A key question in the liability of brokerages in the failure of the auctions for auction rate securities is what customers were told about the risks of the products they bought. The brokerages now claim they properly warned customers about the products, and that they never considered them cash or cash equivalent. Most individual brokers we've spoken to off the record say that this is very inaccurate, and every retail customer we've spoken to (including some who are friends and family of DealBreaker editors) say they bought these securities with the understanding that they were "highly liquid" or "cash equivalents."

So what did the brokerages tell retail customers? There were lots of disclosure documents that say a variety of confusing things but almost none of them reveal the risk of systemic and perhaps permanent auction failures for the auction rate preferred securities that pay low interest rates even after auction failure. And, as the screen shot of a ARPS customer online account above reveals, the brokerages did, in fact, take actions that encouraged customers to regard the ARPS as cash. This account comes from a Merrill Lynch customer account. (Click on image for a bigger version.)

A class action lawsuit was filed in federal court yesterday against Merrill Lynch, hours after we reported that Merrill had been threatened with suits by brokerage customers whose assets were frozen in auction rate securities. Merrill is the latest entrant in a club that includes Morgan Stanley, Deutsche Bank and UBS, all of whom have been separately sued over alleged deceptive marketing of auction-rate securities.

Merrill also faces a separate arbitration claim from ASTAR Air Cargo, which seeks compensatory damages of $9.125 million and punitive damages of at least $27.375 million. ASTAR, an air carrier based in Wilmington,Ohio, filed the claim with the Financial Industry Regulatory Authority to gain access to ASTAR’s funds that currently are frozen in illiquid auction rate securities in the company’s Merrill Lynch account.

According to ASTAR, the air carrier instructed Merrill Lynch to place its cash reserves in products that would provide complete safety of principal and complete liquidity. In response, Merrill Lynch reportedly recommended the company purchase various ARS.

Update: Here's a copy of the complaint against Merrill.

Merrill, Morgan Stanley sued over auction rates [Reuters]
ASTAR alleges Merrill Lynch fraud [Willmington New Journal]

Several months ago Bear Stearns blocked employees in its headquarters from reading DealBreaker. They offered us lots of technical excuses for this, including a few that almost made sense, but all of them were lies. Bear Stearns blocked us because we had ticked off the upper levels of its management. They’d probably still deny this if we bothered to ask, but how many times do you need to let someone lie to you before you simply quit asking questions.

At the time we warned that there was something wrong with management that was concerned enough about how a sarcastic, gossipy website that they’d lash out against it. We regularly mock the higher ups at places like Goldman Sachs but they know they’ve got better things to worry about. We also pointed out that we actually break news around here, and offer serious commentary on news breaking elsewhere. A bank that wants to cut its traders and bankers off from sources of information seems to be making bad choices. What’s more, cutting us off hardly stopped us from writing about Bear Stearns. It just stopped Bear Stearns from getting to know what we were saying about them.

Look. We’re not saying that Bear Stearns collapsed because they decided to block DealBreaker. We’re saying that a Wall Streets firm whose management focuses on crushing dissenting journalists who report embarrassing stories probably doesn’t have it’s priorities straight.

So who else is blocking DealBreaker? Oh, that’s right. Merrill Lynch. They've had a $24 billion in write-downs, and currently have a market cap of $42 billion.

It's not just the heads of giant Persian Gulf funds who are trash-talking each other's favorite banks, the chief executives of rival institutions are getting into the mix too. In a meeting with a group of Wall Street analysts recently, Merrill Lynch chief executive John Thain said that he believes that Citigroup will need another large capital injection.

His words were echoed today at a private equity conference in Dubai, where the top man of Dubai International Capital, Sammer al-Ansari, was asked about the billions of invested in Citigroup by rival sovereign wealth funds and Prince Walid bin Talal. "It's going to take more than that to rescue Citi," he said.

