldwide.
Bank of America Acquisition
On January 1, 2009, Merrill Lynch was acquired by Bank of America Corporation
("Bank of America") through the merger of a wholly-owned subsidiary of Bank of
America with and into ML & Co. with ML & Co. continuing as the surviving
corporation and a wholly-owned subsidiary of Bank of America.
Business Segments
Pursuant to Accounting Standards Codification ("ASC") 280, Segment Reporting,
operating segments represent components of an enterprise for which separate
financial information is available that is regularly evaluated by the chief
operating decision maker in determining how to allocate resources and in
assessing performance. The business activities of Merrill Lynch are included
within certain of the operating segments of Bank of America. Detailed financial
information related to the operations of Merrill Lynch, however, is not provided
to Merrill Lynch's chief operating decision maker. As a result, Merrill Lynch
does not contain any identifiable operating segments under Segment Reporting,
and therefore the financial information of Merrill Lynch is presented as a
single segment.
Form 10-Q Presentation
As a result of the acquisition of Merrill Lynch by Bank of America, certain
information is not included in this Quarterly Report on Form 10-Q as permitted
by General Instruction H of Form 10-Q. We have also abbreviated the MD&A as
permitted by General Instruction H.
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EXECUTIVE OVERVIEW
We reported net losses of $1.2 billion and $2.0 billion for the three and nine
months ended September 30, 2012, respectively, compared with net earnings of
$133 million and a net loss of $903 million for the three and nine months ended
September 30, 2011, respectively. Revenues, net of interest expense ("net
revenues") for the three and nine months ended September 30, 2012 were $4.5
billion and $14.3 billion, respectively, compared with $5.9 billion and $20.6
billion for the three and nine months ended September 30, 2011, respectively.
Our pre-tax losses were $1.0 billion and $2.7 billion for the three and nine
months ended September 30, 2012, respectively, compared with pre-tax losses of
$390 million and $2.2 billion for the three and nine months ended September 30,
2011, respectively.
Our results for the three months ended September 30, 2012 included lower net
revenues, primarily driven by the valuation of certain of our liabilities as
compared with the prior year period. During the quarter ended September 30,
2012, we recorded net losses of $832 million due to the impact of the narrowing
of Merrill Lynch's credit spreads on the carrying value of certain of our
long-term debt liabilities, primarily structured notes, as compared with net
gains of $2.9 billion recorded in the three months ended September 30, 2011 from
such long-term debt liabilities due to the widening of our credit spreads. We
also recorded losses of $252 million in the quarter ended September 30, 2012 due
to net valuation adjustments associated with the consideration of our own
creditworthiness in the fair value of certain derivative liabilities (i.e., the
debit valuation adjustment or "DVA") as compared with gains from DVA of $765
million in the prior year period. Our results also reflected a less favorable
effective income tax rate in the quarter ended September 30, 2012 as compared
with the prior year period. These items were partially offset by higher revenues
from our fixed income trading activities, higher other revenues as compared with
the prior year as a result of a loss recorded in the quarter ended September 30,
2011 from the sale of a private equity investment, and lower non-interest
expenses.
Our results for the nine months ended September 30, 2012 also were impacted by
lower net revenues driven by the valuation of certain of our liabilities as
compared with the prior year period. During the nine months ended September 30,
2012, we recorded net losses of $3.0 billion due to the impact of the narrowing
of Merrill Lynch's credit spreads on the carrying value of certain of our
long-term debt liabilities, primarily structured notes, while in the nine months
ended September 30, 2011, we recorded net gains of $2.7 billion due to the
widening of our credit spreads. In addition, we recorded losses from DVA of $1.0
billion in the nine months ended September 30, 2012 as compared with gains from
DVA of approximately $650 million in the prior year period. Our results for the
nine months ended September 30, 2012 were also adversely affected by a less
favorable effective income tax rate, as well as by a decline in investment
banking and commissions revenues. These items were partially offset by higher
revenues from our fixed income trading activities, as well as a reduction in
non-interest expenses, which was driven by the provision for representations and
warranties related to our repurchase exposure on certain private-label
securitizations. In the nine months ended September 30, 2012, we reduced our
representations and warranties liability by $769 million, since recent levels of
claims and file requests with certain counterparties have been significantly
less than originally anticipated and, as a result, a portion of the loss was no
longer deemed probable. In the nine months ended September 30, 2011, we recorded
a $2.7 billion provision for representations and warranties exposures due to our
determination that we had sufficient experience related to our exposure on
certain private-label securitizations as a result of Bank of America's
settlement with the Bank of New York Mellon during that period. See "Off Balance
Sheet Exposures - Representations and Warranties" for further information.
Transactions with Bank of America
We have entered into various transactions with Bank of America, including
transactions in connection with certain sales and trading and financing
activities, as well as the allocation of certain shared services. Total net
revenues and non-interest expenses related to transactions with Bank of America
for the three months ended September 30, 2012 were $324 million and $471
million, respectively. Such net revenues and non-interest expenses for the nine
months ended September 30, 2012 were $821 million and $1,553 million,
respectively. Total net revenues and non-interest expenses related to
transactions with Bank of America for the three months ended September 30, 2011
were $288 million and $581 million, respectively. Such net revenues and
non-interest expenses for the nine months ended
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September 30, 2011 were $822 million and $1,926 million, respectively. Net
revenues and non-interest expenses for both periods included intercompany
service fee revenues and expenses from Bank of America associated with
allocations of certain centralized or shared business activities between Merrill
Lynch and Bank of America. See Note 2 to the Condensed Consolidated Financial
Statements for further information.
Other Events
U.K. Corporate Income Tax Rate Change
On July 17, 2012, the U.K. 2012 Finance Bill was enacted, which reduced the U.K.
corporate income tax rate by two percent to 23%. The first one percent reduction
was effective on April 1, 2012 and the second reduction will be effective April
1, 2013. These reductions favorably affect income tax expense on future U.K.
earnings, but also required us to remeasure our U.K. net deferred tax assets
using the lower tax rates. The income tax provision (benefit) for the three and
nine months ended September 30, 2012 included a charge of $781 million for the
remeasurement. If the U.K. corporate income tax rate is reduced to 22% by 2014
as suggested in U.K. Treasury announcements and assuming no change in the
deferred tax asset balance, we would record a charge to income tax expense for
approximately $400 million in the period of enactment.
Regulatory Matters
The Financial Reform Act provides for new Federal regulation of the derivatives
markets. As of October 12, 2012, swaps dealers conducting dealing activity with
U.S. persons above a certain threshold will be required to register with the
U.S. Commodity Futures Trading Commission ("CFTC") on or before December 31,
2012. Upon registration, swap dealers will become subject to additional CFTC
rules as and when such rules take effect. Those rules include, but are not
limited to, measures that require clearing and exchange trading of certain
derivatives, new capital and margin requirements for certain market
participants, new reporting requirements and new business conduct requirements
for derivatives under the jurisdiction of the CFTC. There remains some
uncertainty as to whether non-U.S. entities will be required to register as swap
dealers because the CFTC has not yet adopted final cross-border guidance. The
ultimate impact of these regulations, and the time it will take to comply,
continues to remain uncertain. The final regulations will impose additional
operational and compliance costs on us and may require us to restructure certain
businesses and negatively impact our revenues and results of operations.
Sale of International Wealth Management Businesses
In the quarter ended September 30, 2012, Bank of America entered into an
agreement to sell Merrill Lynch's international wealth management business based
outside of the U.S. with approximately $84 billion in client balances. The sale
is subject to regulatory approvals in multiple jurisdictions, with the first of
a series of closings expected in the first quarter of 2013.
Weather Events
In the last few days in October, the mid-Atlantic and northeast regions of the
U.S. experienced a major storm resulting in wide-spread flooding, power outages,
transportation and telecommunication service interruptions and other impacts
including, but not limited to, closures of the New York City based securities
exchanges. Certain services have been restored and others will require longer
periods of recovery time. Our operations in the affected areas have been
impacted. We are continuing to support the needs of our clients and customers
during this difficult time.
