10-K 1 x16704e10vk.htm FORM 10-K FORM 10-K
Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

     
  (Mark One)
   
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  For the fiscal year ended December 30, 2005
 
   
OR
 
   
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
  For the transition period from                   to
 
  Commission file number 1-7182

Merrill Lynch & Co., Inc.

(Exact name of Registrant as specified in its charter)
     
Delaware   13-2740599
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
4 World Financial Center, New York, New York   10080
(Address of principal executive offices)   (Zip Code)
     
Registrant’s telephone number, including area code: (212) 449-1000
     
    Securities registered pursuant to Section 12(b) of the Act:    
     
Title of Each Class      Name of Each Exchange on Which Registered
Common Stock, par value $1.331/3 and attached Rights to Purchase Series A Junior Preferred Stock   New York Stock Exchange; Chicago Stock Exchange; Pacific Exchange; London
Stock Exchange; and Tokyo Stock Exchange
     
Depositary Shares representing 1/1200th share of Floating Rate Non-Cumulative Preferred Stock, Series 1; Depositary Shares representing 1/1200th share of Floating Rate Non-Cumulative Preferred Stock, Series 2; Depositary Shares representing 1/1200th share of 6.375% Non- Cumulative Preferred Stock, Series 3; Depositary Shares representing 1/1200th share of Floating Rate Non-Cumulative Preferred Stock, Series 4; Top Ten Yield MITTS® Securities due August 15, 2006; and S&P 500® Inflation Adjusted MITTS Securities due September 24, 2007   New York Stock Exchange

See the full list of securities listed on the American Stock Exchange on the pages directly following this cover.

Securities registered pursuant to Section 12(g) of the Act:
See the full list of securities registered pursuant to Section 12(g) of the Act on the pages directly following this cover.

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes þ    No o

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes o    No  þ

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

         
Large accelerated filer þ
  Accelerated filer o   Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No þ

As of the close of business on July 1, 2005, the aggregate market value of the voting stock, comprising the Common Stock and the Exchangeable Shares, held by non-affiliates of the Registrant was approximately $55.2 billion.

As of the close of business on February 17, 2006, there were 945,917,006 shares of Common Stock and 2,706,603 Exchangeable Shares outstanding. The Exchangeable Shares, which were issued by Merrill Lynch & Co., Canada Ltd. in connection with the merger with Midland Walwyn Inc., are exchangeable at any time into Common Stock on a one-for-one basis and entitle holders to dividend, voting and other rights equivalent to Common Stock.

Documents Incorporated By Reference: Portions of the Merrill Lynch Proxy Statement to be filed for its 2006 Annual Meeting of Shareholders to be held April 28, 2006 are incorporated by reference in this Form 10-K in response to Part III.

Pages 1 through 18, on which appeared a portion of Merrill Lynch & Co., Inc.’s 2005 Annual Report to Shareholders, are not filed with, incorporated by reference in or otherwise to be deemed a part of this Annual Report on Form 10-K.

 


 


Table of Contents

Securities registered pursuant to Section 12(b) of the Act and listed on the American Stock Exchange are as follows:
Accelerated Return NotesSM Linked to the S&P 500 Index due August 24, 2007; Strategic Return Notes® Linked to the Industrial 15 Index due August 3, 2009; Accelerated Return Notes Linked to the S&P 500 Index due August 24, 2007; Accelerated Return Notes Linked to the Nikkei-225® Index due March 5, 2007; Accelerated Return Bear Market NotesSM Linked to the PHLX Housing Sector Index due March 22, 2007; 8% Monthly Income Strategic Return Notes Linked to the CBOE S&P 500 BuyWrite Index due January 3, 2011; Accelerated Return Notes Linked to the Russell 2000® due February 28, 2007; Nikkei 225® Market Indexed Target Term Securities® due June 5, 2009; 8% Monthly Income Strategic Return Notes Linked to the CBOE DJIA BuyWrite Index due November 9, 2010; Convertible Securities Exchangeable into Pharmaceutical HOLDRs® due September 7, 2010; Accelerated Return Notes Linked to the Nikkei 225® Index due November 7, 2006; Strategic Return Notes Linked to the Industrial 15 Index due August 9, 2010; 8% Monthly Income Strategic Return Notes Linked to the CBOE S&P 500 BuyWrite Index due June 7, 2010; MITTS Securities based upon the Russell 2000 Index due March 30, 2009; Nikkei® 225 Securities due March 30, 2009; S&P 500 MITTS Securities due June 29, 2009; MITTS Securities based upon the Dow Jones Industrial AverageSM due August 7, 2009; S&P 500 MITTS Securities due September 4, 2009; EuroFund MITTS Securities due February 28, 2006; S&P 500 MITTS Securities due March 27, 2006; Consumer Staples Select Sector SPDR Fund MITTS Securities due April 19, 2006; Select Sector SPDR® Fund Growth Portfolio MITTS Securities due May 25, 2006; Major 11 International MITTS Securities due May 26, 2006; MITTS Securities based upon the Dow Jones Industrial Average due June 26, 2006; Russell 2000 MITTS Securities due July 21, 2006; Nikkei 225 MITTS Securities due August 4, 2006; S&P 500 MITTS Securities due August 4, 2006; Energy Select Sector SPDR Fund MITTS Securities due September 20, 2006; Medium-Term Notes, Series B, 0.25% Callable and Exchangeable Stock-Linked Notes due May 10, 2006; Medium-Term Notes, Series B, 1% Callable and Exchangeable Stock-Linked Notes due July 20, 2006; 1% Convertible Securities Exchangeable into McDonald’s Corporation common stock due May 28, 2009; Callable MITTS Securities due October 5, 2007 based upon Semiconductor HOLDRS®; Callable MITTS Securities due September 13, 2007 based upon Broadband HOLDRS; Callable Nasdaq-100® MITTS Securities due August 3, 2007; Callable MITTS Securities due May 4, 2009 Linked to the S&P 500 Index; Callable MITTS Securities due May 4, 2009 Linked to the Amex Biotechnology Index; Callable MITTS Securities due June 1, 2009 Linked to the Amex Defense Index; Callable MITTS Securities due August 3, 2007 based upon Biotech HOLDRS; Medium-Term Notes, Series B, Nikkei 225 MITTS Securities due March 30, 2007; Callable MITTS Securities due March 5, 2007 based upon Internet HOLDRS; Medium-Term Notes, Series B, 0.25% Callable and Exchangeable Stock-Linked Notes due January 7, 2008 (Linked to the performance of Wells Fargo & Company); Nikkei 225 MITTS Securities due June 27, 2007; Strategic Return Notes Linked to the Industrial 15 Index due February 1, 2007; Strategic Return Not es Linked to the Biotech-Pharmaceutical Index due February 8, 2007; Strategic Return Notes Linked to the Select Ten Index due March 1, 2007; Strategic Return Notes Linked to the Oil and Natural Gas Index due March 28, 2007; Strategic Return Notes Linked to the Industrial 15 Index due May 3, 2007; Strategic Return Notes Linked to the Select Ten Index due May 3, 2007; Strategic Return Notes Linked to the Select European 50 Index due June 11, 2007; Strategic Return Notes Linked to the Select Ten Index due June 28, 2007; Strategic Return Notes Linked to the Industrial 15 Index due August 30, 2007; Strategic Return Notes Linked to the Select Ten Index due October 25, 2007; Strategic Return Notes Linked to the Biotech-Pharmaceutical Index due November 1, 2007; Strategic Return Notes Linked to the Select Ten Index due May 30, 2006; Strategic Return Notes Linked to the Industrial 15 Index due June 26, 2006; Strategic Return Notes Linked to the Institutional Holdings Index due June 28, 2006; Strategic Return Notes Linked to the Select Ten Index due July 31, 2006; Strategic Return Notes Linked to the Select Ten Index due November 2, 2006; Convertible Securities Exchangeable into Exxon Mobil Corporation Common Stock due October 3, 2008; Convertible Securities Exchangeable into The Coca-Cola Company Common Stock due September 30, 2008; Strategic Return Notes Linked to the Select Utility Index due February 25, 2009; and Strategic Return Notes Linked to the Select Utility Index due September 28, 2009.

Securities registered pursuant to Section 12(g) of the Act are as follows:
S&P 500 MITTS Securities due June 29, 2007; S&P 500 MITTS Securities due November 20, 2007; S&P 500 MITTS Securities due August 29, 2008; MITTS Securities based upon the Dow Jones Industrial Average due September 29, 2008; MITTS Securities based upon the Dow Jones Industrial Average due January 16, 2009; Market Recovery Notes Linked to the Nasdaq-100 Index; Strategic Return Notes Linked to the Select Ten Index due February 28, 2008; S&P 500 MITTS Securities due June 3, 2010; S&P 500 MITTS Securities due September 3, 2008; S&P 500 MITTS Securities due August 5, 2010; Dow Jones Industrial Average MITTS Securities due December 27, 2010; Nikkei 225 MITTS Securities due March 8, 2011; Nikkei 225 MITTS Securities due September 30, 2010; Strategic Return Notes Linked to the Select Ten Index due June 27, 2008; Strategic Return Notes Linked to the Industrial 15 Index due October 31, 2008; Strategic Return Notes Linked to the Select Ten Index due September 30, 2008; Strategic Return Notes Linked to the Industrial 15 Index due August 5, 2008; Strategic Return Notes Linked to the Select Ten Index due March 2, 2009; 97% Protected Notes Linked to the performance of the Dow Jones Industrial Average due March 28, 2011; 97% Protected Notes Linked to the Dow Jones Industrial Average due March 28, 2011; Strategic Return Notes Linked to the Select Ten Index due March 2, 2009; Strategic Return Notes Linked to the Industrial 15 Index due March 30, 2009; 97% Protected Notes Linked to Global Equity Basket due February 14, 2012; Strategic Return Notes Linked to the Select Ten Index due June 4, 2009; Medium-Term Notes, Series C, S&P 500 MITTS Securities due August 31, 2011; Medium-Term Notes, Series C, Accelerated Return Notes Linked to the Russell 2000 Index due June 30, 2006; Accelerated Return Notes Linked to the Nasdaq 100® Index due August 3, 2007; Leveraged Index Return Notes Linked to the Nikkei 225 Index due March 2, 2009; 9% Callable Stock Return Income DEbt SecuritiesSM due May 22, 2006; and S&P 500 MITTS due June 7, 2010.

