MERRILL LYNCH & CO., INC. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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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 toML & Co. individually,ML & Co. and its subsidiaries, or certain ofML & 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 inUnited 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 ofSeptember 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 theU.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, and in any of ML & Co.'s subsequentSecurities 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 theEuropean 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 87
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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 onJune 23, 1971 . In 1973, the holding companyML & 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.
OnJanuary 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 intoML & Co. withML & 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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Table of Contents EXECUTIVE OVERVIEW We reported net losses of$1.2 billion and$2.0 billion for the three and nine months endedSeptember 30, 2012 , respectively, compared with net earnings of$133 million and a net loss of$903 million for the three and nine months endedSeptember 30, 2011 , respectively. Revenues, net of interest expense ("net revenues") for the three and nine months endedSeptember 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 endedSeptember 30, 2011 , respectively. Our pre-tax losses were$1.0 billion and$2.7 billion for the three and nine months endedSeptember 30, 2012 , respectively, compared with pre-tax losses of$390 million and$2.2 billion for the three and nine months endedSeptember 30, 2011 , respectively. Our results for the three months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2011 from the sale of a private equity investment, and lower non-interest expenses. Our results for the nine months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2012 as compared with gains from DVA of approximately$650 million in the prior year period. Our results for the nine months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2012 were$324 million and$471 million , respectively. Such net revenues and non-interest expenses for the nine months endedSeptember 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 endedSeptember 30, 2011 were$288 million and$581 million , respectively. Such net revenues and non-interest expenses for the nine months ended 89
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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
OnJuly 17, 2012 , theU.K. 2012 Finance Bill was enacted, which reduced theU.K. corporate income tax rate by two percent to 23%. The first one percent reduction was effective onApril 1, 2012 and the second reduction will be effectiveApril 1, 2013 . These reductions favorably affect income tax expense on futureU.K. earnings, but also required us to remeasure ourU.K. net deferred tax assets using the lower tax rates. The income tax provision (benefit) for the three and nine months endedSeptember 30, 2012 included a charge of$781 million for the remeasurement. If theU.K. corporate income tax rate is reduced to 22% by 2014 as suggested inU.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 ofOctober 12, 2012 , swaps dealers conducting dealing activity with U.S. persons above a certain threshold will be required to register with theU.S. Commodity Futures Trading Commission ("CFTC") on or beforeDecember 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 endedSeptember 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 theNew 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 OnNovember 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 90
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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 onJanuary 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. 91
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Table of Contents 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
three and nine months ended
N/M = Not meaningful.
Quarterly Consolidated Results of Operations
Our net loss for the quarter endedSeptember 30, 2012 was$1.2 billion compared with net earnings of$133 million for the quarter endedSeptember 30, 2011 . Net revenues for the quarter endedSeptember 30, 2012 were$4.5 billion compared with$5.9 billion in 2011.
Quarter Ended
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 endedSeptember 30, 2012 compared with$2.8 billion for the quarter endedSeptember 30, 2011 . The 92
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decline included the impact of lower revenues associated with the valuation of certain of our liabilities. In the quarter endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2012 compared with net interest income of$112 million in the quarter endedSeptember 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 endedSeptember 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 theEurope ,Middle East andAfrica ("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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 93
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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 endedSeptember 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 endedSeptember 30, 2012 as compared with a loss of$1.1 billion recorded in the quarter endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 30, 2012 was$191 million compared with an income tax benefit of$523 million for the quarter endedSeptember 30, 2011 . The effective tax rate was (19.3%) for the quarter endedSeptember 30, 2012 compared with 134.1% in the prior year. The effective tax rate for the quarter endedSeptember 30, 2012 was primarily driven by the impact of theU.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 endedSeptember 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 theU.K. corporate income tax rate that was enacted inJuly 2011 and required us to remeasure ourU.K. net deferred tax assets using the lower tax rates.
Year-To-Date Consolidated Results of Operations
For the nine months ended
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Nine Months Ended
Our net revenues for the nine months endedSeptember 30, 2012 were$14.3 billion compared with$20.6 billion for the nine months endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 ofJune 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 endedSeptember 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 ofJune 30, 2011 . The revenues from these operations for the nine months endedSeptember 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 endedSeptember 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 endedSeptember 30, 2012 compared with$10.7 billion in the prior year period. Non-compensation expenses for the nine months endedSeptember 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 endedSeptember 30, 2012 andSeptember 30, 2011 , 95
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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 endedSeptember 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 endedSeptember 30, 2012 compared with an income tax benefit of$1.3 billion for the nine months endedSeptember 30, 2011 , resulting in effective tax rates of 27.3% and 59.5%, respectively. The effective tax rate for the nine months endedSeptember 30, 2012 was primarily driven by the same factors described in the three-month discussion above. The effective tax rate for the nine months endedSeptember 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 ofSeptember 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 AtSeptember 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 AtSeptember 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, includingFirst 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
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 endedSeptember 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) untilAugust 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 ofNew York andDelaware ; the Attorneys General's motions were granted onJune 6, 2012 . 96
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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 theFederal Deposit Insurance Corporation and theFederal 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. OnFebruary 27, 2012 , theU.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. OnApril 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. OnAugust 10, 2012 , the court issued an order setting a schedule for discovery and other proceedings, and setMay 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 atSeptember 30, 2012 compared with$1.1 billion atDecember 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 inJune 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. 97
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The table below presents unresolved representations and warranties claims by counterparty atSeptember 30, 2012 andDecember 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 endedSeptember 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 AtSeptember 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 endedSeptember 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 endedSeptember 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. 98
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Table of Contents dollars in millions 2012 2011 Three Months Three Months Ended September Nine Months Ended Ended
September 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. AtSeptember 30, 2012 andDecember 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 endedSeptember 30, 2012 , as a portion of the loss was no longer deemed probable.