Subsequent Event
On November 1, 2012, in connection with an intragroup reorganization involving
Bank of America and a number of its subsidiaries, Merrill Lynch acquired two
affiliated companies and their respective subsidiaries from Bank of America. The
acquisition was financed through a capital contribution from Bank of America. In
accordance with
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ASC 805, Business Combinations, Merrill Lynch's consolidated financial
statements in periods subsequent to the acquisition will include the historical
results of the acquired entities as if the transaction had occurred on January
1, 2009, the date on which all the entities were first under the common control
of Bank of America. The assets and liabilities acquired in connection with the
transaction will be recorded at their historical carrying values.
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RESULTS OF OPERATIONS
(dollars in millions)
% Change % Change
between between
the the
Three Nine
Months Months
Ended Ended
Sept. 30, Sept. 30,
2012 and 2012 and
the Three the Nine
Months Months
For The Three Months For The Nine Months For The Three For The Nine Ended Ended
Ended September 30, Ended September 30, Months Ended Months Ended Sept. 30, Sept. 30,
2012 2012 September 30, 2011 September 30, 2011 2011 2011
Revenues
Principal transactions $ 193 $ 1,989 $ 2,781 $ 6,125 (93) (68)
Commissions 1,209 3,804 1,441 4,478 (16) (15)
Managed account and
other fee-based
revenues 1,349 4,035 1,354 3,976 - 1
Investment banking 1,262 3,519 1,016 4,162 24 (15)
Earnings from equity
method investments 21 149 70 328 (70) (55)
Intercompany service
fee revenue from Bank
of America 278 650 153 555 82 17
Other revenues(1) 243 1,265 (1,057 ) 1,733 N/M (27)
Subtotal 4,555 15,411 5,758 21,357 (21) (28)
Interest and dividend
revenues 1,694 4,379 2,314 6,220 (27) (30)
Less interest expense 1,732 5,495 2,202 6,945 (21) (21)
Net interest (expense)
income (38 ) (1,116 ) 112 (725 ) N/M 54
Revenues, net of
interest expense 4,517 14,295 5,870 20,632 (23) (31)
Non-interest expenses:
Compensation and
benefits 3,429 11,511 3,638 12,146 (6) (5)
Communications and
technology 351 1,180 432 1,338 (19) (12)
Occupancy and related
depreciation 300 901 385 1,056 (22) (15)
Brokerage, clearing,
and exchange fees 213 738 279 882 (24) (16)
Advertising and market
development 112 349 122 358 (8) (3)
Professional fees 220 641 266 718 (17) (11)
Office supplies and
postage 22 78 31 95 (29) (18)
Representations and
warranties 60 (769 ) 17 2,736 253 N/M
Intercompany service
fee expense from Bank
of America 356 1,288 561 1,793 (37) (28)
Other 445 1,068 529 1,742 (16) (39)
Total non-interest
expenses 5,508 16,985 6,260 22,864 (12) (26)
Pre-tax loss (991 ) (2,690 ) (390 ) (2,232 ) 154 21
Income tax provision
(benefit) 191 (735 ) (523 ) (1,329 ) N/M (45)
Net (loss) earnings $ (1,182 ) $ (1,955 ) $ 133 $ (903 ) N/M 117
(1) Amounts include other income and other-than-temporary impairment losses on
available-for-sale debt securities. The other-than-temporary impairment
losses were $0 million and $6 million for the three and nine months ended
September 30, 2012, respectively, and were $5 million and $49 million for the
three and nine months ended September 30, 2011.
N/M = Not meaningful.
Quarterly Consolidated Results of Operations
Our net loss for the quarter ended September 30, 2012 was $1.2 billion compared
with net earnings of $133 million for the quarter ended September 30, 2011. Net
revenues for the quarter ended September 30, 2012 were $4.5 billion compared
with $5.9 billion in 2011.
Quarter Ended September 30, 2012 Compared With Quarter Ended September 30, 2011
Principal transactions revenues include both realized and unrealized gains and
losses on trading assets and trading liabilities and investment securities
classified as trading. Principal transactions revenues were $193 million for the
quarter ended September 30, 2012 compared with $2.8 billion for the quarter
ended September 30, 2011. The
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decline included the impact of lower revenues associated with the valuation of
certain of our liabilities. In the quarter ended September 30, 2012, we recorded
net losses of $832 million due to the impact of the narrowing of Merrill Lynch's
credit spreads on the carrying value of certain of our long-term debt
liabilities, primarily structured notes, as compared with net gains of $2.9
billion recorded in the quarter ended September 30, 2011 from such long-term
debt liabilities due to the widening of our credit spreads. We also recorded
losses from DVA of $252 million in the quarter ended September 30, 2012 as
compared with gains from DVA of $765 million in the prior year period. These
decreases in principal transactions revenues were partially offset by higher
fixed income trading revenues as compared with the prior year period, primarily
in our mortgage and credit products businesses. Revenues from mortgage products
benefited from improved market conditions as compared with the prior year,
including narrowing credit spreads. Revenues from credit products also benefited
from improved market conditions, as the results for the quarter ended September
30, 2011 were adversely impacted by significant levels of volatility in the
credit markets and decreased client activity as a result of heightened concerns
over European sovereign debt that occurred during that period. Revenues from our
rates and currencies business also improved.
Net interest (expense) income is a function of (i) the level and mix of total
assets and liabilities, including trading assets, deposits, financing and
lending transactions, and trading strategies associated with our businesses, and
(ii) the prevailing level, term structure and volatility of interest rates. Net
interest (expense) income is an integral component of trading activity. In
assessing the profitability of our client facilitation and trading activities,
we view principal transactions and net interest (expense) income in the
aggregate as net trading revenues. Changes in the composition of trading
inventories and hedge positions can cause the mix of principal transactions and
net interest (expense) income to fluctuate from period to period. Net interest
expense was $38 million for the quarter ended September 30, 2012 compared with
net interest income of $112 million in the quarter ended September 30, 2011. The
fluctuation was primarily due to lower net interest revenues generated from our
trading activities, partially offset by lower financing costs. Lower net
interest revenues from our global wealth management business also contributed to
the decrease in net interest income.
Commissions revenues primarily arise from agency transactions in listed and
over-the-counter ("OTC") equity securities and commodities and options.
Commissions revenues also include distribution fees for promoting and
distributing mutual funds. Commissions revenues were $1.2 billion for the
quarter ended September 30, 2012, a decrease of 16% from the prior year. The
decline was primarily attributable to our global equity products business, and
included the impact of lower single-stock trading volumes in the U.S. and the
Europe, Middle East and Africa ("EMEA") region, which declined by 17% and 40%,
respectively, from the prior year period. Commissions revenues from our global
wealth management business also declined due to lower transaction volumes as
compared with the prior year period.
Managed account and other fee-based revenues primarily consist of asset-priced
portfolio service fees earned from the administration of separately managed and
other investment accounts for retail investors, annual account fees, and certain
other account-related fees. Managed account and other fee-based revenues were
$1.3 billion for the quarter ended September 30, 2012, a marginal decrease from
the prior year period.
Investment banking revenues include fees for the underwriting and distribution
of debt, equity and loan products, and fees for advisory services and tailored
risk management solutions. Total investment banking revenues were $1.3 billion
for the quarter ended September 30, 2012, an increase of 24% from the prior
year, primarily due to strong performance in capital markets underwriting
activity during the quarter. Underwriting revenues increased 38% to $1.0
billion, as higher fees from debt underwritings were partially offset by lower
equity underwriting fees. Equity underwriting fees in the quarter ended
September 30, 2011 included approximately $125 million of revenues from Bank of
America in connection with the sale of a portion of its interest in China
Construction Bank. Revenues from advisory services decreased 16% to $218
million.
Earnings from equity method investments include our pro rata share of income and
losses associated with investments accounted for under the equity method of
accounting. Earnings from equity method investments were $21 million for the
quarter ended September 30, 2012 compared with $70 million for the prior year
period. The decrease reflected lower revenues from certain equity method
investments. Refer to Note 8 to the Consolidated Financial Statements included
in our 2011 Annual Report on Form 10-K for further information on equity method
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investments.
Intercompany service fee revenues from Bank of America include revenues
associated with the provision of certain shared business activities with Bank of
America. Intercompany service fee revenues from Bank of America were $278
million in the quarter ended September 30, 2012 compared with $153 million in
the prior year period. The increase was driven by higher fees earned from Bank
of America in connection with certain shared brokerage and trading activities.
Other revenues include gains and losses on investment securities, including
certain available-for-sale securities, gains and losses on private equity
investments, and gains and losses on loans and other miscellaneous items. Other
revenues were $243 million in the quarter ended September 30, 2012 as compared
with a loss of $1.1 billion recorded in the quarter ended September 30, 2011.