Thain did not go into specifics about the financial condition of Citi but his words struck a chord with those at the meeting. Today news reports say that analysts at Merrill Lynch have reduced their full-year earnings forecast for Citigroup and projected that the bank could book another write-down of debt tied to souring mortgages. But hearing the words from Thain himself had a powerful effect on those present. If Wall Street's ultimate insiders are this negative on the prospects of their rivals, perhaps the downturn on Wall Street could be even worse than expected.

Both Merrill Lynch and Citi have suffered badly from the financial market turmoil that began last year. Merrill has written down $24.5 billion in losses, while Citigroup has recorded $22.4 billion in losses.

In a filing with the Securities and Exchange Commission on Monday, Merrill Lynch said its cash flow statements for 2005, 2006 and the first three quarters of 2007 were wrong. The statements overstated cash provided by derivatives financing transactions. But, lucky for them, they made another mistake, overstating cash used for trading liabilities. So no big deal, right? Take a little from here, add a little there. It offsets.

Except that we have no idea what this means. What exactly did Merrill get wrong? The actual filing is extremely vague about these errors and it would be helpful to know how and why these were made. It's hard to be confident that Merrill understands its exposure to various derivatives if it only discloses non-specific errors and provides no detail. Anyone care to venture a guess what Merrill's mistakes were?

Merrill 8-K [ML.com]

There are gray storm clouds hanging over Wall Street this February but Merrill Lynch’s Greg Fleming appears to be weathering the storm. The Securities and Exchange Commission has initiated a formal investigation into whether the brokerage knew more than it revealed to shareholders about the value of its subprime investments prior to announcing the giant write-downs with its third-quarter results. Federal prosecutors have opened a preliminary investigation, leading to speculation that criminal charges could possibly brought against some Merrill executives. But sources at Merrill Lynch say Fleming, who continues in his role as president of the bank after the losses forced the departures of a co-president and the chief executive, was not involved in the businesses reportedly being scrutinized and they do not expect him to be a subject of the investigation.

Wall Street abounds with speculation that Greg Fleming, who has managed to hold on to his position as sole president of Merrill Lynch through a whirlwind of management changes, might finally be facing a challenge that could shake him out of his elevated position.

Fleming’s presidency has endured the worst losses in the history of Merrill, internal criticism, and alleged pressure from newly minted chief executive John Thain. Although the Justice Department’s investigation is in its earliest stage, rumors are already spreading, both within and outside of Merrill, that the threat of a criminal investigation might bring Fleming down.

Despite rapid changes in the management structure at Merrill Lynch, Greg Fleming has held onto his position as the president of the firm. He has insisted that he will remain the sole president, and resisted any plans to elevate others at the firm to be co-president. But his inflexibility on this point may be imperiling his position, according to people familiar with the situation.

“He’s on the verge of a nervous breakdown,” a source tells DealBreaker. Others dispute this characterization however, saying that Fleming shows no signs of anything like "a nervous breakdown."

When John Thain took over as chief executive of the bank, one of the very first changes he announced was a flatter management structure. More executives now report directly to Thain, in effect circumventing Fleming’s office. Under Stan O’Neal, the risk management executives did not report directly to the top—a situation which has been blamed for some of the excesses that lead to enormous losses over the last several months.

Fleming, who also serves as chief operating officer and oversees the investment banking business, is said to have dug in as president, and told others that he will not accept a co-presidency with others at the firm. This is seen by many as resisting the flatter structure Thain is putting in place, and may be alienating him from others at Merrill. Perhaps more important, Thain is thought to be chagrined by Fleming’s stance.

“Fleming could have been a team player. He’s still got the investment bank under him,” said one person with knowledge of the dynamics within the firm. “But he went the other way. He saw moving back to being just head of investment banking as a demotion.”

Some feel that the flatter management structure has effectively demoted Fleming already. With the new head of risk management, the top spokesperson, their general counsel, the chief financial officer and the brokerage head of the brokerage arm, among others, reporting directly to Thain, the office of the bank’s president may be superfluous. Last week, both Market Watch and Bloomberg referred to Fleming as the “chief operating officer” of Merrill without mentioning his role as president.

