Non-Investment Grade Holdings and Highly Leveraged Transactions
Non-investment grade holdings and highly leveraged transactions involve risks related to the creditworthiness of the issuers or counterparties and the liquidity of the market for such investments. Merrill Lynch recognizes these risks and, whenever possible, employs strategies to mitigate exposures. The specific components and overall level of non-investment grade and highly leveraged positions may vary significantly from period to period as a result of inventory turnover, investment sales, and asset redeployment.In the normal course of business, Merrill Lynch underwrites, trades, and holds non-investment grade cash instruments in connection with its investment banking, market-making, and derivative structuring activities. Non-investment grade holdings have been defined as debt and preferred equity securities rated as BB+ or lower or equivalent ratings by recognized credit rating agencies, sovereign debt in emerging markets, amounts due under derivative contracts from non-investment grade counterparties, and other instruments that, in the opinion of management, are non-investment grade.
In addition to the amounts included in the following table, derivatives may also expose Merrill Lynch to credit risk related to the underlying security where a derivative contract can either synthesize ownership of the underlying security (e.g., long total return swaps) or potentially force ownership of the underlying security (e.g., short put options). Derivatives may also subject Merrill Lynch to credit spread or issuer default risk, in that changes in credit spreads or in the credit quality of the underlying securities may adversely affect the derivatives' fair values. Merrill Lynch seeks to manage these risks by engaging in various hedging strategies to reduce its exposure associated with non-investment grade positions, such as purchasing an option to sell the related security or entering into other offsetting derivative contracts.
Merrill Lynch provides financing and advisory services to, and invests in, companies entering into leveraged transactions, which may include leveraged buyouts, recapitalizations, and mergers and acquisitions. Merrill Lynch provides extensions of credit to leveraged companies, in the form of senior and subordinated debt, as well as bridge financing on a select basis. In addition, Merrill Lynch syndicates loans for non-investment grade companies, or in connection with highly leveraged transactions and may retain a residual portion of these loans.
Merrill Lynch holds direct equity investments in leveraged companies and interests in partnerships that invest in leveraged transactions. Merrill Lynch has also committed to participate in limited partnerships that invest in leveraged transactions. Future commitments to participate in limited partnerships and other direct equity investments will continue to be made on a select basis.
Trading Exposures
The following table summarizes trading exposures to non-investment grade or highly leveraged issuers or counterparties at year-end 2000 and 1999:
Included in the preceding table are debt and equity securities and bank loans of companies in various stages of bankruptcy proceedings or in default. At December 29, 2000, the carrying value of such debt and equity securities totaled $43 million, of which 64% resulted from Merrill Lynch's market-making activities in such securities. This compared with $47 million at December 31, 1999, of which 70% related to market-making activities. Also included are distressed bank loans totaling $122 million and $86 million at year-end 2000 and 1999, respectively.
Non-Trading Exposures
The following table summarizes non-trading exposures to non-investment grade or highly leveraged issuers or counterparties at year-end 2000 and 1999:
- Increases since December 31, 1999 are primarily due to new loans to several telecommunications companies.
- Represents outstanding loans to 135 and 115 companies at year-end 2000 and 1999, respectively.
- Includes $504 million and $599 million in investments at year-end 2000 and 1999, respectively, related to deferred compensation plans, for which the default risk of the investments rests with the participating employees.
- Includes investments in 98 and 62 enterprises at year-end 2000 and 1999, respectively.
The following table summarizes Merrill Lynch's commitments with exposure to non-investment grade or highly leveraged counterparties at year-end 2000 and 1999:
- Subsequent to year-end 2000, the commitments were reduced by $1.0 billion.
At December 29, 2000, the largest industry exposure was to the financial services sector, which accounted for 31% of total non-investment grade positions and highly leveraged transactions.