The increase in other revenues as compared with the prior year was primarily
driven by a loss of approximately $975 million recorded in the quarter ended
September 30, 2011, which resulted from the sale of the majority of our stake in
a private equity investment.
Compensation and benefits expenses were $3.4 billion in the quarter ended
September 30, 2012, a decrease of 6% from the prior year period. The decrease
was primarily due to lower costs for salary and other employee compensation
costs. Amortization expense associated with stock-based compensation awards and
severance costs also declined.
Non-compensation expenses were $2.1 billion in the quarter ended September 30,
2012 compared with $2.6 billion in the prior year period. Communications and
technology expenses decreased 19% to $351 million due primarily to lower
technology equipment and systems consulting costs. Occupancy and related
depreciation expenses were $300 million, a decrease of 22%, reflecting lower
rental and other occupancy costs. Brokerage, clearing and exchange fees were
$213 million, a decrease of 24%, which reflected lower brokerage and other fees
due to lower transaction volumes. Professional fees were $220 million, a
decrease of 17%, primarily reflecting lower legal and consulting fees.
Intercompany service fee expenses from Bank of America were $356 million in the
quarter ended September 30, 2012 compared with $561 million in the prior year
period. The decrease reflected a lower level of allocated expenses from Bank of
America. Other expenses were $445 million, a decrease of 16% from the prior year
period. The decrease reflected lower litigation-related expenses as well as
certain other expenses, partially offset by lower expense in the prior year
associated with non-controlling interests of certain principal investments.
The income tax provision for the quarter ended September 30, 2012 was $191
million compared with an income tax benefit of $523 million for the quarter
ended September 30, 2011. The effective tax rate was (19.3%) for the quarter
ended September 30, 2012 compared with 134.1% in the prior year. The effective
tax rate for the quarter ended September 30, 2012 was primarily driven by the
impact of the U.K. corporate income tax rate reduction (see "Executive Overview
- U.K. Corporate Income Tax Rate Change"), partially offset by tax benefits
related to certain non-U.S. jurisdictions, including an increase in our
accumulated earnings presumed to be permanently reinvested in non-U.S.
subsidiaries. The effective tax rate for the quarter ended September 30, 2011
was driven by a $593 million benefit for capital loss deferred tax assets
recognized in connection with the liquidation of certain subsidiaries, a $255
million release of a valuation allowance provided for capital loss carryforward
tax benefits and by the recognition of $234 million of previously unrecognized
tax benefits associated with certain jurisdictions. These benefits were
partially offset by a charge of $774 million related to a 2% reduction to the
U.K. corporate income tax rate that was enacted in July 2011 and required us to
remeasure our U.K. net deferred tax assets using the lower tax rates.
Year-To-Date Consolidated Results of Operations
For the nine months ended September 30, 2012, our net loss was $2.0 billion
compared with a net loss of $903 million in the prior year period.
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Nine Months Ended September 30, 2012 Compared With Nine Months Ended September
30, 2011
Our net revenues for the nine months ended September 30, 2012 were $14.3 billion
compared with $20.6 billion for the nine months ended September 30, 2011. The
decrease primarily reflected lower principal transactions, commissions,
investment banking, and other revenues. Principal transactions revenues were
$2.0 billion for the nine months ended September 30, 2012 as compared with $6.1
billion in the prior year period. The decline was driven by higher losses
associated with the valuation of certain of our liabilities. In the nine months
ended September 30, 2012, we recorded net losses of $3.0 billion due to the
impact of the narrowing of Merrill Lynch's credit spreads on the carrying value
of certain of our long-term debt liabilities, primarily structured notes, as
compared with net gains of $2.7 billion recorded in the prior year period due to
the widening of our credit spreads. We also recorded losses from DVA of $1.0
billion in the nine months ended September 30, 2012 as compared with DVA gains
of approximately $650 million in the prior year period. In addition, as
discussed below, principal transactions revenues from proprietary trading
declined by $418 million due to the exit of our stand-alone proprietary trading
business as of June 30, 2011. These decreases in principal transactions revenues
were partially offset by higher revenues generated by our mortgage product
business, as the results for the nine months ended September 30, 2011 reflected
less favorable market conditions and included losses from credit valuation
adjustments related to financial guarantors. Revenues from our rates and
currencies and credit products businesses also increased. Commissions revenues
were $3.8 billion for the nine months ended September 30, 2012, a decrease of
15% from the prior year. The decline was primarily attributable to our global
equity products business due to lower trading volumes. Commissions revenues from
our global wealth management business also declined. Investment banking revenues
were $3.5 billion, a decrease of 15% from the prior year period, primarily
reflecting lower fees from equity underwritings and advisory services due to an
overall decline in global fee pools. Other revenues were $1.3 billion in the
nine months ended September 30, 2012 compared with $1.7 billion in the prior
year period. The decline included lower revenues from certain investment
securities. Other revenues for the nine months ended September 30, 2012 included
gains of $405 million resulting from the repurchase and retirement of certain of
our long-term borrowings and a gain of $145 million from the sale of an office
building. Other revenues for the nine months ended September 30, 2011 included a
gain of $377 million from the sale of our remaining investment in BlackRock,
Inc.
Included in principal transactions revenues for the nine months ended September
30, 2011 were net revenues associated with activities we identified as
"proprietary trading," which was conducted separately from our customer trading
activities. Our stand-alone proprietary trading operations engaged in trading
activities in a variety of products, including stocks, bonds, currencies and
commodities. In conjunction with regulatory reform measures and our initiative
to optimize our balance sheet, we exited our stand-alone proprietary trading
business as of June 30, 2011. The revenues from these operations for the nine
months ended September 30, 2011 were $442 million, of which $418 million were
included within principal transactions revenues. The remainder of the revenues
for these operations were primarily recorded within net interest revenues. See
also "MD&A - Executive Overview - Other Events - Financial Reform Act -
Limitations on Proprietary Trading" in our 2011 Annual Report on Form 10-K.
Compensation and benefits expenses were $11.5 billion for the nine months ended
September 30, 2012, a decrease of 5% from the prior year period. The decline
included lower salary and other compensation costs and lower amortization
expense associated with stock-based compensation awards, including lower expense
for retirement-eligible employees due to a decline in award grants. These
decreases in compensation and benefits expense were partially offset by higher
incentive-based compensation accruals, reflecting an increase in net revenues
(after giving effect to the changes in net revenues associated with the
valuation of our long-term debt and DVA).
Non-compensation expenses were $5.5 billion for the nine months ended September
30, 2012 compared with $10.7 billion in the prior year period. Non-compensation
expenses for the nine months ended September 30, 2012 included a $769 million
reduction of our liability for representations and warranties, while the prior
year period included a provision for representations and warranties of $2.7
billion. See "Off Balance Sheet Exposures - Representations and Warranties" for
further information. Excluding the impact of these items, non-compensation
expenses were $6.2 billion and $8.0 billion for the nine months ended September
30, 2012 and September 30, 2011,
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respectively. Communications and technology expenses decreased 12% to $1.2
billion due primarily to lower technology equipment costs. Occupancy and related
depreciation expenses were $901 million, a decrease of 15%, reflecting lower
rental and other occupancy costs. Brokerage, clearing and exchange fees were
$738 million, a decrease of 16%, which reflected lower brokerage and other fees
due to lower transaction volumes. Professional fees were $641 million, a
decrease of 11%, primarily reflecting lower legal and consulting fees.
Intercompany service fee expenses from Bank of America were $1.3 billion in the
nine months ended September 30, 2012 compared with $1.8 billion in the prior
year period. The decline reflected a lower level of allocated expenses from Bank
of America. Other expenses were $1.1 billion, a decrease of 39% from the prior
year period. The decrease reflected lower litigation-related expenses as well as
certain other expenses.
The income tax benefit was $735 million for the nine months ended September 30,
2012 compared with an income
tax benefit of $1.3 billion for the nine months ended September 30, 2011,
resulting in effective tax rates of 27.3% and 59.5%, respectively. The effective
tax rate for the nine months ended September 30, 2012 was primarily driven by
the same factors described in the three-month discussion above. The effective
tax rate for the nine months ended September 30, 2011 was also driven by the
same factors described in the three-month discussion above, partially offset by
the establishment of a valuation allowance for a portion of certain non-U.S.
deferred tax assets that was recorded in the second quarter of 2011.