Fleming remains respected as an investment banker at the firm, even by those who are surprised at his alleged inflexibility. He remains youthful, plain-spoken and full of energy, according to people at Merrill Lynch. He is known as a perfectionist and an investment banking star—which is all the more reason his continued grasping to the title of sole president has some feeling “mystified.”

Merrill Lynch would not comment on this story.

So who is on this list of 14 companies under investigation by the FBI for their involvement in the subprime mortgage crisis? The FBI apparently intends to keep us in suspense because they won’t give details. All we know is that they are looking into “allegations of fraud at various stages of the mortgage process, from companies that bundled the loans into securities to the banks that ended up holding them.”

So let’s recklessly speculate. Two companies that are sure to be on the list are Bear Stearns—which is already under investigation by federal prosecutors and the SEC—and Countrywide, which is both the biggest home loan lender and also facing an SEC inquiry. Goldman Sachs is very likely on the list. It was accused on the pages of the Sunday New York Times of misleading clients by packaging CDOs while shorting the mortgage market. We know that at least one Senator read the article and has been making a stink, and we know that federal investigators often get their leads by reading the paper. What’s more, Goldman Sachs has said that it is cooperating with an unnamed government agency.

Morgan Stanley has also admitted to cooperating with unnamed government authorities. At first, everyone assumed this was the SEC. But why wouldn’t they come out and say that? More likely they declined to name the agency out of fear that saying they were cooperating with the FBI would tar them with serious criminality—rather than the everyday Wall Street shenanigans implied by an SEC investigation.

So that gives us four good leads. Who else is a cylon on the list? No doubt some additional mortgage companies and some home builders. Maybe the ratings agencies are also. Leave your guesses in the comments section below.

FBI Launches Subprime Probe [Wall Street Journal]

Yesterday Merrill Lynch said that Greg Fleming—the bank’s president and chief operating officer—and Bob McCann—who heads the brokerage business—would not receive bonuses for 2007. This decision was made by the board of directors on Monday, according to a filing with the Securities and Exchange Commission.

Zeroing out executive bonuses has become something of a trend on Wall Street. Bear Stearns and Morgan Stanley have made similar moves. But before you weep for Fleming and McCann you should read the fine print. Both men received their base salary of $350,000 as well as "retention options."

The real story here, however, is taking place more quietly and behind the scenes. Newly minted chief executive John Thain is working to dismantle some of the institutional hierarchy of Merrill, flattening the leadership structure and having more executives report directly to him. This is widely seen as effectively demoting Greg Fleming—who, for now, still holds the title of President of Merrill—who will no longer be a gatekeeper through whom more junior executives report to the chief executive. There has been some talk by insiders that the unwinding of the hierarchical structure that grew under Stan O’Neal has some executives bristling that they are losing rank and authority.

Yesterday Thain told investors that Merrill is exiting the collateralized debt obligations and structured credit businesses.

Merrill executives received no bonuses for 2007 [Reuters]
Merrill Lynch Filing [SEC]

As hard as it is to believe, the guy who ran the market risk team at Merrill Lynch from March of 2005 right into last year's Summer of Blood still has is job. In fact, Ahmass Fakahany was named co-president with Greg Fleming in May. But the dancing had to stop at some point since the music ended months ago. And this morning, Charlie Gasparino of CNBC reported that Am-Fak is set to resign later to day.

Update: Charlie G says that there are going to be more layoffs. There is a review of the brokerage business that is expected to result in job cuts. But no-one really fires brokers, you just don't pay them if they aren't earning for the firm. So these cuts will most likely be support staff folks.

To judge from the comments and our email, many of our readers think we’ve lost our minds on Merrill Lynch. We were impressed by the performance of Thain and Co. on this morning’s earnings call and wrote a good deal about it early this morning. We thought it was a strong performance but readers point out that shares of Merrill have been plummeting all day long. They say this indicates that the market doesn’t buy our evaluation of the earnings call. We’re not so sure. It may have been far worse if Thain and his guys had come off as badly at Vikram Pandit’s guys did on Tuesday.