 


 

Table of Contents
             
Selected Financial Data     20  
Management’s Discussion and Analysis of Financial Condition and Results of Operations     21  
     Overview     21  
     Risk Factors that Could Affect Our Business     22  
     Critical Accounting Policies and Estimates     24  
     Business Environment     27  
     Results of Operations     28  
          Consolidated Results of Operations     28  
          Income Taxes     30  
          Business Segments     30  
     Consolidated Balance Sheets     40  
     Off Balance Sheet Arrangements     43  
     Contractual Obligations and Commitments     44  
     Capital and Funding     45  
     Risk Management     51  
     Non-Investment Grade Holdings and Highly Leveraged Transactions     57  
     Recent Developments     59  
     Activities of Principal Subsidiaries     60  
Management’s Discussion of Financial Responsibility, Disclosure Controls and Procedures, and Report on Internal Control Over Financial Reporting     63  
Report of Independent Registered Public Accounting Firm     65  
Consolidated Financial Statements     67  
     Consolidated Statements of Earnings     67  
     Consolidated Balance Sheets     68  
     Consolidated Statements of Changes in Stockholders’ Equity     70  
     Consolidated Statements of Comprehensive Income     71  
     Consolidated Statements of Cash Flows     72  
Notes to Consolidated Financial Statements     73  
     NOTE 1.
  Summary of Significant Accounting Policies     73  
     NOTE 2.
  Subsequent Events     86  
     NOTE 3.
  Segment and Geographic Information     86  
     NOTE 4.
  Securities Financing Transactions     88  
     NOTE 5.
  Investment Securities     89  
     NOTE 6.
  Trading Assets and Liabilities     91  
     NOTE 7.
  Securitization Transactions and Transactions with Special Purpose Entities     94  
     NOTE 8.
  Loans, Notes, and Mortgages and Related Commitments to Extend Credit     99  
     NOTE 9.
  Commercial Paper and Short- and Long-Term Borrowings     101  
     NOTE 10.
  Deposits     104  
     NOTE 11.
  Stockholders' Equity and Earnings Per Share     104  
     NOTE 12.
  Commitments, Contingencies and Guarantees     106  
     NOTE 13.
  Employee Benefit Plans     113  
     NOTE 14.
  Employee Incentive Plans     118  
     NOTE 15.
  Income Taxes     122  
     NOTE 16.
  Regulatory Requirements and Dividend Restrictions     123  
     NOTE 17.
  Other Events     125  
     Supplemental Financial Information (Unaudited)     126  
     Quarterly Information     126  
     Dividends Per Common Share     126  
     Stockholder Information     126  
Other Information (Unaudited)     127  
Corporate Information     136  
Exhibits and Financial Statement Schedules     137  
CROSS-REFERENCE INDEX     141  
SIGNATURES     142  
 EX-12: STATEMENT RE: COMPUTATION OF RATIOS
 EX-14.1: GUIDELINES FOR BUSINESS CONDUCT
 EX-21: SUBSIDIARIES OF ML & CO
 EX-23: CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 EX-31.1: CERTIFICATION
 EX-31.2: CERTIFICATION
 EX-32.1: CERTIFICATION
 EX-32.2: CERTIFICATION
 EX-99.1: REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 EX-99.2: REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 EX-99.3: CHARTER OF THE AUDIT COMMITTEE
 EX-99.4: CHARTER OF THE FINANCE COMMITTEE
 EX-99.5: CHARTER OF THE MANAGEMENT DEVELOPMENT AND COMPENSATION COMMITTEE
 EX-99.6: CHARTER OF THE NOMINATING AND CORPORATE GOVERNANCE COMMITTEE
 EX-99.8: CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
 (MERRILL LYNCH LOGO)
 


Table of Contents

Selected Financial Data
                                         
    Year Ended Last Friday in December  
  2005     2004     2003     2002     2001  
(dollars in millions, except per share amounts) (52 weeks)     (53 weeks)     (52 weeks)     (52 weeks)     (52 weeks)  
 
 
                                       
Results of Operations
                                       
Total Revenues
  $ 47,783     $ 32,619     $ 27,924     $ 28,361     $ 39,019  
Less Interest Expense
    21,774       10,560       8,024       9,990       17,471  
     
Net Revenues
    26,009       22,059       19,900       18,371       21,548  
Non-Interest Expenses
    18,778       16,223       14,680       16,059       21,789  
     
Earnings (Loss) Before Income Taxes
    7,231       5,836       5,220       2,312       (241 )
Income Tax Expense
    2,115       1,400       1,384       604       99  
     
Net Earnings (Loss)
  $ 5,116     $ 4,436     $ 3,836     $ 1,708     $ (340 )
     
Net Earnings (Loss) Applicable to Common Stockholders(1)
  $ 5,046     $ 4,395     $ 3,797     $ 1,670     $ (378 )
     
 
                                       
Financial Position
                                       
Total Assets
  $  681,015     $  628,098     $  480,233     $  440,252     $  431,173  
Short-Term Borrowings(2)
  $ 301,405     $ 259,804     $ 191,184     $ 180,213     $ 178,154  
Long-Term Borrowings
  $ 132,409     $ 119,513     $ 85,178     $ 79,788     $ 77,273  
Long-Term debt issued to TOPrSSM partnerships
  $ 3,092     $ 3,092     $ 3,203     $ 3,188     $ 3,181  
Total Stockholders’ Equity
  $ 35,600     $ 31,370     $ 28,884     $ 24,081     $ 20,787  
     
 
                                       
Common Share Data
                                       
(in thousands, except per share amounts)
                                       
Earnings (Loss) Per Share:
                                       
Basic
  $ 5.66     $ 4.81     $ 4.22     $ 1.94     $ (0.45 )
     
Diluted
  $ 5.16     $ 4.38     $ 3.87     $ 1.77     $ (0.45 )
     
Weighted-Average Shares Outstanding:
                                       
Basic
    890,744       912,935       900,711       862,318       838,683  
Diluted
    977,736       1,003,779       980,947       947,282       838,683  
Shares Outstanding at Year-End(3)
    915,602       928,037       945,911       867,291       843,474  
Book Value Per Share
  $ 35.82     $ 32.99     $ 29.96     $ 27.07     $ 23.95  
Dividends Paid Per Share
  $ 0.76     $ 0.64     $ 0.64     $ 0.64     $ 0.64  
     
 
                                       
Financial Ratios
                                       
Pre-Tax Profit Margin
    27.8 %     26.5 %     26.2 %     12.6 %     N/M  
Common Dividend Payout Ratio
    13.4 %     13.3 %     15.2 %     33.0 %     N/M  
Return on Average Assets
    0.7 %     0.8 %     0.8 %     0.4 %     N/M  
Return on Average Common Stockholders’ Equity
    16.0 %     14.9 %     14.8 %     7.5 %     N/M  
     
 
                                       
Other Statistics
                                       
Full-Time Employees:
                                       
U.S.
    43,200       40,200       38,200       40,000       43,400  
Non-U.S.
    11,400       10,400       9,900       10,900       13,700  
     
Total(4)
    54,600       50,600       48,100       50,900       57,100  
     
Private Client Financial Advisors
    15,160       14,140       13,530       14,010       16,350  
Client Assets (dollars in billions)
  $ 1,764     $ 1,597     $ 1,507     $ 1,311     $ 1,556  
 
(1)  
Net earnings (loss) less preferred stock dividends.
(2)  
Consists of Payables under repurchase agreements and securities loaned transactions, Commercial paper and other short-term borrowings, and Deposits.
(3)  
Does not include 2,708; 2,783; 2,900; 3,911; and 4,195 shares exchangeable into common stock at year-end 2005, 2004, 2003, 2002, and 2001, respectively. See Note 11 to the Consolidated Financial Statements.
(4)  
Excludes 200; 100; 200; 1,500; and 3,500 full-time employees on salary continuation severance at year-end 2005, 2004, 2003, 2002, and 2001, respectively.
20
Merrill Lynch 2005 Annual Report
 


Table of Contents

Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Certain statements in this report may be considered forward-looking, including those about management expectations, strategic objectives, growth opportunities, business prospects, anticipated financial results, the impact of off balance sheet arrangements, significant contractual obligations, anticipated results of litigation and regulatory investigations and proceedings, and other similar matters. These forward-looking statements represent only Merrill Lynch & Co., Inc.’s (“ML & Co.” and, together with its subsidiaries, “Merrill Lynch”) beliefs regarding future performance, which is inherently uncertain. There are a variety of factors, many of which are beyond Merrill Lynch’s control, which affect its operations, performance, business strategy and results and could cause its actual results and experience to differ materially from the expectations and objectives expressed in any forward-looking statements. These factors include, but are not limited to, actions and initiatives taken by both current and potential competitors, general economic conditions, the effects of current, pending and future legislation, regulation and regulatory actions, and the other risks and uncertainties detailed in this report. See Risk Factors that Could Affect Our Business. Accordingly, readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the dates on which they are made. Merrill Lynch does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the dates they are made. The reader should, however, consult further disclosures Merrill Lynch may make in future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
Available Information
ML & Co. files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). You may read and copy any document we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the Public Reference Room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Merrill Lynch) file electronically with the SEC. The SEC’s internet site is www.sec.gov.
ML & Co.’s internet address is www.ml.com, and the investor relations section of our website can be accessed directly at www.ir.ml.com. ML & Co. makes available, free of charge, our proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These reports are available through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Also posted on our website are corporate governance materials including Merrill Lynch’s Guidelines for Business Conduct, Code of Ethics for Financial Professionals, Director Independence Standards, Corporate Governance Guidelines and charters for the committees of our Board of Directors. In addition, our website includes information on purchases and sales of our equity securities by our executive officers and directors, as well as disclosures relating to certain non-GAAP financial measures (as defined in the SEC’s Regulation G) that we may make public orally, telephonically, by webcast, by broadcast or by similar means from time to time.
We will post on our website amendments to our Guidelines for Business Conduct and Code of Ethics and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange. The information on Merrill Lynch’s website is not incorporated by reference into this Report. Shareholders may obtain printed copies of these documents, free of charge, upon written request to Judith A. Witterschein, Corporate Secretary, Merrill Lynch & Co., Inc., 222 Broadway, 17th Floor, New York, NY 10038 or by email at corporate_secretary@ml.com.
Overview
Merrill Lynch was formed in 1914 and became a publicly traded company on June 23, 1971. In 1973, Merrill Lynch created the holding company, ML & Co., a Delaware corporation that, through its subsidiaries, provides broker-dealer, investment banking, financing, wealth management, advisory, asset management, insurance, lending, and related products and services on a global basis.
Merrill Lynch conducts business from various locations throughout the world. Merrill Lynch’s world headquarters is located in the World Financial Center in New York City, and its other principal United States business and operational centers are located in New Jersey and Florida. Merrill Lynch has a presence in 35 countries and territories outside the United States, and its major geographic regions of operations include the United States; Europe, the Middle East and Africa (“EMEA”); the Pacific Rim; Canada; and Latin America.
Merrill Lynch’s activities are conducted through three business segments:
 
Global Markets and Investment Banking Group (“GMI”), Merrill Lynch’s institutional business segment, provides equity, debt and commodities trading, capital market services, investment banking and advisory services to corporations, financial institutions, and
 (MERRILL LYNCH LOGO)
 


Table of Contents

   
governments around the world. GMI’s Global Markets division facilitates client transactions and is a market maker in securities, derivatives, currencies, commodities and other financial instruments to satisfy client demands, and in connection with proprietary trading activities. Global Markets also provides clients with financing, securities clearing, settlement, and custody services and also engages in principal investments and private equity investing. GMI’s Investment Banking division provides a wide range of origination and strategic advisory services for issuer clients, including underwriting and placement of public and private equity, debt and related securities, as well as lending and other financing activities for clients globally. These services also include advising clients on strategic issues, valuation, mergers, acquisitions and restructurings. In 2005, GMI generated 52% of Merrill Lynch’s net revenues and 65% of Merrill Lynch’s pre-tax earnings. GMI’s growth strategy entails a program of significant investments in personnel and technology to gain further scale in certain asset classes and geographies.
 