OFF-BALANCE SHEET EXPOSURES
As a part of our normal operations, we enter into various off-balance sheet
arrangements that may require future payments. The table and discussion below
outline our significant off-balance sheet arrangements, as well as their future
expirations, as of September 30, 2012. Refer to Note 14 to the Condensed
Consolidated Financial Statements for further information.
(dollars in millions)
Expiration
Maximum Less than 1 - 3 3 - 5 Over 5
Payout 1 Year Years Years Years
Standby liquidity facilities $ 783 $ 764 $ - $ 3 $ 16
Residual value guarantees 320 206 114 - -
Standby letters of credit and
other guarantees 412 323 62 27 -
Standby Liquidity Facilities
We provide standby liquidity facilities primarily to certain unconsolidated
municipal bond securitization variable interest entities ("VIEs"). In these
arrangements, we are required to fund these standby liquidity facilities if
certain contingent events take place (e.g., a failed remarketing) and in certain
cases if the fair value of the assets held by the VIE declines below the stated
amount of the liquidity obligation. The potential exposure under the facilities
is mitigated by economic hedges and/or other contractual arrangements entered
into by Merrill Lynch. Refer to Note 9 to the Condensed Consolidated Financial
Statements for further information.
Residual Value Guarantees
At September 30, 2012, residual value guarantees of $320 million consist of
amounts associated with certain power plant facilities. Payments under these
guarantees would be required only if the fair value of such assets declined
below their guaranteed value.
Standby Letters of Credit
At September 30, 2012, we provided guarantees to certain counterparties in the
form of standby letters of credit in the amount of $0.4 billion.
Representations and Warranties
Background
In prior years, Merrill Lynch and certain of its subsidiaries, including First
Franklin Financial Corporation ("First Franklin"), sold pools of first-lien
residential mortgage loans and home equity loans as private-label
securitizations (in a limited number of these securitizations, monolines insured
all or some of the securities) or in the form of whole loans. Most of the loans
sold in the form of whole loans were subsequently pooled into private-label
securitizations sponsored by the third-party buyer of the whole loans. In
addition, Merrill Lynch and First Franklin securitized first-lien residential
mortgage loans generally in the form of mortgage-backed securities guaranteed by
the government sponsored enterprises (the "GSEs"). In connection with these
transactions, we made various representations and warranties. Breaches of these
representations and warranties may result in the requirement to repurchase
mortgage loans or to otherwise make whole or provide other remedies to the GSEs,
whole-loan investors, securitization trusts or monoline insurers (collectively,
"repurchases"). In all such cases, Merrill Lynch would be exposed to any credit
loss on the repurchased mortgage loans after accounting for any mortgage
insurance or mortgage guarantee payments that it may receive.
Subject to the requirements and limitations of the applicable sales and
securitization agreements, these representations and warranties can be enforced
by the GSEs, the whole-loan investors, the securitization trustees, or others as
governed by the applicable agreement or, in a limited number of first-lien and
home equity securitizations where monoline insurers have insured all or some of
the securities issued, by the monoline insurer. In the case of loans sold to
parties other than the GSEs, the contractual liability to repurchase typically
arises only if there is a breach of the representations and warranties that
materially and adversely affects the interest of the investor or investors in
the loan or of the monoline insurer (as applicable). Contracts with the GSEs do
not contain equivalent language.
For additional information about accounting for representations and warranties
and our representations and warranties claims and exposures, see Note 14 to the
Condensed Consolidated Financial Statements and Item 1A. "Risk Factors" in
Merrill Lynch's 2011 Annual Report on Form 10-K.
We have vigorously contested any request for repurchase when we conclude that a
valid basis for repurchase does not exist and will continue to do so in the
future. We may reach settlements in the future if opportunities arise on terms
we believe to be advantageous.
Recent Developments Related to the Bank of America BNY Mellon Settlement
As a result of Bank of America's settlement (the "BNY Mellon Settlement") with
the Bank of New York Mellon, as trustee (the "Trustee") in the second quarter of
2011, Merrill Lynch determined that it had sufficient experience to record a
liability of $2.7 billion in that period related to its exposure on certain
private-label securitizations. Recent levels of claims and file requests with
certain counterparties have been significantly less than originally anticipated,
and as a result the liability for representations and warranties was reduced by
$769 million in the nine months ended September 30, 2012 as a portion of the
loss was no longer deemed probable.
The BNY Mellon Settlement is subject to final court approval and certain other
conditions. Under an order entered by the state court in connection with the BNY
Mellon Settlement, potentially interested persons had the opportunity to give
notice of intent to object to the settlement (including on the basis that more
information was needed) until August 30, 2011. Approximately 44 groups or
entities appeared prior to the deadline; seven of those groups or entities have
subsequently withdrawn from the proceeding and one motion to intervene was
denied. Certain of these groups or entities filed notices of intent to object,
made motions to intervene, or both filed notices of intent to object and made
motions to intervene. The parties filing motions to intervene include the
Attorneys General of the states of New York and Delaware; the Attorneys
General's motions were granted on June 6, 2012.
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Certain of the motions to intervene and/or notices of intent to object allege
various purported bases for opposition to the settlement. These include
challenges to the nature of the court proceeding and the lack of an opt-out
mechanism, alleged conflicts of interest on the part of the institutional
investor group and/or the Trustee, the inadequacy of the settlement amount and
the method of allocating the settlement amount among the 525 legacy Countrywide
first-lien and five second-lien non-GSE securitization trusts, while other
motions do not make substantive objections but state that they need more
information about the settlement. Parties who filed notices stating that they
wished to obtain more information about the settlement include the Federal
Deposit Insurance Corporation and the Federal Housing Finance Agency.
An investor opposed to the settlement removed the proceeding to federal district
court, and the federal district court denied the Trustee's motion to remand the
proceeding to state court. On February 27, 2012, the U.S. Court of Appeals
issued an opinion reversing the district court denial of the Trustee's motion to
remand the proceeding to state court and ordered that the proceeding be remanded
to state court. On April 24, 2012, a hearing was held on threshold issues, at
which the court denied the objectors' motion to convert the proceeding to a
plenary proceeding. Several status hearings on discovery and other case
administration matters have taken place. On August 10, 2012, the court issued an
order setting a schedule for discovery and other proceedings, and set May 2,
2013 as the date for the final court hearing on the settlement to begin. Bank of
America and Merrill Lynch are not parties to the proceeding.
It is not currently possible to predict how many of the parties who have
appeared in the court proceeding will ultimately object to the BNY Mellon
Settlement, whether the objections will prevent receipt of final court approval
or the ultimate outcome of the court approval process, which can include appeals
and could take a substantial period of time. In particular, conduct of discovery
and the resolution of the objections to the settlement and any appeals could
take a substantial period of time and these factors could materially delay the
timing of final court approval. Accordingly, it is not possible to predict when
the court approval process will be completed.
Unresolved Repurchase Claims
Unresolved representations and warranties repurchase claims represent the
notional amount of repurchase claims made by counterparties, typically the
outstanding principal balance or the unpaid principal balance at the time of
default. In the case of first-lien mortgages, this amount is significantly
greater than the expected loss amount due to the benefit of collateral and, in
some cases, mortgage insurance or mortgage guarantee payments. Claims received
from a counterparty remain outstanding until the underlying loan is repurchased,
the claim is rescinded by the counterparty, or the claim is otherwise resolved.
The notional amount of unresolved claims from private-label securitization
trustees, whole-loan investors and others increased to $4.3 billion at
September 30, 2012 compared with $1.1 billion at December 31, 2011. The increase
in the notional amount of unresolved claims is primarily due to increases in
submissions of claims by private-label securitization trustees, claim quality
and the lack of an established process to resolve disputes related to these
claims. We anticipated an increase in aggregate non-GSE claims at the time of
the BNY Mellon Settlement in June 2011, and such increase in aggregate non-GSE
claims was taken into consideration in developing the increase in our
representations and warranties liability at that time. Although recent claims
activity has been lower than anticipated, we expect unresolved repurchase claims
related to private-label securitizations to continue to increase as claims
continue to be submitted by private-label securitization trustees, and there is
not an established process for the ultimate resolution of claims on which there
is a disagreement. The documents governing private-label securitizations require
repurchase claimants to show that a breach of representations and warranties had
a material adverse impact on the claimant. We believe this to mean that the
claimant is required to prove that the breach caused a loss to investors in the
trust (or in certain cases, to the monoline insurer or other financial
guarantor). We also believe that many of the defaults observed in private-label
securitizations have been, and continue to be, driven by external factors, such
as the substantial depreciation in home prices, persistently high unemployment
and other negative economic trends, diminishing the likelihood that breaches of
representation and warranties, where present, caused a loss.