Our estimated liability atSeptember 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
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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 atSeptember 30, 2012 , an increase of$0.7 billion fromDecember 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
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) atSeptember 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 100
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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 atSeptember 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 ofSeptember 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, 101
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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 includingInternational Swaps and Derivatives Association, Inc. ("ISDA") -related and nonISDA -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 ofML & Co. on a going forward basis. All existingML & 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 priorML & Co. guarantees or otherwise guaranteed such securities. There were approximately$6.6 billion of securities guaranteed by Bank of America atSeptember 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 atSeptember 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 allowsML & 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 effectiveJanuary 1, 2012 with a maturity date ofJanuary 1, 2013 . The credit line will automatically be extended by one year to the succeedingJanuary 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 atSeptember 30, 2012 . In addition to the$75 billion unsecured line of credit, there is also a revolving unsecured line of credit that allowsML & 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 onFebruary 12, 2013 . AtSeptember 30, 2012 , there was approximately$4.1 billion 102
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outstanding under the line of credit.
• A
line of credit is based on prevailing short-term market rates. The credit
line matures on
year to the succeeding
notice not to extend at least 45 days prior to the maturity date. At
credit.
• A
line of credit is based on prevailing short-term market rates. The line of
credit matures on
During the quarter endedJune 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 andML & Co.
• A subordinated loan agreement for approximately
under this agreement was calculated based on a spread to LIBOR.
• A
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 onJanuary 1, 2013 and will automatically be extended by one year to the succeedingJanuary 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 bothSeptember 30, 2012 andDecember 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 onFebruary 12, 2013 . AtSeptember 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. OnOctober 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. OnJune 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 andML & 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 andML & 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 , aU.K. -based registered investment firm and subsidiary ofML & 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 , anIreland -based bank subsidiary ofML & 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 consequentlyML & 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 orML & 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. AtSeptember 30, 2012 , if the rating agencies had downgraded their long-term senior debt ratings forML & 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 forML & 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 forML & Co. or certain subsidiaries by one incremental notch, the derivative liability that would be subject to unilateral termination by counterparties as ofSeptember 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 forML & Co. or certain subsidiaries by a second incremental notch, the derivative liability that would be subject to unilateral termination by counterparties as ofSeptember 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
OnJune 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. OnJuly 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. 105
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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, includingGreece ,Ireland ,Italy ,Portugal andSpain , 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 atSeptember 30, 2012 . Our total sovereign and non-sovereign exposure to these countries was$3.7 billion atSeptember 30, 2012 compared with$2.7 billion atDecember 31, 2011 . Our total exposure to these countries, net of all hedges, was$2.3 billion atSeptember 30, 2012 compared with$1.1 billion atDecember 31, 2011 . AtSeptember 30, 2012 andDecember 31, 2011 , the fair value of hedges and net credit default protection purchased was$1.3 billion and$1.6 billion , respectively. 106
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Table of Contents 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 atSeptember 30, 2012 . Counterparty exposure has not been reduced by hedges or credit default protection. 107
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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. AtSeptember 30, 2012 , the gross notional amount of single-name CDS protection purchased and sold on reference assets was$85 million and$62 million inGreece ,$596 million and$890 million inIreland ,$8.3 billion and$6.4 billion inItaly ,$997 million and$726 million inPortugal and$1.9 billion and$2.2 billion inSpain . After the consideration of legally-enforceable counterparty master netting agreements, the gross notional CDS protection purchased and sold on those same reference assets atSeptember 30, 2012 was$47 million and$24 million inGreece ,$548 million and$892 million inIreland ,$4.3 billion and$2.4 billion inItaly ,$408 million and$137 million inPortugal , and$853 million and$1.1 billion inSpain . AtSeptember 30, 2012 , the gross fair value of single-name CDS protection purchased and sold was$15 million and$11 million inGreece ,$107 million and$86 million inIreland ,$852 million and$730 million inItaly ,$100 million and$73 million inPortugal , and$166 million and$199 million inSpain . 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 inGreece ,$105 million and$85 million inIreland ,$500 million and$379 million inItaly ,$36 million and$8 million inPortugal , and$63 million and$96 million inSpain . 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 variousISDA 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. 108
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For additional information on the debt crisis in
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