 
Global Private Client (“GPC”), Merrill Lynch’s full-service retail wealth management segment, provides brokerage, investment advisory and financial planning services, offering a broad range of both proprietary and third-party wealth management products and services globally to individuals, small- to mid-size businesses, and employee benefit plans. The largest portion of this business is offered through the Advisory Division, where services are delivered by Merrill Lynch Financial Advisors (“FAs”) through a global network of branch offices. GPC’s offerings include commission and fee-based investment accounts; banking, cash management, and credit services, including consumer and small business lending and credit cards; trust and generational planning; retirement services; and insurance products. In 2005, GPC generated 41% of Merrill Lynch’s net revenues and 28% of Merrill Lynch’s pre-tax earnings. GPC’s growth priorities include the hiring of additional FAs, client segmentation, annuitization of revenues through fee-based products, diversification of revenues through adding products and services, investments in technology to enhance productivity and efficiency, and disciplined expansion into additional geographic areas globally.
 
 
Merrill Lynch Investment Managers (“MLIM”), Merrill Lynch’s asset management segment, offers a wide range of investment management capabilities to retail and institutional investors through proprietary and third-party distribution channels globally. Asset management capabilities include equity, fixed income, money market, index, enhanced index and alternative investments, which are offered through vehicles such as mutual funds, privately managed accounts, and retail and institutional separate accounts. In 2005, MLIM generated 7% of Merrill Lynch’s net revenues and pre-tax earnings. MLIM’s growth priorities include driving strong relative long-term investment performance and broadening the distribution of its products through multiple channels, while maintaining discipline on expenses. MLIM is committed to increasing sales in both the proprietary and non-proprietary channels in the United States, as well as non-U.S. regions. On February 15, 2006, Merrill Lynch entered into an agreement with BlackRock, Inc. (“BlackRock”), to combine the MLIM business with BlackRock. See Note 2 to the Consolidated Financial Statements for further information.
Merrill Lynch also provides a variety of research services on a global basis through its Global Securities Research and Economics Group. These services are at the core of the value proposition offered to institutional and individual client sales forces and their customers, and are an integral component of the product offering in GMI and GPC. This group distributes research focusing on four main disciplines globally: fundamental equity research, fixed income and equity-linked research, equity strategy and economic analyses, and wealth management strategy which leverages macroeconomic and other research views to produce investment ideas. Merrill Lynch consistently ranks among the leading research providers in the industry, and its analysts and other professionals in 18 countries cover approximately 2,650 companies.
Merrill Lynch is a Consolidated Supervised Entity (“CSE”) and is subject to group-wide supervision by the SEC. As such, Merrill Lynch computes allowable capital and allowances thereto; permits the SEC to examine the books and records of the holding company and any affiliate that does not have a principal regulator; and has adopted various additional SEC reporting, record-keeping, and notification requirements. Merrill Lynch is in compliance with applicable CSE standards. Being a CSE has imposed additional costs, although not material to date, and has introduced new requirements to monitor capital adequacy. In respect of the European Union (“EU”) Financial Conglomerates (“or Financial Groups”) Directive, the U.K. Financial Services Authority (“FSA”) has determined that the SEC undertakes equivalent consolidated supervision for Merrill Lynch.
Risk Factors that Could Affect Our Business
In the course of conducting its business operations, Merrill Lynch could be exposed to a variety of risks that are inherent to the financial services business. A summary of some of the significant risks that could affect Merrill Lynch’s financial condition and results of operations is included below. Some of these risks are managed in accordance with established risk management policies and procedures, most of which are described in the Risk Management section of the Management’s Discussion and Analysis.
22
Merrill Lynch 2005 Annual Report
 


Table of Contents

Market Risk
Merrill Lynch’s various businesses may be adversely impacted by global market and economic conditions that may cause fluctuations in interest rates, exchange rates, equity and commodity prices and credit spreads.
The financial services industry and the global financial markets are influenced by numerous unpredictable factors including economic conditions, monetary and fiscal policies, the liquidity of global markets, availability and cost of capital, international and regional political events, acts of war or terrorism and investor sentiment. Changes in these factors may result in volatility in interest rates, exchange rates, equity and commodity prices, and credit spreads. Merrill Lynch has a large and increasing amount of trading and investment positions, which include proprietary trading positions in fixed income, currency, commodities and equity securities, as well as in real estate, private equity and other investments. Merrill Lynch may incur losses as a result of increased market volatility, as these fluctuations may adversely impact the valuation of its trading and investment positions. Conversely, a decline in volatility may adversely affect the results in Merrill Lynch’s trading businesses, which depend on market volatility to create client and proprietary trading opportunities.
Credit Risk
Merrill Lynch may incur losses from its credit exposure related to trading, lending, and other business activities.
Merrill Lynch is exposed to the potential for credit-related losses that can occur as a result of an individual, counterparty or issuer being unable or unwilling to honor its contractual obligations. These credit exposures exist within lending relationships, commitments, letters of credit, derivatives, foreign exchange and other transactions. These exposures may arise, for example, from a decline in the financial condition of a counterparty, from a decrease in the value of securities of third parties held by Merrill Lynch as collateral, from entering into swap or other derivative contracts under which counterparties have long-term obligations to make payments to Merrill Lynch, and from extending credit to clients through loans or other arrangements. An increase in Merrill Lynch’s credit exposure could have an adverse effect on its business and profitability if credit losses exceed credit provisions.
Operational Risk
Merrill Lynch may incur losses from inadequate or failed internal processes, people and systems or from external events.
Merrill Lynch may incur losses arising from its exposure to operational risk. Financial services firms, including Merrill Lynch, are exposed to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Such operational risks may include, for example, exposure to natural or man-made disasters, mistakes made in the confirmation or settlement of transactions or from improper recording, evaluating or accounting for transactions. Merrill Lynch could suffer financial loss, disruption of its business, liability to clients, regulatory intervention or reputational damage, which would affect its business and financial condition.
Liquidity Risk
Merrill Lynch’s business and financial condition may be adversely impacted by an inability to borrow funds or sell assets to meet maturing obligations.
Financial services firms, including Merrill Lynch, are exposed to liquidity risk, which is the potential inability to repay short-term borrowings with new borrowings or assets that can be quickly converted into cash while meeting other obligations and continuing to operate as a going concern. Merrill Lynch’s liquidity may be impaired due to circumstances that it may be unable to control, such as general market disruptions or an operational problem that affects its trading clients, third parties or itself. Merrill Lynch’s ability to sell assets may also be impaired if other market participants are seeking to sell similar assets at the same time. The inability of Merrill Lynch to borrow funds or sell assets to meet maturing obligations, a negative change in its credit ratings, which would have an adverse effect on its ability to borrow funds, or regulatory capital restrictions imposed on the free flows of funds between Merrill Lynch and its affiliates may have a negative effect on its business and financial condition.
Litigation Risk
Legal proceedings could adversely affect Merrill Lynch’s operating results and financial condition for a particular period and impact its credit ratings.
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. Some of the legal actions against Merrill Lynch include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the issuers who would otherwise be the primary defendants are bankrupt or otherwise in financial distress. Given the number of these matters, some are likely to result in adverse judgments, penalties, injunctions, fines, or other relief. Merrill Lynch is also involved in investigations and/or proceedings by governmental and self-regulatory agencies. The number of these investigations has also increased in recent years with regard to many firms, including Merrill Lynch.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch may explore potential settlements before a case is taken through trial because of uncertainty and risks inherent in the litigation process. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies, Merrill Lynch will accrue a liability when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. In many lawsuits and arbitrations, disclosed in Other Information (Unaudited) — Legal Proceedings, including almost all of the class action lawsuits, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until the case is close to resolution, in which case no accrual is made until that time. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases in which claimants seek substantial or indeterminate damages, Merrill Lynch cannot predict what the eventual loss or range of loss related to such matters will be, which may be material to its operating results or cash flows for any particular period and may impact its credit ratings.
Regulatory and Legislative Risks
Many of Merrill Lynch’s businesses are highly regulated and could be adversely impacted by regulatory and legislative initiatives around the world.
Merrill Lynch’s businesses may be adversely affected by regulatory and legislative initiatives imposed by various U.S. and non-U.S. regulatory and exchange authorities, such as federal and state securities regulators including the SEC, the FSA, self-regulatory organizations including The New York Stock Exchange, Inc. (“NYSE”) and the National Association of Securities Dealers, Inc. (“NASD”), and industry participants that continue to review and, in many cases, adopt changes to their established rules and policies. Such changes have occurred in areas such as corporate governance, anti-money laundering, privacy, research analyst conflicts of interest and qualifications, practices related to the issuance of securities, mutual fund trading, disclosure practices and auditor independence.
Competitive Environment
Competitive pressures in the financial services industry in which Merrill Lynch operates could adversely affect its business and results of operations.
Merrill Lynch competes globally for individual and institutional clients on the basis of price, the range of products that it offers, the quality of its services, its financial resources, and product and service innovation. The financial services industry continues to be affected by an intensifying competitive environment, as demonstrated by the introduction of new technology platforms, consolidation through mergers, increased competition from new and established industry participants and diminishing margins in many mature products and services. Merrill Lynch competes with U.S. and non-U.S. commercial banks and other broker-dealers in brokerage, underwriting, trading, financing and advisory businesses. For example, the financial services industry in general, including Merrill Lynch, has experienced intense price competition in brokerage, as the ability to execute trades electronically, through the internet and through other alternative trading systems has pressured trading commissions and spreads. Merrill Lynch competes for investment funds with mutual fund management companies, insurance companies, finance and investment advisory companies, banks, trust companies and other institutions. Many of Merrill Lynch’s non-U.S. competitors may have competitive advantages in their home markets. In addition, Merrill Lynch’s business is substantially dependent on its continuing ability to compete effectively to attract and retain qualified employees, including successful Financial Advisors, investment bankers, trading professionals and other revenue-producing or support personnel.
For further information on Risks refer to Note 6 to the Consolidated Financial Statements.
Critical Accounting Policies and Estimates
Use of Estimates
In presenting the Consolidated Financial Statements, management makes estimates regarding:
 