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The table below presents unresolved representations and warranties claims by
counterparty at September 30, 2012 and December 31, 2011. The unresolved
repurchase claims include only claims where we believe that the counterparty has
a basis to submit claims. During the three and nine months ended September 30,
2012, we received $0.8 billion and $3.3 billion of new repurchase claims
primarily from private-label securitization trustees.
Unresolved Repurchase Claims by Counterparty
(dollars in millions)
September 30, 2012 December 31, 2011
GSEs $ 74 $ 65
Monoline 147 136
Whole-loan investors, private-label
securitization trustees and other 4,344 1,101
Total $ 4,565 $ 1,302
At September 30, 2012, the notional amount of unresolved repurchase claims was
$4,565 million. We have performed an initial review with respect to $4,500
million of these claims and do not believe a valid basis for repurchase has been
established by the claimant. We are still in the process of reviewing the
remaining $65 million of these claims. When a claim has been denied and there
has not been communication with the counterparty for six months, Merrill Lynch
views these claims as inactive; however, they remain in the unresolved
repurchase claims balance until resolution.
In addition to the claims above, during the first quarter of 2012, we received
$1.4 billion in repurchase demands from a master servicer where we believe the
claimant has not satisfied the contractual thresholds to direct the
securitization trustee to take action and/or that these demands are otherwise
procedurally or substantively invalid. We do not believe the $1.4 billion in
demands received are valid repurchase claims, and therefore it is not possible
to predict the resolution with respect to such demands.
Cash Settlements
As presented in the table below, during the three and nine months ended
September 30, 2012, Merrill Lynch paid $19 million and $48 million to resolve
$22 million and $53 million of repurchase claims through repurchase or
reimbursement to investors or securitization trusts for losses they incurred,
resulting in a loss on the related loans at the time of repurchase or
reimbursement of $16 million and $39 million. During the three and nine months
ended September 30, 2011, Merrill Lynch paid $16 million and $41 million to
resolve $26 million and $51 million of repurchase claims through repurchase or
reimbursement to investors or securitization trusts for losses they incurred,
resulting in a loss on the related loans at the time of repurchase or
reimbursement of $11 million and $36 million. Cash paid for loan repurchases
includes the unpaid principal balance of the loan plus past due interest. The
amount of loss for loan repurchases is reduced by the fair value of the
underlying loan collateral. The repurchase of loans and indemnification payments
related to repurchase claims generally resulted from material breaches of
representations and warranties related to the loans' material compliance with
the applicable underwriting standards, including borrower misrepresentation,
credit exceptions without sufficient compensating factors and non-compliance
with underwriting procedures. The actual representations and warranties made in
a sales transaction and the resulting repurchase and indemnification activity
can vary by transaction or investor. A direct relationship between the type of
defect that causes the breach of representations and warranties and the severity
of the realized loss has not been observed.
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dollars in millions
2012 2011
Three Months Three Months
Ended September Nine Months Ended EndedSeptember Nine Months Ended
30 September 30 30 September 30
Claims resolved (1) $ 22 $ 53 $ 26 $ 51
Repurchases $ 4 $ 11 $ 6 $ 6
Indemnification payments 15 37 10 35
Total $ 19 $ 48 $ 16 $ 41
(1) Represents unpaid principal balance.
Liability for Representations and Warranties
The liability for representations and warranties is included in Interest and
other payables on the Condensed Consolidated Balance Sheets, and the related
provision is included in Non-interest expenses on the Condensed Consolidated
Statements of (Loss) Earnings.
Our estimates of the liability for representations and warranties exposures and
the corresponding range of possible loss are based on currently available
information, significant judgment, and a number of other factors, which are
subject to change. Changes to any one of these factors could significantly
impact the estimate of the liability and could have a material adverse impact on
our results of operations for any particular period. For additional information,
see Note 14 to the Condensed Consolidated Financial Statements.
The liability for representations and warranties exposures and the corresponding
estimated range of possible loss for these representations and warranties
exposures do not consider any losses related to litigation matters disclosed in
Note 14 to the Condensed Consolidated Financial Statements or in Note 14 to the
Consolidated Financial Statements included in our 2011 Annual Report on Form
10-K, nor do they include any potential securities law or fraud claims or
potential indemnity or other claims against us. We are not able to reasonably
estimate the amount of any possible loss with respect to any such securities law
(except to the extent reflected in the aggregate range of possible loss for
litigation and regulatory matters disclosed in Note 14 to the Condensed
Consolidated Financial Statements), fraud or other claims against us; however,
such loss could be material.
At September 30, 2012 and December 31, 2011, the liability for representations
and warranties was $2.0 billion and $2.8 billion. As a result of the BNY Mellon
Settlement in the second quarter of 2011, we determined that we had sufficient
experience to record a liability of $2.7 billion in that period related to our
exposure on certain private-label securitizations. Recent levels of claims and
file requests with certain counterparties have been significantly less than
originally anticipated and, as a result, the liability for representations and
warranties was reduced by $769 million in the nine months ended September 30,
2012, as a portion of the loss was no longer deemed probable.
Estimated Range of Possible Loss
Our estimated liability at September 30, 2012 for obligations under
representations and warranties is necessarily dependent on, and limited by, a
number of factors, including the implied repurchase experience based on the BNY
Mellon settlement, as well as certain other assumptions and judgmental factors.
Accordingly, future provisions associated with obligations under representations
and warranties and/or the corresponding ranges of possible loss may be
materially impacted if actual experiences are different from our historical
experience or our understandings, interpretations or assumptions.
We believe that our representations and warranties liability recorded as of
September 30, 2012 provides for a substantial portion of our representations and
warranties exposures. However, it is reasonably possible that future
representations and warranties losses may occur in excess of the amounts
recorded for these exposures. In addition,
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we have not recorded any representations and warranties liability for certain
private-label securitizations sponsored by whole-loan investors. We currently
estimate that the range of possible loss for all representations and warranties
exposures could be up to $1.2 billion over accruals at September 30, 2012, an
increase of $0.7 billion from December 31, 2011. The increase in the range of
possible loss was primarily attributable to the reduction in our liability for
representations and warranties exposures discussed above. This estimated range
of possible loss related to representations and warranties exposures does not
represent a probable loss and is based on currently available information,
significant judgment, and a number of assumptions, including those set forth
below, that are subject to change. For additional information about the
methodology used to estimate the representations and warranties liability and
the corresponding range of possible loss, see Note 14 to the Condensed
Consolidated Financial Statements.
Future provisions and/or ranges of possible loss for representations and
warranties exposures may be significantly impacted if actual experiences are
different from our assumptions in our predictive models, including, without
limitation, those regarding the ultimate resolution of the BNY Mellon
Settlement, estimated repurchase rates, economic conditions, estimated home
prices, consumer and counterparty behavior, and a variety of other judgmental
factors. Adverse developments with respect to one or more of the assumptions
underlying the liability for representations and warranties and the
corresponding estimated range of possible loss could result in significant
increases to future provisions and/or this estimated range of possible loss. For
example, if courts, in the context of claims brought by private-label
securitization trustees, were to disagree with our interpretation that the
underlying agreements require a claimant to prove that the representations and
warranties breach was the cause of the loss, it could significantly impact the
estimated range of possible loss.
Additionally, if court rulings related to monoline litigation, including one
related to an affiliate of ours, that have allowed sampling of loan files
instead of requiring a loan-by-loan review to determine if a representations and
warranties breach has occurred are followed generally by the courts,
private-label securitization counterparties may view litigation as a more
attractive alternative as compared to a loan-by-loan review. Finally, although
we believe that the representations and warranties typically given in non-GSE
transactions are less rigorous and actionable than those given in GSE
transactions, we do not have significant experience resolving loan-level claims
in non-GSE transactions to measure the impact of these differences on the
probability that a loan will be required to be repurchased.