We aren’t yet at the point where we’re going to be swallowing Thain’s kool-aid but our attention to his words might have led us to overlook something in his interview with CNBC’s Maria Bartiromo. This afternoon Street Insider points out that the interview took place on the fixed income trading floor. Why do it there? Well, perhaps to prove that people are still trading fixed income—or that the place has totally been totally cleaned up since that unspeakable incident we wouldn’t stop talking about earlier this week and last week. (Update: They were on the seventh floor, twelve floors below the scene of last week's crime.)

But this might not have had the desired effect. The traders on the fixed income floor seemed oddly unoccupied, gathering in the background and looking at their boss—or perhaps themselves—on television monitors. This has people wondering why these folks weren’t busy engaging in actual trading.

“Traders usually do not have time to do many other things, than trade, but this morning this small group of traders were more concerned with their tv appearance than making money for Merrill Lynch,” Street Insider says. “I don't know if this should tell you something about how John Thain runs Merrill, or if this was just a few traders that had a slight lapse in judgment, in what has been very tough days for Merrill Lynch workers in recent weeks.”

Merrill Lynch Traders Do Not Appear Too Busy [Street Insider]

After his well-received conference call and an appearance on CNBC, Merrill Lynch chief executive John Thain spoke to employees about the firm's future. His confident and well-informed remarks about the CDO market were peppered with wise-cracks that left the crowd of employees laughing out loud, according to a source present at the talk. The mood on the floor is said to be much almost cheerful. It's a great vote of confidence for the new CEO from a group that was wary of being lead outsider said to be sometimes robotic.

"Much improved from Stan's lame town halls," the source said.

We pressed our source for more information about the meeting but John Thain had to take another call.*

Merrill Lynch could not immediately comment on this story. We're pretty sure they were afraid we were going to ask them about the Turd War again.

The name "John Thain" has been changed to protect the identity of our source.

If you missed the Merrill Lynch earnings call and are frustrated you can't find a transcript yet, we suggest you check out David Gaffen's live blogging the call. David's been doing this for quite sometime and they keep getting better. And, while you're at it, you can read Felix Salmon's summary of the call. Felix says Merrill handled the call just right. The results: "A decidedly modest drop in the share price. Yes, it's down about 2.5% from where it closed on Wednesday, but it's up from where it closed on Tuesday, when the capital infusions were announced. And at $53.70, it's already up more than 10% from its 2008 lows. Well done, that man!"

Already people are saying that Thain has poured a little Goldman magic on Merrill.

We're getting flooded by emails from analysts who are complaining that our earlier post taking them to task for getting this week's earnings so dramatically wrong isn't fair. They have to put out numbers, and are encouraged to put out numbers by both their employers, clients and the companies on which they report. In short, they're just following orders.

But what excuses the performance on today's Merrill conference call? More than one got on the call to challenge Merrill's write-downs--on the basis that Merrill had gone to far. From our perspective, it sounded like a lot of analysts were attempting to defend their own inadequate calls by raising questions about Merrill's numbers. At the very least, this is the impression we go from Citigroup's comments.

Bearish skeptics of the CDO write-downs have raised concerns that Wall Street banks may still be too confident that the market for CDOs will recover soon. They've accused banks of holding CDOs at above market value based on a belief that the market is facing a temporary, unprecedented "squeeze" rather than a fundamental shift in the risk outlook for these assets.

On today's call, John Thain made it clear that Merrill Lynch is taking the opposite position. When asked by an analyst at CItigroup about the deeper than expected write-downs, Thain replied that in Merrill's view it is unlikely that the market for CDOs is going to recover. He said that the "fundamental assumptions" related to home prices and mortgage defaults had changed. In short, the problem is not a short-term liquidity squeeze but a new view of underlying value. Forget the credit crunch. This is a real shift of economic reality.