Valuations of assets and liabilities requiring fair value estimates including:
   
Trading inventory and investment securities;
 
   
Private equity investments;
 
   
Loans and allowance for loan losses;
 
The outcome of litigation;
 
 
The realization of deferred tax assets and tax reserves;
 
 
Assumptions and cash flow projections used in determining whether variable interest entities (“VIEs”) should be consolidated and the determination of the qualifying status of special purpose entities (“QSPEs”);
 
   
The carrying amount of goodwill and other intangible assets;
 
 
Valuation of employee stock options;
24
Merrill Lynch 2005 Annual Report
 


Table of Contents

 
Insurance reserves and recovery of insurance deferred acquisition costs; and
 
 
Other matters that affect the reported amounts and disclosure of contingencies in the financial statements.
Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ from those estimates and could have a material impact on the Consolidated Financial Statements, and it is possible that such changes could occur in the near term. For more information regarding the specific methodologies used in determining estimates, refer to Use of Estimates in Note 1 to the Consolidated Financial Statements.
The following is a summary of Merrill Lynch’s critical accounting policies and estimates.
Valuation of Financial Instruments
Proper valuation of financial instruments is a critical component of Merrill Lynch’s financial statement preparation. Fair values for exchange-traded securities and certain exchange-traded derivatives, principally futures and certain options, are based on quoted market prices. Fair values for over-the-counter (“OTC”) derivative financial instruments, principally forwards, options, and swaps, represent amounts estimated to be received from or paid to a third party in settlement of these instruments. These derivatives are valued using pricing models based on the net present value of estimated future cash flows, and directly observed prices from exchange-traded derivatives, other OTC trades, or external pricing services, while taking into account the counterparty’s credit ratings, or Merrill Lynch’s own credit ratings as appropriate.
New and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation often incorporate significant estimates and assumptions, which may impact the level of precision in the Consolidated Financial Statements. For long-dated and illiquid contracts, extrapolation methods are applied to observed market data in order to estimate inputs and assumptions that are not directly observable. This enables Merrill Lynch to mark-to-market all positions consistently when only a subset of prices is directly observable. Values for OTC derivatives are verified using observed information about the costs of hedging the risk and other trades in the market. As the markets for these products develop, Merrill Lynch continually refines its pricing models based on experience to correlate more closely to the market risk of these instruments. Obtaining the fair value for OTC derivative contracts requires the use of management judgment and estimates. At the inception of the contract, unrealized gains for these instruments are not recognized unless significant inputs to the valuation model are observable in the market.
Merrill Lynch holds investments that may have quoted market prices but that are subject to restrictions (e.g., consent of the issuer or other investors to sell) that may limit Merrill Lynch’s ability to realize the quoted market price. Accordingly, Merrill Lynch estimates the fair value of these securities based on management’s best estimate, which incorporates pricing models based on projected cash flows, earnings multiples, comparisons based on similar market transactions and/or review of underlying financial conditions and other market factors.
Valuation adjustments are an integral component of the mark-to-market process and may be taken where either the sheer size of the trade or other specific features of the trade or particular market (such as counterparty credit quality, concentration or market liquidity) requires adjustment to the values derived by the pricing models.
Because valuation may involve significant estimation where readily observable prices are not available, a categorization of Merrill Lynch’s financial instruments based on liquidity of the instrument and the amount of estimation required in determining its value as recorded in the Consolidated Financial Statements is provided below. In preparing the categorization, certain estimates have been made regarding the allocation of netting adjustments permitted under FASB Interpretation No. (“FIN”) 39, Offsetting of Amounts Related to Certain Contracts, and other adjustments.
Assets and liabilities recorded on the Consolidated Balance Sheets can be broadly categorized as follows:
Category 1. Highly liquid cash and derivative instruments, primarily carried at fair value, for which quoted market prices are readily available (for example, exchange-traded equity securities, certain listed options, and U.S. Government securities).
Category 2. Liquid instruments, primarily carried at fair value, including:
  a)  
Cash instruments for which quoted prices are available but which trade less frequently such that there may not be complete pricing transparency for these instruments across all market cycles (for example, corporate and municipal bonds and certain physical commodities);
 
  b)  
Derivative instruments that are valued using a model, where inputs to the model are directly observable in the market (for example, U.S. dollar interest rate swaps); and
 
  c)  
Instruments that are priced with reference to financial instruments whose parameters can be directly observed (for example, certain trading loans).
 (MERRILL LYNCH LOGO)
 


Table of Contents

Category 3. Less liquid instruments that are valued using management’s best estimate of fair value, and instruments which are valued using a model, where either the inputs to the model and/or the models themselves require significant judgment by management (for example, private equity investments, long-dated or complex derivatives such as certain foreign exchange options and credit default swaps, distressed debt and commodity derivatives, such as long-dated options on gas and power and weather derivatives).
At December 30, 2005 and December 31, 2004, certain assets and liabilities on the Consolidated Balance Sheets can be categorized using the above classification scheme as follows:
                                 
(dollars in millions)                        
2005   Category 1     Category 2     Category 3     Total  
 
Assets
                               
Trading assets, excluding contractual agreements
  $  56,556     $  63,344     $ 2,594     $ 122,494  
Contractual agreements
    5,008       18,177       3,031       26,216  
Investment securities
    6,115       54,805       8,353       69,273  
Liabilities
                               
Trading liabilities, excluding contractual agreements
  $ 48,688     $ 11,248     $ 242     $ 60,178  
Contractual agreements
    4,623       17,490       6,642       28,755  
 
2004
                               
 
Assets
                               
Trading assets, excluding contractual agreements
  $ 72,272     $ 63,714     $ 2,716     $ 138,702  
Contractual agreements
    5,240       27,137       3,498       35,875  
Investment securities
    7,868       64,142       6,450       78,460  
Liabilities
                               
Trading liabilities, excluding contractual agreements
  $ 51,763     $ 10,827     $ 1,269     $ 63,859  
Contractual agreements
    5,090       26,387       4,257       35,734  
 
In addition, other trading-related assets recorded in the Consolidated Balance Sheets at year-end 2005 and 2004 include $255.5 billion and $173.4 billion, respectively, of receivables under resale agreements and receivables under securities borrowed transactions. Trading-related liabilities recorded in the Consolidated Balance Sheets at year-end 2005 and 2004 include $217.5 billion and $176.1 billion, respectively, of payables under repurchase agreements and payables under securities loaned transactions. These securities financing transactions are recorded at their contractual amounts, which approximate fair value, and for which little or no estimation is required by management.
Litigation
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. Merrill Lynch is also involved in investigations and/or proceedings by governmental and self-regulatory agencies. In accordance with SFAS No. 5, Accounting for Contingencies, Merrill Lynch will accrue a liability when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. In many lawsuits and arbitrations, including class action lawsuits, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until the case is close to resolution, in which case no accrual is made until that time. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases in which claimants seek substantial or indeterminate damages, Merrill Lynch cannot predict what the eventual loss or range of loss related to such matters will be. See Note 12 to the Consolidated Financial Statements and Other Information (Unaudited) – Legal Proceedings for further information.
Variable Interest Entities
In the normal course of business, Merrill Lynch enters into a variety of transactions with VIEs. The applicable accounting guidance requires Merrill Lynch to perform a qualitative and/or quantitative analysis of each new VIE at inception to determine whether it is the primary beneficiary of the VIE and therefore must consolidate the VIE. In performing this analysis, Merrill Lynch makes assumptions regarding future performance of assets held by the VIE, taking into account estimates of credit risk, estimates of the fair value of assets, timing of cash flows, and other significant factors. Although a VIE’s actual results may differ from projected outcomes, a revised consolidation analysis is generally not required subsequent to the initial assessment. If a VIE meets the conditions to be considered a QSPE, it is typically not required to be consolidated by Merrill Lynch. A QSPE’s activities must be significantly limited. A servicer of the assets held by a QSPE may have discretion in restructuring or working out assets held by the QSPE as long as the discretion is significantly limited and the parameters of that discretion are fully described in the legal documents that established the QSPE. Determining whether the activities of a QSPE and its servicer meet these conditions requires the use of judgment by management.
26
Merrill Lynch 2005 Annual Report
 