Experience with Non-GSE Investors
As presented in the table below, Merrill Lynch, including First Franklin, sold
loans originated from 2004 to 2008 (primarily subprime and alt-A) with an
original principal balance of $132 billion to investors other than the GSEs
(although the GSEs are investors in certain private-label securitizations), of
which approximately $65 billion in principal has been paid off and $45 billion
has defaulted or is severely delinquent (i.e., 180 days or more past due) at
September 30, 2012.
As it relates to private-label securitizations, a contractual liability to
repurchase mortgage loans generally arises only if counterparties prove there is
a breach of the representations and warranties that materially and adversely
affects the interest of the investor or all investors in a securitization trust
or of the monoline insurer (as applicable). We believe that the longer a loan
performs, the less likely it is that an alleged representations and warranties
breach had a material impact on the loan's performance or that a breach even
exists. Because the majority of the borrowers in this population would have made
a significant number of payments if they are not yet 180 days or more past due,
we believe that the principal balance at the greatest risk for repurchase claims
in this population of private-label securitization investors is a combination of
loans that already have defaulted and those that are currently severely
delinquent. Additionally, the obligation to repurchase loans also requires that
counterparties have the contractual right to demand repurchase of the loans
(presentation thresholds). Private-label securitization investors generally do
not have the contractual right to demand repurchase of loans directly or the
right to access loan files.
While we believe the agreements for private-label securitizations generally
contain less rigorous representations and warranties and place higher burdens on
investors seeking repurchases than the explicit provisions of the comparable
agreements with the GSEs, without regard to any variations that may have arisen
as a result of dealings with the
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GSEs, the agreements generally include a representation that underwriting
practices were prudent and customary.
The following table details the population of loans originated between 2004 and
2008 and the population of loans sold as whole loans or in non-GSE private-label
securitizations by entity together with the defaulted and severely delinquent
loans stratified by the number of payments the borrower made prior to default or
becoming severely delinquent at September 30, 2012. In connection with these
transactions, we provided representations and warranties, and the whole-loan
investors may retain those rights even when the whole loans were aggregated with
other collateral into private-label securitizations sponsored by the whole-loan
investors. At least 25 payments have been made on approximately 60% of the
defaulted and severely delinquent loans. In the current year, we have received
approximately $3.2 billion of representations and warranties claims from
private-label securitization trustees related to these vintages, and
approximately $12.9 million from whole-loan investors related to these vintages.
We believe that many of the defaults observed in these securitizations have
been, and continue to be, driven by external factors, such as the substantial
depreciation in home prices, persistently high unemployment and other negative
economic trends, diminishing the likelihood that any loan defect (assuming one
exists at all) was the cause of a loan's default. As of September 30, 2012,
approximately 34% of the loans sold to non-GSE counterparties that were
originated between 2004 and 2008 have defaulted or are severely delinquent.
(dollars in
billions)
Principal Balance Principal at Risk
Outstanding Outstanding Borrower Borrower
Original Principal Principal Defaulted Defaulted Made Less Borrower Borrower Made More
Principal Balance Balance Principal or Severely than 13 Made 13 to Made 25 to Than 36
Entity Balance September 30, 2012 Over 180 Days Balance Delinquent Payments 24 Payments 36 Payments Payments
Merrill Lynch
(excluding
First
Franklin) $ 50 $ 14 $ 4 $ 13 $ 17 $ 3 $ 4 $ 3 $ 7
First
Franklin 82 18 6 22 28 5 6 4 13
Total (1) $ 132 $ 32 $ 10 $ 35 $ 45 $ 8 $ 10 $ 7 $ 20
(1) Excludes transactions sponsored by Merrill Lynch where no representations or
warranties were made.
Legal Matters
Merrill Lynch has been named as a defendant in various legal actions, including
arbitrations, class actions, and other litigation arising in connection with its
activities as a global diversified financial services institution. Refer to
Note 14 to the Condensed Consolidated Financial Statements for further
information, including the estimated aggregate range of possible loss.
Derivatives
We record all derivative transactions at fair value on our Condensed
Consolidated Balance Sheets. We do not monitor our exposure to derivatives based
on the notional amount because that amount is not a relevant indicator of our
risk to these contracts, as it is generally not indicative of the amount that we
would owe on the contract. Instead, a risk framework is used to define risk
tolerances and establish limits to help to ensure that certain risk-related
losses occur within acceptable, predefined limits. Derivatives that meet the
accounting definition of a guarantee and credit derivatives are included in
Note 6 to the Condensed Consolidated Financial Statements.
Involvement with VIEs
We transact with VIEs in a variety of capacities, including those that we help
establish as well as those initially established by third parties. We utilize
VIEs in the ordinary course of business to support our own and our customers'
financing and investing needs. Merrill Lynch securitizes loans and debt
securities using VIEs as a source of funding and a means of transferring the
economic risk of the loans or debt securities to third parties. We also
administer, structure or invest in or enter into derivatives with other VIEs,
including multi-seller conduits,
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municipal bond trusts, collateralized debt obligations ("CDOs") and other
entities. Our involvement with VIEs can vary and we are required to continuously
reassess prior consolidation and disclosure conclusions (refer to Note 9 to the
Condensed Consolidated Financial Statements). Refer to Note 1 to the Condensed
Consolidated Financial Statements for a discussion of our consolidation
accounting policy.
Contractual Obligations
We have contractual obligations to make future payments of debt, lease and other
agreements. Additionally, in the normal course of business, we enter into
contractual arrangements whereby we commit to future purchases of products or
services from unaffiliated parties. Other obligations include our contractual
funding obligations related to our employee benefit plans. See Notes 12, 14 and
15 to the Condensed Consolidated Financial Statements.
In the normal course of business, we periodically guarantee the obligations of
affiliates in a variety of transactions including International Swaps and
Derivatives Association, Inc. ("ISDA") -related and non ISDA-related
transactions such as trading, repurchase agreements, prime brokerage agreements
and other transactions. We have also entered into an agreement with a non-U.S.
regulator that could allow it, in its capacity as regulator, to request payments
from us to support obligations to clients of the regulated non-U.S. branch. We
believe the likelihood of payment under the terms of this agreement to be
remote.
FUNDING AND LIQUIDITY
Funding
We fund our assets primarily with a mix of secured and unsecured liabilities
through a globally coordinated funding strategy with Bank of America. We fund a
portion of our trading assets with secured liabilities, including repurchase
agreements, securities loaned and other short-term secured borrowings, which are
less sensitive to our credit ratings due to the underlying collateral. Refer to
Note 12 to the Condensed Consolidated Financial Statements for additional
information regarding our borrowings.
Beginning late in the third quarter of 2009, in connection with the update or
renewal of certain Merrill Lynch international securities offering programs,
Bank of America agreed to guarantee debt securities, warrants and/or
certificates issued by certain subsidiaries of ML & Co. on a going forward
basis. All existing ML & Co. guarantees of securities issued by those same
Merrill Lynch subsidiaries under various international securities offering
programs will remain in full force and effect as long as those securities are
outstanding, and Bank of America has not assumed any of those prior ML & Co.
guarantees or otherwise guaranteed such securities. There were approximately
$6.6 billion of securities guaranteed by Bank of America at September 30, 2012.
In addition, Bank of America has guaranteed the performance of Merrill Lynch on
certain derivative transactions. The aggregate amount of such derivative
liabilities was approximately $1.3 billion at September 30, 2012.
Following the completion of Bank of America's acquisition of Merrill Lynch, ML &
Co. became a subsidiary of Bank of America and established intercompany lending
and borrowing arrangements to facilitate centralized liquidity management.
Included in these intercompany agreements is a $75 billion one-year revolving
unsecured line of credit that allows ML & Co. to borrow funds from Bank of
America at a spread to the London Interbank Offered Rate ("LIBOR") that is reset
periodically and is consistent with other intercompany agreements. This credit
line was renewed effective January 1, 2012 with a maturity date of January 1,
2013. The credit line will automatically be extended by one year to the
succeeding January 1st unless Bank of America provides written notice not to
extend at least 45 days prior to the maturity date. The agreement does not
contain any financial or other covenants. There were no outstanding borrowings
against the line of credit at September 30, 2012.
In addition to the $75 billion unsecured line of credit, there is also a
revolving unsecured line of credit that allows ML & Co. to borrow up to $25
billion from Bank of America. Interest on borrowings under the line of credit is
based on prevailing short-term market rates. The line of credit does not contain
any financial or other covenants. The line of credit matures on February 12,
2013. At September 30, 2012, there was approximately $4.1 billion
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outstanding under the line of credit.