Thain also displayed a very detailed understanding of the loss assumptions that underlie Merrill's write downs, noting that the firm is using cumulative loss assumptions on the mortgages underlying asset backed securities of between 16 and 21 percent. This is not quite a "sky is falling" assumption but it is relatively conservative and shows that Merrill is certainly not, to mix metaphors, following the pie-in-the-sky, temporary squeeze assumptions that informed, for instance, Stan O'Neal's comments on last quarter's earnings call.

People used to talk about "first mover advantage" but sometimes going second can have a distinct advantage. CItigroup's conference call left analysts and investors concerned that the bank could not confidently discuss its write-downs, and worried that more write-downs for asset backed securities may yet loom in the bank's future. Merrill Lynch's team has done a much better job at assuring those listening into its call that it has a firm grasp on its credit market exposure.

Perhaps the first correction from Citi's approach is that where Pandit sat out most of the question and answer session, Merrill's Thain stayed involved in the call the entire time. When UBS's Glenn Schorr asked about whether write-downs on illiquid assets were deep enough that the firm could now transfer them at par value--basically, whether they had marked the assets to a market-clearing price--Thain jumped in and confidently announced that he was confident the assets were saleable as now valued.

The next correction was demonstrating a firm understanding of the risks faced by the firm. Where Citi CFO Gary "the Critter" Crittenden was forced to admit he had a weak understanding of many of the risks involved with asset backed securities, Merrill chief financial officer Nelson Chai and Thain both began discussing how Merrill's $23 billion in short hedges reduced its risk in the CDO hedges.

It's a marked contrast in how Citi handled its earnings call. Thain displayed a hands-on style, and obviously had drilled rather deeply into his firm's numbers. The ghost of O'Neal has been exorcised.

John Thain's comments on today's earnings conference call confirm reports that Merrill Lynch's new chief executive plans to rely on the brokerage business to restore the profitability and reputation of the company. We've been reporting that John Thain's new plan for Merrill Lynch will include a new emphasis on core strength's, primarily its wealth management business.

Describing Merrill as "a world class franchise." Thain went on to say that he has been very impressed with the commitment on employees to the company. He immediately began talking about the strength of Merrill's culture which he saw at a conference in Arizona. That's the same conference of managers of the firm's wealth management business that DealBreaker first reported earlier this week.

“I have been very impressed with how many of the Merrill employees talk about their commitment to the company and talk about their long tenure at the company," Thain said.

This is a one-hundred and eighty degree turnaround from the way that former CEO Stan O'Neal talked about his firm. This kind of emphasis on the brokers is meant to boost morale with a sign of respect to Merrill's legendary thundering herd.

We hear that Merrill is bailing out of at least two big private equity funds that are concentrated on real estate, selling it's limited partnership shares back to the fund managers at a discount. This is igniting speculation that Merrill could pull out of other investments as well, perhaps in an effort to raise capital before announcing earnings tomorrow. The two funds Merrill is said to have left are thought to be managed by Blackstone.

"Merrill Lynch must be in really doo-doo," a source with knowledge of the matter said.

When John Thain took the helm at Merrill Lynch, there was a lot of speculation about what direction he might take the fabled brokerage house. It seemed unlikely that the former Goldman Sachs executive continue Stan O’Neal’s drive to remake Merrill in the image of Goldman. That hadn’t worked out so well. Yesterday the Financial Times reported that Thain is aiming to pump up the importance of the global private client unit.

[O'Neal] also worked hard to de-emphasise Merrill’s private client group – the public face of the bank for years. He demoted Bob McCann, president of that division, so that he didn’t report directly to Mr O’Neal, and refused to put senior retail officials to the executive board.

Now, insiders at Merrill say, Mr Thain plans to elevate the importance of the global private-client unit again. This can only be a good thing given that the bank paid 24 times forecast 2007 earnings and 3.4 times current book value in January 2007 to acquire private bank First Republic specifically to expand its high net worth business.

Thain reverses ‘Goldmanising’ [Financial Times]