Table of Contents

Income Taxes
Merrill Lynch is under examination by the Internal Revenue Service (“IRS”) and other tax authorities in major countries such as Japan and the United Kingdom, and states in which Merrill Lynch has significant business operations, such as New York. The tax years under examination vary by jurisdiction. An IRS examination covering the years 2001-2003 is expected to be completed in 2006. There are carryback claims from these years of approximately $250 million to $300 million, which will undergo Joint Committee review. A tax benefit would be recorded to the extent that Merrill Lynch is successful in obtaining the tax benefit from these carryback claims. IRS audits have also commenced for the 2004 and 2005 tax years. In the second quarter of 2005, Merrill Lynch paid a tax assessment from the Tokyo Regional Tax Bureau for the years 1998-2002. The assessment reflected the Japanese tax authority’s view that certain income on which Merrill Lynch previously paid income tax to other international jurisdictions, primarily the United States, should have been allocated to Japan. Merrill Lynch is taking steps to file a request for reinvestigation of this assessment, including seeking clarification from international authorities on the appropriate allocation of income among multiple jurisdictions to prevent double taxation. Merrill Lynch regularly assesses the likelihood of additional assessments in each of the tax jurisdictions resulting from these examinations. Tax reserves have been established, which Merrill Lynch believes to be adequate in relation to the potential for additional assessments. However, there is a reasonable possibility that additional amounts may be incurred. The estimated additional possible amounts are no more than $150 million. Merrill Lynch will adjust the level of reserves when there is more information available, or when an event occurs requiring a change to the reserves. The reassessment of tax reserves could have a material impact on Merrill Lynch’s effective tax rate in the period in which it occurs.
Business Environment(1)
Global financial market conditions improved during 2005, despite rising U.S. short-term interest rates and energy prices. Non-U.S. stock markets outperformed those of the United States. The U.S. dollar strengthened against most major currencies, hitting two-year highs against the euro and the yen. Fixed income markets remained active, and the yield curve flattened throughout the year, at times becoming inverted. Long-term interest rates, as measured by the yield on the 10-year U.S. Treasury bond, began 2005 at 4.22% and moved as low as 3.89% by mid-year, only to rebound and end the year at 4.39%. The U.S. Federal Reserve System’s Federal Open Market Committee raised the federal funds rate eight times during the year from 2.25% to 4.25%.
In 2005, U.S. equity markets did not perform as well as the rest of the world. Major U.S. equity indices declined during the first half of the year but recovered this decline during the second half of 2005. The Dow Jones Industrial Average ended the year essentially unchanged from 2004. Both the Standard & Poor’s 500 Index and the Nasdaq Composite Index finished the year with modest gains of 3% and 1%, respectively.
Global equity indices rallied in the latter part of the year, primarily due to strong economic growth and rising corporate profits. The Dow Jones World Index, excluding the United States, rose 14% during the year. European stocks performed particularly well in 2005 as the Dow Jones Stoxx 50 index and the FTSE 100 index rose 21% and 17%, respectively. As a result of surging oil prices, the best performances in Western Europe were those of Norway and Austria, as Norway’s OSE All Share index and Austria’s ATX index grew 52% and 51%, respectively. In Eastern Europe, Russia’s benchmark index rose 63% also due to escalating oil and gas prices. Japan’s economic recovery led to a 40% rise in the Nikkei Stock Average, making it one of the top-performing markets. The Dow Jones Asia-Pacific index rose 22% led by South Korea, India and Japan. Emerging markets maintained their strong performances as Brazil’s Bovespa Index rose 28% and Mexico’s Bolsa Index rose 38% for the year.
U.S. Equity trading volumes for 2005 were generally higher than 2004. On the NYSE both the dollar volume of shares and the number of shares increased compared to the prior year. On the Nasdaq, the dollar volume of shares rose, while the number of shares declined compared to 2004. U.S. equity market volatility declined compared to prior year levels as measured by the VIX and QQV volatility indices.
In 2005, global debt and equity underwriting volumes increased to $6.5 trillion, up 13% for the year. Despite the rise in short-term interest rates during the year, debt issuances increased by 14% to $6.0 trillion. Global debt underwriting fees were $5.0 billion, down 23% from year-ago levels, while global equity underwriting fees declined by 7% to $8.8 billion. The value of Global Initial Public Offerings (“IPOs”) increased by 18% as non-U.S. regions outperformed the United States.
Global merger and acquisition activity increased significantly with the total value of announced deals rising 39% to $2.7 trillion, making 2005 the most active year since 2000. In the United States, the value of announced deals rose 33% to $1.1 trillion for the year. The total value of global completed merger and acquisition activity was $2.2 trillion, 35% higher than 2004. In the United States, the value of completed deals rose 14% to $887 billion.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch continually evaluates its businesses for profitability, performance, and client service to ensure alignment with its long-term strategic objectives under varying market and competitive conditions. The strategy of maintaining long-term client relationships, closely monitoring costs and risks, diversifying revenue sources, and growing fee-based and recurring revenues all continue as objectives to mitigate the effects of a volatile market environment on Merrill Lynch’s business as a whole.
(1) Debt and equity underwriting and merger and acquisition statistics were obtained from Thomson Financial Securities Data.
Results of Operations
                         
(dollars in millions, except per share amounts)   2005     2004     2003  
 
Net revenues
                       
Asset management and portfolio service fees
  $ 6,031     $ 5,440     $ 4,698  
Commissions
    5,371       4,874       4,299  
Investment banking
    3,594       3,268       2,643  
Principal transactions
    3,583       2,248       3,065  
Revenues from consolidated investments
    438       346       70  
Other
    2,195       1,454       1,492  
     
Subtotal
    21,212       17,630       16,267  
Interest and dividend revenues
    26,571       14,989       11,657  
Less interest expense
    21,774       10,560       8,024  
     
Net interest profit
    4,797       4,429       3,633  
     
Total net revenues
    26,009       22,059       19,900  
     
Non-interest expenses
                       
Compensation and benefits
    12,441       10,663       9,886  
Communications and technology
    1,608       1,461       1,457  
Occupancy and related depreciation
    938       893       889  
Brokerage, clearing, and exchange fees
    842       773       676  
Professional fees
    727       715       598  
Advertising and market development
    599       533       429  
Expenses of consolidated investments
    258       231       68  
Office supplies and postage
    210       203       197  
Other
    1,155       751       627  
Net recoveries related to September 11
                (147 )
     
Total non-interest expenses
    18,778       16,223       14,680  
     
Earnings before income taxes
  $ 7,231     $ 5,836     $ 5,220  
     
Net earnings
  $ 5,116     $ 4,436     $ 3,836  
     
Earnings per common share
                       
Basic
  $ 5.66     $ 4.81     $ 4.22  
Diluted
    5.16       4.38       3.87  
     
Return on average common stockholders’ equity
    16.0 %     14.9 %     14.8 %
     
Pre-tax profit margin
    27.8 %     26.5 %     26.2 %
     
Compensation and benefits as a percentage of net revenues
    47.8 %     48.3 %     49.7 %
Non-compensation expenses as a percentage of net revenues
    24.4 %     25.2 %     24.1 %
Book value per share
  $ 35.82     $ 32.99     $ 29.96  
 
Consolidated Results of Operations
Merrill Lynch’s net earnings per diluted share were a record $5.16 in 2005 compared to $4.38 in 2004. Net earnings were a record $5.1 billion in 2005, up 15% from 2004 on net revenues of $26.0 billion, which increased 18% from 2004. Net earnings in 2004 were $4.4 billion, up 16% from $3.8 billion in 2003. Net earnings in 2003 included $91 million of after-tax September 11-related net insurance recoveries ($147 million pre-tax) and after-tax net benefits from restructuring and other charges of $3 million ($20 million of pre-tax expense). The 2005 results reflect the impact of a litigation-related subsequent event as described in Note 2 to the Consolidated Financial Statements.
In 2005, the return on average common stockholders’ equity was 16.0%, and the pre-tax profit margin was a record 27.8%. In 2004, the return on average common stockholders’ equity was 14.9%, and the pre-tax profit margin was 26.5%. In 2003, the return on average common stockholders’ equity was 14.8%, and the pre-tax profit margin was 26.2%.
28
Merrill Lynch 2005 Annual Report
 


Table of Contents

The following chart illustrates the composition of net revenues by category in 2005:

(PIE CHART)
Asset management and portfolio service fees primarily consist of (i) fees earned from the management and administration of retail mutual funds and separately managed accounts for retail investors, as well as institutional funds such as pension assets, (ii) performance fees earned on certain separately managed accounts and institutional money management arrangements, (iii) servicing fees related to these accounts and (iv) annual account fees and certain other account-related fees. Asset management and portfolio service fees were $6.0 billion, up 11% from 2004. The increase in portfolio service fees reflects the impact of net inflows into asset-priced accounts, and the increase in asset management fees reflects the impact of net inflows of higher-yielding assets as well as higher equity market values.
Commissions revenues primarily arise from agency transactions in listed and OTC equity securities and commodities, insurance products and options. Commissions revenues also include distribution fees for promoting and distributing mutual funds (“12b-1 fees”), as well as contingent deferred sales charges earned when a shareholder redeems shares prior to the required holding period. Commissions revenues were $5.4 billion, up 10% from 2004, due primarily to a global increase in client transaction volumes, particularly in listed equities and mutual funds.
Principal transactions revenues include realized gains and losses from the purchase and sale of securities, such as equity securities, fixed income securities, including government bonds and municipal securities, in which Merrill Lynch acts as principal, as well as unrealized gains and losses on trading assets and liabilities, including commodities, derivatives, and loans. Principal transactions revenues were $3.6 billion, 59% higher than a year ago, due primarily to increased revenues from trading of debt and equity products, as well as the addition of the commodities business, which was acquired in November 2004.
Net interest profit is a function of (i) the level and mix of total assets and liabilities, including trading assets owned, deposits, financing and lending transactions and trading strategies associated with the institutional securities business, and (ii) the prevailing level, term structure and volatility of interest rates. Net interest profit is an integral component of trading activity. Net interest profit was $4.8 billion, up 8% from 2004, due primarily to the impact of rising short-term interest rates on deposit spreads earned.
Investment banking revenues include (i) origination revenues representing fees earned from the underwriting of debt, equity and equity-linked securities, as well as loan syndication and commitment fees and (ii) strategic advisory services revenues including merger and acquisition and other investment banking advisory fees. Investment banking revenues were $3.6 billion, up 10% from 2004, driven primarily by increased merger and acquisition advisory revenues as well as higher debt origination fees.
Revenues from consolidated investments include revenues from consolidated investments which are less than 100% owned. Revenues from consolidated investments were $438 million, up from $346 million in 2004, reflecting higher investment gains.
Other revenues include realized investment gains and losses, equity income from unconsolidated subsidiaries, distributions on cost method investments, fair value adjustments on private equity investments made by non-broker-dealer subsidiaries that are held for capital appreciation and/or current income, gains related to the sale of mortgages, write-downs of certain available-for-sale securities, and translation gains and losses on foreign denominated assets and liabilities. Other revenues were $2.2 billion in 2005, up from $1.5 billion in 2004 due primarily to revenues of $541 million in the principal investing and private equity businesses. This amount excludes revenues from consolidated investments. These revenues included fair value adjustments resulting from the recapitalization of equity investments and the sale through an IPO of an equity investment. These revenues were partially offset by lower gains on the sales of mortgages as compared to a year ago.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Net revenues in 2004 were $22.1 billion, 11% higher than in 2003. Asset management and portfolio service fees in 2004 were $5.4 billion, up 16%, due primarily to higher portfolio service fees arising from higher average equity market values in 2004, increased investment and fund management fees and an increased proportion of higher yielding assets. Commission revenues in 2004 were $4.9 billion, up 13% due primarily to a global increase in client transaction volumes, particularly in listed equities and mutual funds. Principal transactions revenues in 2004 decreased 27%, to $2.2 billion, due to significantly lower debt and debt derivatives trading revenues as compared to 2003, which benefited from a more favorable interest rate and credit environment. Net interest profit in 2004 was $4.4 billion, up 22% due primarily to increased secured lending activity and increases in short-term interest rates, partially offset by increased credit provisions related to small- and middle-market lending in GPC. Investment banking revenues of $3.3 billion in 2004 increased 24% from 2003 due to increased transaction volumes as market conditions improved. Revenues from consolidated investments were $346 million, up from $70 million in 2003 reflecting the full-year impact of entities consolidated in late 2003, as well as the impact of entities consolidated in 2004.
Compensation and benefits expenses were $12.4 billion in 2005, up 17% from a year-ago, reflecting higher incentive compensation accruals associated with increased net revenues, as well as higher staffing levels. Compensation and benefits expenses were 47.8% of net revenues for 2005, as compared to 48.3% a year ago. The compensation ratio depends on the absolute level of net revenues, the business mix underlying those revenues and industry compensation trends.
Non-compensation expenses were $6.3 billion in 2005, up 14% from 2004. Communications and technology costs were $1.6 billion, up 10%, due primarily to higher system consulting costs related to investments for growth, including acquisitions, and higher market information and communications costs. Advertising and market development expenses were $599 million, up 12% from 2004, due primarily to higher travel expenses associated with increased activity levels and increased sales promotion and advertising costs. Other expenses were $1,155 million, up from $751 million in 2004, primarily reflecting higher litigation provisions.
Compensation and benefits expenses were $10.7 billion in 2004, an increase of 8% from 2003. The increase was due primarily to higher incentive compensation expenses resulting from increased net revenues and increased staffing levels. Compensation and benefits expenses were 48.3% of net revenues in 2004, compared to 49.7% of net revenues in 2003.
Non-compensation expenses were $5.6 billion in 2004, 16% higher than 2003. Brokerage, clearing and exchange fees were $773 million in 2004, up 14% from 2003 due in part to the acquisition of a clearing business. Professional fees were $715 million in 2004, up 20% from 2003, due principally to higher legal, consulting and recruiting fees. Advertising and market development expenses were $533 million, up 24% from 2003, due primarily to increased travel expenses, sales promotion costs and deal-related expenses. Expenses of consolidated investments were $231 million, up from $68 million in 2003, reflecting the full-year impact of entities consolidated in late 2003 and entities consolidated in 2004. Other expenses were $751 million in 2004, up 20% from 2003, principally due to higher litigation provisions.
Income Taxes
Merrill Lynch’s 2005 income tax provision was $2.1 billion, representing a 29.2% effective tax rate compared with 24.0% in 2004. The 2005 effective tax rate increased from the prior year reflecting the net impact of the business mix, tax settlements, and the $97 million of tax expense ($113 million of tax expense recorded in the fourth quarter, less a $16 million tax benefit recorded in the second quarter) associated with the foreign earnings repatriation of $1.8 billion. The 2004 effective tax rate decreased from the 2003 rate of 26.5% and reflected the mix of U.S. and foreign-sourced income, and utilization and the reversal of the $281 million Japanese valuation allowance, primarily related to the Japan private client business that was restructured in 2001. Deferred tax assets and liabilities are recorded for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the Consolidated Financial Statements. Merrill Lynch assesses its ability to realize deferred tax assets within each jurisdiction, primarily based on a strong earnings history and other factors as discussed in SFAS No. 109, Accounting for Income Taxes. During the last 10 years, average annual pre-tax earnings were $3.7 billion. Accordingly, management believes that it is more likely than not that remaining deferred tax assets, net of the remaining related valuation allowance, will be realized. See Note 15 to the Consolidated Financial Statements for further information.
Business Segments
The following discussion provides details of the operating performance for each of Merrill Lynch’s three business segments, as well as details of products and services offered. The discussion also includes details of net revenues by segment. Certain prior year amounts have been reclassified to conform to the current year presentation.
30
Merrill Lynch 2005 Annual Report
 