Merrill Lynch Pierce Fenner & Smith Incorporated ("MLPF&S") also has the
following borrowing agreements with Bank of America:
• A $4 billion one-year revolving unsecured line of credit - Interest on the
line of credit is based on prevailing short-term market rates. The credit
line matures on November 1, 2013 and may automatically be extended by one
year to the succeeding November 1st unless Bank of America provides written
notice not to extend at least 45 days prior to the maturity date. At
September 30, 2012, there were no outstanding borrowings under the line of
credit.
• A $15 billion 364-day revolving unsecured line of credit - Interest on the
line of credit is based on prevailing short-term market rates. The line of
credit matures on February 19, 2013. At September 30, 2012, approximately
$0.9 billion was outstanding under the line of credit.
During the quarter ended June 30, 2012, $2.6 billion that was outstanding under
the following MLPF&S borrowing agreements with Bank of America was repaid and
the agreements were terminated. The terminated agreements were replaced by
intercompany funding arrangements between MLPF&S and ML & Co.
• A subordinated loan agreement for approximately $1.5 billion - Interest
under this agreement was calculated based on a spread to LIBOR.
• A $7.0 billion revolving subordinated line of credit - Interest under this
agreement was calculated based on a spread to LIBOR.
Bank of America and Merrill Lynch have entered into certain intercompany lending
and borrowing arrangements to facilitate centralized liquidity management.
Included in these arrangements is a $50 billion extendible one-year revolving
credit facility that allows Bank of America to borrow funds from Merrill Lynch
at a spread to LIBOR that is reset periodically and is consistent with other
intercompany agreements. The credit facility matures on January 1, 2013 and will
automatically be extended by one year to the succeeding January 1st unless
Merrill Lynch provides written notice not to extend at least 45 days prior to
the maturity date. There were no amounts outstanding at both September 30, 2012
and December 31, 2011 under this credit facility. There is also a short-term
revolving credit facility that allows Bank of America to borrow up to an
additional $25 billion. Interest on borrowings under the credit facility is
based on prevailing short-term market rates. The line of credit matures on
February 12, 2013. At September 30, 2012, there were no amounts outstanding
under this credit facility.
Credit Ratings
Our borrowing costs and ability to raise funds are impacted by our credit
ratings. In addition, credit ratings may be important to customers or
counterparties when we compete in certain markets and when we seek to engage in
certain transactions, including OTC derivatives. Thus, it is our objective to
maintain high-quality credit ratings.
Credit ratings and outlooks are opinions on our creditworthiness and that of our
obligations or securities, including long-term debt, short-term borrowings and
other securities, including asset securitizations. Following the acquisition of
Merrill Lynch by Bank of America, the major credit rating agencies have
indicated that the major drivers of Merrill Lynch's credit ratings are Bank of
America's credit ratings. Bank of America's credit ratings are subject to
ongoing review by the rating agencies, which consider a number of factors,
including Bank of America's financial strength, performance, prospects and
operations as well as factors not under Bank of America's control. The rating
agencies could make adjustments to our ratings at any time and they provide no
assurances that they will maintain our ratings at current levels.
Other factors that influence Bank of America's and our credit ratings include
changes to the rating agencies' methodologies for our industry or certain
security types, the rating agencies' assessment of the general operating
environment for financial services companies, our mortgage exposures, our
relative positions in the markets in
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which we compete, reputation, liquidity position, diversity of funding sources,
funding costs, the level and volatility of earnings, corporate governance and
risk management policies, capital position, capital management practices, and
current or future regulatory and legislative initiatives.
On October 10, 2012, Fitch Ratings ("Fitch") announced the results of its
periodic review of its ratings for 12 large, complex, securities trading and
universal banks, including Bank of America. As part of this action, Fitch
affirmed Bank of America's and ML & Co.'s credit ratings. On June 21, 2012,
Moody's Investors Service, Inc. ("Moody's") completed its previously-announced
review for possible downgrade of financial institutions with global capital
markets operations, downgrading the ratings of 15 banks and securities firms,
including the ratings of Bank of America and ML & Co. Bank of America's and ML &
Co.'s long-term debt credit ratings were downgraded one notch as part of this
action. The Moody's downgrade has not had a material impact on our financial
condition, results of operations or liquidity. Each of the three major rating
agencies, Moody's, Standard & Poor's Ratings Services ("S&P") and Fitch,
downgraded the ratings of Bank of America and ML & Co. in late 2011.
Currently, Bank of America's and ML & Co.'s long-term/short-term senior debt
ratings and outlooks expressed by the rating agencies are as follows: Baa2/P-2
(negative) by Moody's; A-/A-2 (negative) by S&P; and A/F1 (stable) by Fitch.
MLPF&S's long-term/short-term senior debt ratings and outlooks are A/A-1
(negative) by S&P and A/F1 (stable) by Fitch. Merrill Lynch International, a
U.K.-based registered investment firm and subsidiary of ML & Co., has a
long-term/short-term senior debt rating and outlook of A/A-1 (negative) by S&P.
Merrill Lynch International Bank Limited, an Ireland-based bank subsidiary of ML
& Co., has a long-term/short-term senior debt rating and outlook of A/F1
(stable) by Fitch.
The major rating agencies have each indicated that, as a systemically important
financial institution, Bank of America's (and consequently ML & Co.'s) credit
ratings currently reflect their expectation that, if necessary, Bank of America
would receive significant support from the U.S. government, and that they will
continue to assess such support in the context of sovereign financial strength
and regulatory and legislative developments.
A further reduction in certain of our credit ratings may have a material adverse
effect on our liquidity, potential loss of access to credit markets, the related
cost of funds, our businesses and on certain trading revenues, particularly in
those businesses where counterparty creditworthiness is critical. In addition,
under the terms of certain OTC derivative contracts and other trading
agreements, the counterparties to those agreements may require us to provide
additional collateral, or to terminate these contracts or agreements, which
could cause us to sustain losses and/or adversely impact our liquidity. If Bank
of America's or ML & Co.'s short-term credit ratings, or those of our bank or
broker-dealer subsidiaries, were downgraded by one or more levels, the potential
loss of access to short-term funding sources, such as repurchase agreement
financing, and the effect on our incremental cost of funds could be material.
At September 30, 2012, if the rating agencies had downgraded their long-term
senior debt ratings for ML & Co. or certain subsidiaries by one incremental
notch, the amount of additional collateral contractually required by such
derivative contracts and other trading agreements would have been approximately
$0.5 billion. If the rating agencies had downgraded their long-term senior debt
ratings for ML & Co. or certain subsidiaries by a second incremental notch,
approximately $4.0 billion in additional collateral would have been required.
Also, if the rating agencies had downgraded their long-term senior debt ratings
for ML & Co. or certain subsidiaries by one incremental notch, the derivative
liability that would be subject to unilateral termination by counterparties as
of September 30, 2012 was $2.7 billion, against which $2.0 billion of collateral
had been posted. Further, if the rating agencies had downgraded their long-term
debt ratings for ML & Co. or certain subsidiaries by a second incremental notch,
the derivative liability that would be subject to unilateral termination by
counterparties as of September 30, 2012 was an incremental $1.3 billion, against
which $0.7 billion of collateral had been posted.
While certain potential impacts are contractual and quantifiable, the full scope
of consequences of a credit ratings downgrade to a financial institution is
inherently uncertain, as it depends upon numerous dynamic, complex and
inter-related factors and assumptions, including whether any downgrade of a
firm's long-term credit ratings
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precipitates downgrades to its short-term credit ratings, and assumptions about
the potential behaviors of various customers, investors and counterparties.
For information regarding the additional collateral and termination payments
that would be required in connection with certain OTC derivative contracts and
other trading agreements as a result of such a credit ratings downgrade, see
Note 6 to the Condensed Consolidated Financial Statements and Item 1A. "Risk
Factors" of Merrill Lynch's 2011 Annual Report on Form 10-K.
U.S. Sovereign Credit Ratings
On June 8, 2012, S&P affirmed its 'AA+' long-term and 'A-1+' short-term
sovereign credit rating on the U.S. The outlook remains negative. On July 10,
2012, Fitch affirmed its 'AAA' long-term and 'F1+' short-term sovereign credit
rating on the U.S. The outlook remains negative. All three rating agencies have
indicated that they will continue to assess fiscal projections and consolidation
measures, as well as the medium-term economic outlook for the U.S.