Table of Contents

Merrill Lynch reports its results in three business segments: GMI, GPC, and MLIM. GMI provides full service global markets and origination capabilities, products and services to corporate, institutional, and government clients around the world. GPC provides wealth management products and services globally to individuals, small- to mid-size businesses, and employee benefit plans. MLIM manages financial assets for individual, institutional and corporate clients.

(PIE CHART)
Certain MLIM and GMI products are distributed through GPC distribution channels, and, to a lesser extent, certain MLIM products are distributed through GMI. Revenues and expenses associated with these inter-segment activities are recognized in each segment and eliminated at the corporate level. In addition, revenue and expense sharing agreements for joint activities between segments are in place, and the results of each segment reflect the agreed-upon apportionment of revenues and expenses associated with these activities. The following segment results represent the information that is relied upon by management in its decision-making processes. These results exclude items reported in the Corporate segment. Business segment results are reclassified to reflect reallocations of revenues and expenses that result from changes in Merrill Lynch’s business strategy and organizational structure. See Note 3 to the Consolidated Financial Statements for further information.
Global Markets and Investment Banking
GMI provides equity, debt and commodities trading, capital markets services, investment banking and advisory services to issuer and investor clients around the world. The Global Markets division combines the debt, equity and commodities sales and trading activities for investor clients, while the Investment Banking division provides a wide range of origination and strategic advisory services for issuer clients. Global Markets makes a market in securities, derivatives, currencies, and other financial instruments to satisfy client demands, and in connection with proprietary trading activities. Global Markets is a leader in the global distribution of fixed income, currency and energy commodity products and derivatives. Global Markets has one of the largest equity trading operations in the world and is a leader in the origination and distribution of equity and related products. Further, Global Markets provides clients with financing, securities clearing, settlement, and custody services and also engages in principal investments and private equity investing. Investment Banking raises capital for its clients through underwritings and private placements of equity, debt and related securities, and loan syndications. Investment Banking also offers advisory services to clients on strategic issues, valuation, mergers, acquisitions and restructurings.
Global Markets
Global Markets revenues are reported in two major categories, Debt Markets and Equity Markets, based on asset class. Global Markets’ business lines include the following:
Debt Markets
 
Global Credit, Real Estate and Structured Products Group – responsible on a global basis for asset-based lending, securitization and secured commercial real estate lending, collateralized mortgage obligations and asset-backed securities trading, and securitizations related to these transactions, as well as equity investments in real estate and other secured assets; and credit trading of money market instruments, investment grade debt, credit derivatives, structured credit products, syndicated loans, high-yield debt, distressed debt, and emerging markets debt;
 
 
Global Rates and Foreign Exchange Group – responsible on a global basis for sales and trading activities for interest rate derivatives, currency, complex options, United States government and other Federal agency securities, obligations of other sovereigns, municipal securities, pass-through mortgage obligations trading, and debt financial futures and options;
 
 
Global Commodities Group – responsible for energy and weather risk management, as well as marketing and trading of natural gas, power, oil, coal and other energy related products on a global basis; and
 
 
Debt Markets Strategic Risk Trading and Global Hybrid Exotics – responsible for strategic risk trading in Global Debt Markets, with a primary focus on interest rate and foreign exchange trading. This group is also focused on hybrid exotic capabilities, including structured product trading across all asset classes.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Equity Markets
 
Global Equity Trading Group – responsible for cash equity trading and trading activities in equity-linked derivatives, exchange-traded options, convertibles and financial futures on a global basis; also includes equity financing and services, including prime brokerage, stock loan, money manager services and clearing, settlement and custody functions; and
 
 
Global Private Equity – manages assets primarily for its own account and for that of certain investment partnerships of Merrill Lynch employees.
Investment Banking
GMI’s Global Investment Banking structure includes the following businesses:
 
Country/Sector Coverage – responsible for all origination and advisory activities, across countries and sectors, on behalf of issuer clients;
 
 
Corporate Finance – responsible for structured product capabilities, financial product development and commodities origination;
 
 
Equity Capital Markets – responsible for all capital related activities for issuer clients generated in the equity markets, including convertibles and equity derivative products;
 
 
Debt Capital Markets – responsible for all capital related activities for issuer clients generated in the high grade debt markets including derivative products, liability management, private placements, money markets, and structured transactions;
 
 
Leveraged Finance – responsible for all financing activities for non-investment grade issuer clients, including high yield bond and syndicated loans;
 
 
Mergers and Acquisitions – responsible for advising corporate clients regarding strategic alternatives, divestitures, mergers and acquisition activities; and
 
 
Executive Client Coverage Group – senior client relationship managers who focus exclusively on strengthening relationships and maximizing opportunities with key clients.
2005 Developments
GMI’s 2005 results included increased contributions from key areas of investment such as commodities, equity derivatives, principal investing, private equity, prime brokerage and investment banking coverage.
During 2005, GMI made key hires and substantial investments in technology to expand its trading capabilities and capitalize on opportunities and add to client revenue streams. GMI experienced solid revenue growth from these activities in 2005 and expects additional growth in 2006. Significant investments have also been made in the principal investing and private equity businesses, pursuant to which GMI both advises and invests alongside its clients. Investments have also been made to expand the technology infrastructure in prime brokerage and portfolio trading, which led to a greater share of the NYSE program trading volume in 2005. During the year, the commodity business expanded its scope by beginning to trade oil and coal, and commenced trading in Asia. In 2006, GMI will continue to execute to realize the potential on the investments made. In 2006, GMI plans to continue to broaden the scope of the commodities business in terms of product, geography, and linkage to the broader client franchise. In 2006, GMI also plans to focus on expanding its structured product capabilities to meet the needs of investors and for distribution through both proprietary and third-party retail channels globally. Additionally, GMI will continue to invest in mortgage finance and trading, municipals, prime brokerage and portfolio trading. GMI also will continue to focus on building its presence outside of the United States, especially in emerging markets where there is strong potential for future growth.
GMI completed the acquisition of the Chicago-based options, stock and futures clearing firm, Pax Clearing Corporation (“Pax Clearing”) in 2005. This transaction augmented the equity financing and services business and enhanced the quality of service provided to clients. GMI also fully integrated the 2004 purchase of an energy trading business. As a result, Merrill Lynch is now ranked as one of the top firms for trading and marketing natural gas and electric power. These investments have resulted in growth in the number of GMI employees in 2005, bringing in new expertise and adding scale in the asset classes and geographies targeted for growth.
In the fourth quarter of 2005, Merrill Lynch announced that it is increasing its stake in the joint venture, DSP Merrill Lynch, India’s leading investment bank, to further expand the capabilities of that platform and capitalize on the opportunities in that market. In addition, Merrill Lynch has taken steps towards establishing a joint venture with a domestic securities firm in China that will allow Merrill Lynch to participate in the ongoing development of the Chinese capital markets.
32
Merrill Lynch 2005 Annual Report
 


Table of Contents

GMI’s Results of Operations
                         
(dollars in millions)   2005     2004     2003  
 
Global Markets
                       
Debt
  $ 6,324     $ 5,213     $ 5,051  
Equity
    4,381       3,036       2,845  
     
Total Global Markets net revenues
    10,705       8,249       7,896  
     
Investment banking
                       
Origination
                       
Debt
    1,330       1,135       846  
Equity
    952       1,001       715  
Strategic Advisory Services
    882       678       560  
     
Total Investment Banking net revenues
    3,164       2,814       2,121  
     
Total net revenues
    13,869       11,063       10,017  
     
Non-interest expenses
    8,841       7,194       6,246  
     
Pre-tax earnings
  $ 5,028     $ 3,869     $ 3,771  
     
Pre-tax profit margin
    36.3 %     35.0 %     37.6 %
Total full-time employees
    13,400       12,000       10,300  
 
GMI’s 2005 net revenues were $13.9 billion, up 25% from the prior year, and pre-tax earnings increased 30% from 2004 to $5.0 billion. GMI’s pre-tax profit margin was 36.3%, up from 35.0% in the prior year. GMI’s growth in net revenues and pre-tax earnings were a result of increased revenues in all three of GMI’s major business lines – Debt Markets, Equity Markets and Investment Banking. Geographically, Europe contributed the most to the increases in net revenues and pre-tax earnings.
In 2004, GMI’s pre-tax earnings were $3.9 billion, 3% higher than in 2003, on net revenues that increased 10%, to $11.1 billion. During 2003, GMI recognized $155 million in September 11-related business interruption insurance recoveries for forgone pre-tax profits. These insurance reimbursements were recorded as reductions of non-interest expenses. GMI’s increased net revenues and pre-tax earnings in 2004 were due principally to strong revenue growth in investment banking, improved cash equity trading results, and growth in the global principal investments and secured financing business. Geographically, the United States and the Pacific Rim contributed to the increases in net revenues and pre-tax earnings.
A detailed discussion of GMI’s net revenues follows:
Debt Markets
Debt Markets net revenues include principal transactions and net interest profit (which should be viewed in aggregate to assess trading results), commissions, revenues from principal investments, fair value adjustments on private equity investments made by non-broker dealer subsidiaries that are held for capital appreciation and/or current income, and other revenues. In 2005, Debt Markets net revenues of $6.3 billion increased 21% from 2004, as net revenues increased for all major products. The largest increase in net revenues was recorded by the global principal investing and secured finance business (which primarily includes principal investing in and financing of distressed assets and real estate, as well as mortgage and asset-backed securitization and trading activities), followed by the commodities business, which was acquired in 2004, and the trading of credit products. Debt Markets net revenues in 2005 included principal investing gains, including a single gain of approximately $152 million, which was recorded in other revenues on the Consolidated Statements of Earnings, primarily associated with the change in the fair value of an equity principal investment upon its recapitalization. Given the event-driven nature of many principal investments, revenue realization and trends in the principal investing business may be uneven. In addition, revenues from equity method investments were $104 million in 2005 compared to $220 million for 2004. This year-over-year reduction was due to the change in accounting treatment for an investment from the equity method to the cost method following the adoption of Emerging Issues Task Force (“EITF”) Issue No. 02-14, Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence Through Other Means. Net revenues related to equity method investments are included in other revenues on the Consolidated Statements of Earnings.
In 2004, Debt Markets net revenues were $5.2 billion, 3% higher than 2003, driven primarily by increased revenues from the global principal investments and secured financing business, and the addition of the commodities trading business in late 2004. These increases were partially offset by lower revenues from credit products and interest rate trading compared to the strong 2003 results.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Equity Markets
Equity Markets net revenues include commissions, principal transactions and net interest profit, (which should be viewed in aggregate to assess trading results), revenues from equity method investments, fair value adjustments on private equity investments made by non-broker-dealer subsidiaries that are held for capital appreciation and/or current income, and other revenues. Equity Markets net revenues of $4.4 billion increased 44% from 2004 driven by increased revenues from private equity, cash and equity-linked trading, and the equity financing and services business, which includes prime brokerage and clearing, and reflects the acquisition of Pax Clearing. During 2005, Merrill Lynch recognized approximately $443 million of revenues related to fair value adjustments on private equity investments, including adjustments resulting from the recapitalization of private equity investments and the sale through an IPO of a private equity investment. In addition, Equity Markets net revenues in 2005 included $321 million of revenues from equity method investments compared to $182 million during 2004.
In 2004, Equity Markets net revenues increased 7% from 2003 to $3.0 billion. This increase was due principally to higher revenues from the cash equity trading business, as trading volumes increased in 2004.
Investment Banking
Investment Banking net revenues increased 12% in 2005 to $3.2 billion as increased strategic advisory services and debt origination revenues were partially offset by lower equity origination revenues. Investment Banking net revenues increased 33% in 2004 to $2.8 billion, reflecting a more favorable environment and investments made to better position the origination effort in key industry sectors and regions.
Origination
Origination revenues represent fees earned from the underwriting of debt, equity and equity-linked securities as well as loan syndication fees.
Origination revenues in 2005 were $2.3 billion, up 7% from 2004, driven by higher debt underwriting revenues, which increased 17% from 2004, partially offset by equity underwriting revenues which declined 5% from 2004. The increase in debt origination revenues reflects higher revenues from syndicated lending activities as well as increased overall debt origination activity during the year. Total origination revenues were $2.1 billion in 2004, up 37% from 2003, reflecting increased debt and equity underwriting revenues. Debt origination revenues increased 34% from 2003, reflecting higher margin transactions and a favorable market environment for debt origination with narrowing credit spreads and low interest rates. Equity origination revenues increased 40% from 2003 due primarily to an increased volume of IPOs and a significant improvement in the market environment for equity origination.
Strategic Advisory Services
Strategic advisory services revenues, which include merger and acquisition and other advisory fees, were $882 million in 2005, up 30% due to an increase in transaction volumes. In 2004, strategic advisory services revenues increased 21% to $678 million, as global completed mergers and acquisitions volume increased substantially and Merrill Lynch’s market share of completed transactions increased.
Global Private Client
GPC provides a full range of advice-based wealth management products and services to assist clients in managing all aspects of their financial profile through the Total MerrillSM platform. GPC’s offerings include commission and fee-based investment accounts; banking, cash management, and credit services, including consumer and small business lending and credit cards; trust and generational planning; retirement services; and insurance products. GPC serves individual investors and small- and middle-market corporations and institutions through approximately 15,160 FAs in over 700 offices around the world as of year-end 2005.
Advisory Division
Brokerage and advisory financial services are provided in the United States to GPC clients principally through the Financial Advisor network. Outside the United States, Merrill Lynch provides comprehensive brokerage and investment services and related products through a network of offices located in 26 countries. Banking and trust services, as well as asset management services, are also offered to private clients in many countries.
To be more responsive to client needs and enhance the quality of its clients’ experience, Merrill Lynch offers a multi-channel service model that more closely aligns its FAs with clients based on levels of investable assets. The Advisory Division’s FAs are focused primarily on clients with more than $100,000, but less than $10 million of investable assets. Private Wealth Advisors who have completed a rigorous accreditation program focus primarily on clients with more than $10 million of investable assets. GPC’s Financial Advisory Center, a team-based service platform with access by telephone and internet, is focused primarily on U.S. clients with less than $100,000 of investable assets. GPC also uses International Financial Advisory Centers to more effectively serve non-U.S. clients with lower levels of investable assets.
34
Merrill Lynch 2005 Annual Report
 


Table of Contents

Merrill Lynch provides electronic brokerage services through Merrill Lynch Direct®, an internet-based brokerage service for U.S. clients preferring a self-directed approach to investing. Merrill Lynch Direct® offers online equity and fixed income trading, mutual funds, access to Merrill Lynch and other research and a variety of online investing tools.
Individual clients access the full range of GPC brokerage and advisory services through the CMA® account. At the end of 2005, there were approximately 2.3 million CMA® accounts with aggregate assets of approximately $674 billion. Small- and medium-sized businesses obtain a wide range of securities account and cash management services through the Working Capital Management Account® (“WCMA account”) and related services. The WCMA account combines business checking, investment and electronic funds transfer services into one account for participating business clients. At the end of 2005, there were almost 111,000 WCMA accounts with aggregate assets of more than $116 billion.
To help align products and services to each client’s specific investment requirements and goals, GPC offers a choice of traditional commission-based investment accounts, a variety of asset-priced brokerage and investment advisory services and self-directed online accounts. Assets in GPC accounts totaled $1.5 trillion at December 30, 2005, an 8% increase from December 31, 2004, due primarily to market appreciation and, to a lesser extent, net new money.
Banking, Trust and Insurance Services
Through the Beyond Banking® account, a Merrill Lynch client in the United States has access to a special securities account product designed for everyday transactions, savings and cash management that combines Visa, check writing and ATM access with available advice and guidance. GPC also makes mortgage and small business loans to clients through Merrill Lynch’s banks.
GPC securities brokerage clients provide deposits to Merrill Lynch’s banking entities which are used by these entities for lending and investment activities. GPC also recognizes revenue from a number of different business lines including residential mortgage financing, small and mid-size business lending and securities based lending. GPC also sells life insurance and annuity products and provides personal trust, employee benefit trust and custodial services for its clients. These activities are conducted through various Merrill Lynch bank, trust and insurance subsidiaries and are more fully described in the Activities of Principal Subsidiaries section.
Retirement Services
The Merrill Lynch Retirement Group is responsible for approximately $363 billion in retirement assets for approximately 6.2 million individuals. This group provides a wide variety of investment and custodial services to individuals in the United States through Individual Retirement Accounts (“IRAs”) or through one of approximately 31,000 workplace-based retirement programs covered by the group. Merrill Lynch also provides investment, administration, communications and consulting services to corporations and their employees for their retirement programs. These programs include equity award and executive services, 401(k), pension, profit-sharing and non-qualified deferred compensation plans, as well as other retirement benefit plans. In addition, Merrill Lynch offers Merrill Lynch Advice Access®, an investment advisory service for individuals in retirement plans that provides plan participants with the option of obtaining advice through their local FA, an advisor at the Financial Advisory Center or through Merrill Lynch’s Benefits Online® website.
2005 Developments
GPC continued to focus on organic and inorganic growth initiatives during 2005, continuing to drive operating leverage through a strategy of revenue and product diversification, annuitization, client segmentation, growth in FA headcount, and investments to improve productivity. Over 1,000 FAs were added during 2005, and productivity per FA increased over 2004. The growth in FAs came through GPC’s recruiting efforts, its acquisition of The Advest Group, Inc., (“Advest”) and the continued low rate of turnover among GPC’s most productive FAs. GPC continues to make investments to carefully expand both within and outside the United States, where substantial opportunity for growth exists in a number of markets.
GPC continued to make progress in diversifying revenues by increasing fee-based and recurring revenue sources. Fee-based revenue and net interest profit and related hedges as a percentage of GPC’s total net revenues rose to 66% despite a year-over-year increase in transactional and origination revenues. GPC fee-based revenues from asset-priced and managed account products, including Merrill Lynch Consults® and Unlimited AdvantageSM, rose 11% in 2005.
The rollout of the Wealth Management Technology Platform (“WMTP”) to more than 23,000 U.S. users, including FAs, Client Associates, and the Financial Advisory Center’s Investor Services Advisors, commenced in 2004 and was substantially completed in 2005. WMTP is a fully integrated workstation that incorporates a comprehensive suite of market data and financial planning tools. This deployment resulted in higher infrastructure expense in 2005 and is expected to similarly impact future periods.
 (MERRILL LYNCH LOGO)
 