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Credit Risk Management
For information about our credit risk management activities, refer to Item 7A,
"Quantitative and Qualitative Disclosures About Market Risk - Credit Risk
Management" included in our 2011 Annual Report on Form 10-K.
European Exposures
Certain European countries, including Greece, Ireland, Italy, Portugal and
Spain, have experienced varying degrees of financial stress. Risks from the
ongoing debt crisis in these countries could continue to disrupt the financial
markets, which could have a detrimental impact on global economic conditions and
sovereign and non-sovereign debt in these countries. In the third quarter of
2012, European policymakers continued to make incremental progress toward
greater fiscal and monetary unity; however, fundamental issues of
competitiveness, growth and fiscal solvency remain as challenges. As a result,
volatility is expected to continue. We expect to continue to support client
activities in the region, and our exposures may vary over time as we monitor the
situation and manage our risk profile.
The table below presents our direct sovereign and non-sovereign exposures in
these countries at September 30, 2012. Our total sovereign and non-sovereign
exposure to these countries was $3.7 billion at September 30, 2012 compared with
$2.7 billion at December 31, 2011. Our total exposure to these countries, net of
all hedges, was $2.3 billion at September 30, 2012 compared with $1.1 billion at
December 31, 2011. At September 30, 2012 and December 31, 2011, the fair value
of hedges and net credit default protection purchased was $1.3 billion and $1.6
billion, respectively.
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Select European Countries
Country Hedges and Net Country
Funded Loans Unfunded Net Securities/ Exposure Credit Exposure
and Loan Loan Counterparty Other September 30, Default September 30,
(dollars in
millions) Equivalents Commitments Exposure (1) Investments (2) 2012 Protection (3) 2012 (4)
Country
Greece
Sovereign $ - $ - $ - $ 3 $ 3 $ - $ 3
Financial
Institutions - - 1 - 1 (14 ) (13 )
Corporates - - 1 55 56 (1 ) 55
Total
Greece $ - $ - $ 2 $ 58 $ 60 $ (15 ) $ 45
Ireland
Sovereign $ 12 $ - $ 24 $ 6 $ 42 $ - $ 42
Financial
Institutions 61 12 137 18 228 (10 ) 218
Corporates - - 5 33 38 (5 ) 33
Total
Ireland $ 73 $ 12 $ 166 $ 57 $ 308 $ (15 ) $ 293
Italy
Sovereign $ - $ - $ 560 $ 739 $ 1,299 $ (667 ) $ 632
Financial
Institutions - - 363 263 626 (5 ) 621
Corporates - - 162 210 372 (279 ) 93
Total
Italy $ - $ - $ 1,085 $ 1,212 $ 2,297 $ (951 ) $ 1,346
Portugal
Sovereign $ - $ - $ 34 $ 2 $ 36 $ (25 ) $ 11
Financial
Institutions - - 2 33 35 (8 ) 27
Corporates - - 9 116 125 (100 ) 25
Total
Portugal $ - $ - $ 45 $ 151 $ 196 $ (133 ) $ 63
Spain
Sovereign $ - $ - $ 57 $ 297 $ 354 $ (59 ) $ 295
Financial
Institutions 9 - 72 77 158 (53 ) 105
Corporates 8 21 45 204 278 (79 ) 199
Total
Spain $ 17 $ 21 $ 174 $ 578 $ 790 $ (191 ) $ 599
Total
Sovereign $ 12 $ - $ 675 $ 1,047 $ 1,734 $ (751 ) $ 983
Financial
Institutions 70 12 575 391 1,048 (90 ) 958
Corporates 8 21 222 618 869 (464 ) 405
Total $ 90 $ 33 $ 1,472 $ 2,056 $ 3,651 $ (1,305 ) $ 2,346
(1)Net counterparty exposure includes the fair value of derivatives including
counterparty risk associated with credit default protection and secured
financing transactions. Derivatives have been reduced by all eligible collateral
pledged under legally enforceable netting agreements. Secured financing
transactions have been reduced by eligible cash or securities pledged. The
notional amount of reverse repurchase transactions was $647 million at September
30, 2012. Counterparty exposure has not been reduced by hedges or credit default
protection.
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(2)Long securities exposures have been netted on a single-name basis to but not
below zero by hedges and short positions.
(3)Represents credit default protection purchased, net of credit default
protection sold, which is used to mitigate our risk to exposures that comprise
"Country Exposure" as listed, including ($481 million) in net credit default
protection purchased to hedge loans and securities and short positions, and
($824 million) in additional credit default protection purchased to hedge
derivative assets. Amounts are calculated based on the credit default protection
notional amount assuming zero recovery adjusted for any fair value receivable or
payable.
(4)Represents country exposure less hedges and credit default protection.
We hedge certain of our selected European country exposure with credit default
protection, primarily in the form of single-name as well as index and tranche
credit default swaps ("CDS"). The exposures associated with these hedges
represent the amount that would be realized upon the isolated default of an
individual issuer in the relevant country assuming a zero recovery rate for that
individual issuer. Changes in the assumption of an isolated default can produce
different results in a particular tranche.
The majority of our CDS contracts are with highly-rated financial institutions
primarily outside of the Eurozone and we work to limit or eliminate correlated
CDS. Due to our engagement in market-making activities, our CDS portfolio
contains contracts with various maturities to a diverse set of counterparties.
We work to limit mismatches in maturities between our exposures and the CDS we
use to hedge them. However, there may be instances where the protection
purchased has a different maturity from the exposure for which the protection
was purchased, in which case those exposures and hedges are subject to more
active monitoring and management.
At September 30, 2012, the gross notional amount of single-name CDS protection
purchased and sold on reference assets was $85 million and $62 million in
Greece, $596 million and $890 million in Ireland, $8.3 billion and $6.4 billion
in Italy, $997 million and $726 million in Portugal and $1.9 billion and $2.2
billion in Spain. After the consideration of legally-enforceable counterparty
master netting agreements, the gross notional CDS protection purchased and sold
on those same reference assets at September 30, 2012 was $47 million and $24
million in Greece, $548 million and $892 million in Ireland, $4.3 billion and
$2.4 billion in Italy, $408 million and $137 million in Portugal, and $853
million and $1.1 billion in Spain.
At September 30, 2012, the gross fair value of single-name CDS protection
purchased and sold was $15 million and $11 million in Greece, $107 million and
$86 million in Ireland, $852 million and $730 million in Italy, $100 million and
$73 million in Portugal, and $166 million and $199 million in Spain. After the
consideration of legally-enforceable counterparty master netting agreements, the
gross fair value of CDS protection purchased and sold on those same reference
assets was $6 million and $1 million in Greece, $105 million and $85 million in
Ireland, $500 million and $379 million in Italy, $36 million and $8 million in
Portugal, and $63 million and $96 million in Spain.
Losses could still result even if there is credit default protection purchased
because the purchased credit protection contracts only pay out under certain
scenarios and thus not all losses may be covered by the credit protection
contracts. The effectiveness of our CDS protection as a hedge of these risks is
influenced by a number of factors, including the contractual terms of the CDS.
Generally, only the occurrence of a credit event as defined by the CDS terms
(which may include, among other events, the failure to pay by, or restructuring
of, the reference entity) results in a payment under the purchased credit
protection contracts. The determination as to whether a credit event has
occurred is made by the relevant ISDA Determination Committee (comprised of
various ISDA member firms) based on the terms of the CDS and facts and
circumstances for the event. Accordingly, uncertainties exist as to whether any
particular strategy or policy action for addressing the European debt crisis
would constitute a credit event under the CDS. A voluntary restructuring may not
trigger a credit event under CDS terms and consequently may not trigger a
payment under the CDS contract.
In addition to our direct sovereign and non-sovereign exposures, a significant
deterioration in the European debt crisis could result in material reductions in
the value of sovereign debt and other asset classes, disruptions in capital
markets, widening of credit spreads of U.S. and other financial institutions,
loss of investor confidence in the financial services industry, a slowdown in
global economic activity and other adverse developments.
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For additional information on the debt crisis in Europe, see Item 1A. "Risk
Factors" in our 2011 Annual Report on Form 10-K.
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