Table of Contents

In 2005, Merrill Lynch completed its acquisition of the U.S. retirement business of AMVESCAP Plc; entered into a definitive agreement to establish a private banking and wealth management joint venture in Japan with Mitsubishi UFJ Financial Group; and completed its acquisition of Advest for approximately $400 million.
GPC’s Results of Operations
                         
(dollars in millions)   2005     2004     2003  
 
Fee-based revenues
  $ 5,340     $ 4,801     $ 4,068  
Transactional and origination revenues
    3,311       3,293       3,042  
Net interest profit and related hedges(1)
    1,801       1,293       1,301  
Other revenues
    312       440       487  
     
Total net revenues
    10,764       9,827       8,898  
     
Non-interest expenses
    8,587       7,954       7,369  
     
Pre-tax earnings
  $ 2,177     $ 1,873     $ 1,529  
     
Pre-tax profit margin
    20.2 %     19.1 %     17.2 %
Total full-time employees
    33,000       31,000       30,200  
Total Financial Advisors
    15,160       14,140       13,530  
 
(1)  
Includes interest component of non-qualifying derivatives which are included in other revenues on the Consolidated Statements of Earnings.
GPC generated $2.2 billion of pre-tax earnings in 2005, up 16% from 2004 on net revenues that increased 10% to $10.8 billion. Compared with 2004, higher asset values and strong annuitized net asset inflows led to increased fee-based revenues, which were supplemented by higher net interest profit and partially offset by lower mortgage-related revenues. The pre-tax margin was 20.2% compared to 19.1% in 2004. Non-interest expenses were 8% higher, principally reflecting increased compensation costs associated with higher revenues and growth in FA headcount.
GPC’s 2004 pre-tax earnings were $1.9 billion, up 22% compared to 2003, on net revenues that increased 10% to $9.8 billion. GPC’s 2004 pre-tax profit margin of 19.1% increased from 17.2% in 2003 and was driven by increased net revenues and expense discipline. Higher asset values and annuitized asset flows drove an 18% increase in fee-based revenues, and a more active market environment led to growth in GPC’s transactional and origination revenues.
Total assets in GPC accounts increased 8% from 2004, to $1.5 trillion. Net inflows into annuitized products rose 25% from 2004 to $44.6 billion, and total net new money was $46.2 billion in 2005, up 94% from 2004.
Fee-based Revenues
Fee-based revenues are comprised of portfolio service fees which are primarily derived from accounts that charge an annual fee based on net asset value, such as Merrill Lynch Consults®, a separate account product, and Unlimited AdvantageSM, as well as fees from insurance products, taxable and tax-exempt money market funds, and alternative investment products. Also included in fee-based revenues are fixed annual account fees and other account-related fees, and commissions related to distribution fees on mutual funds.
GPC generated $5.3 billion of fee-based revenues in 2005, up 11% from 2004. This increase reflected growth in client assets due to higher market valuations and annuitized net asset inflows. This asset growth resulted in higher portfolio service fees and increased distribution fees related to mutual fund sales. In 2004, fee-based revenues totaled $4.8 billion, up 18% from 2003, reflecting market-driven increases in asset levels, higher portfolio service fees, and increased distribution fees related to mutual fund sales.
The value of assets in GPC accounts and assets in asset-priced accounts at year-end 2005, 2004, and 2003 follows. Assets in asset-priced accounts are those assets in clients’ brokerage accounts for which fees are determined based on the value of assets in the account.
                         
(dollars in billions)   2005     2004     2003  
 
Assets in GPC accounts
                       
U.S.
  $ 1,356     $ 1,244     $ 1,164  
Non-U.S.
    117       115       103  
     
Total
  $ 1,473     $ 1,359     $ 1,267  
     
Assets in asset-priced accounts
  $ 284     $ 257     $ 226  
As a percentage of total assets in GPC accounts
    19.3 %     18.9 %     17.8 %
 
36
Merrill Lynch 2005 Annual Report
 


Table of Contents

Transactional and Origination Revenues
Transactional and origination revenues include certain commission revenues, such as those that arise from agency transactions in listed and OTC equity securities, insurance products, and mutual funds. Also included are principal transactions revenues which primarily represent bid-offer revenues on government bonds and municipal securities, as well as new issue revenues which include selling concessions on newly issued debt and equity securities, including shares of closed-end funds.
Transactional and origination revenues were $3.3 billion in 2005, essentially unchanged from 2004 as a marginal increase in transaction-related revenues was offset by lower origination revenues. In 2004, transactional and origination revenues totaled $3.3 billion, up 8% from 2003, primarily reflecting increased transactions resulting from more active markets. Increased commissions revenues on equity securities and insurance products and higher equity new issue revenues were the largest contributors.
Net Interest Profit and Related Hedges
Net interest profit (interest revenues less interest expenses) and related hedges includes GPC’s allocation of the interest spread earned in Merrill Lynch’s banks for deposits, as well as interest earned on margin, small- and middle-market business and other loans, corporate funding allocations, and the interest component of non-qualifying derivatives.
GPC’s net interest profit and related hedges were $1.8 billion in 2005, up 39% from 2004. This increase primarily reflects higher margins on deposits resulting from rising short-term interest rates and lower provisions associated with the small- and middle-market business loan portfolio. GPC’s net interest profit and related hedges were $1.3 billion in 2004, down 1% from 2003. Higher net interest revenues resulting from increases in short-term interest rates were more than offset by increased credit provisions associated with secured business loans extended to small- and middle-market businesses.
Other Revenues
GPC’s other revenues were $312 million in 2005, down from $440 million in 2004 on lower mortgage-related revenues which were driven in part by lower variable rate mortgage originations. Other revenues in 2004 were down 10% from 2003, also reflecting lower mortgage lending-related revenue.
Merrill Lynch Investment Managers
MLIM and its affiliates are among the world’s largest asset managers with approximately $539 billion of assets under management at the end of 2005. Firmwide assets under management, including $5 billion of assets managed by GPC, totaled approximately $544 billion.
With portfolio managers located in the United States, the United Kingdom, Japan and Australia, MLIM manages a wide array of taxable and tax-exempt fixed-income, equity and balanced mutual funds and segregated accounts for a diverse global clientele, as well as a wide assortment of index-based equity and alternative investment products.
MLIM’s clients include institutions, pension funds, high-net-worth individuals and retail investors. MLIM’s product distribution is managed through five channels: proprietary retail (GPC); Americas non-proprietary retail; Americas institutional; EMEA Pacific third-party retail; and EMEA Pacific institutional. MLIM also distributes certain of its products through GMI. MLIM maintains a significant sales and marketing presence both inside and outside the United States that is focused on acquiring and maintaining institutional investment management relationships by marketing its services to institutional investors both directly and through pension consultants, and establishing third-party distribution relationships.
At the end of 2005, MLIM provided global advisory services for mutual funds, unit investment trusts and other non-U.S. equivalent products totaling approximately $245 billion. MLIM’s non-U.S. mutual fund ranges are based in a number of domiciles and cover a range of asset classes, including cash, fixed income and equities. In the United States, the primary retail offering is the Merrill Lynch family of funds. The primary retail fund range offered outside the United States is Merrill Lynch International Investment Funds (“MLIIF”), which is authorized for distribution in more than 30 jurisdictions worldwide.
MLIM manages separate accounts for high-net-worth retail investors as well as assets for governments, pension funds, endowments and other institutional investors in a wide variety of active and passive strategies covering both equity and fixed income assets. At the end of 2005, MLIM managed a total of approximately $44 billion in separate accounts and $250 billion in institutional accounts.
MLIM also offers a wide assortment of alternative investment products such as structured products, real estate funds, hedge funds, hedge funds of funds, private equity funds of funds, managed futures funds and exchange traded funds. These products are sold to both U.S. and non-U.S. high-net-worth retail and institutional investors. At the end of 2005, assets under management included approximately $13.8 billion of client capital committed to, and approximately $10.6 billion invested in, alternative investment products.
 (MERRILL LYNCH LOGO)
 


Table of Contents

2005 Developments
During 2005, MLIM continued with its strategy of maintaining strong investment performance to drive sales globally. MLIM is committed to increasing sales in both its proprietary and non-proprietary channels in the United States. On February 15, 2006, Merrill Lynch announced that it had reached an agreement to combine MLIM with BlackRock in exchange for an economic interest in the combined investment management firm of 49.8%. Refer to Note 2 to the Consolidated Financial Statements for further information.
MLIM continued to focus on driving strong relative long-term investment performance and broadening the distribution of its products through multiple channels, while maintaining discipline on expenses. Current industry standards typically measure investment results for institutional accounts against a benchmark (such as the S&P 500 Index) and investment results for retail mutual funds against competitor results ranked by quartile within investment category as reported by third-party organizations, such as Lipper or Standard & Poor’s. More than 70% of MLIM’s global assets under management were above benchmark or category median for the 3- and 5-year periods ending December 2005.
In September 2005, MLIM acquired the pension business of Royal Philips Electronics (“Philips”), adding approximately $18 billion to its assets under management.
MLIM’s Results of Operations
                         
(dollars in millions)   2005     2004     2003  
 
Asset management fees
  $  1,573     $  1,413     $  1,233  
Commissions
    105       116       132  
Other revenues
    129       51       (3 )
     
Total net revenues
    1,807       1,580       1,362  
     
Non-interest expenses
    1,221       1,120       1,101  
     
Pre-tax earnings
  $ 586     $ 460     $ 261  
     
Pre-tax profit margin
    32.4 %     29.1 %     19.2 %
Total full-time employees
    2,600       2,500       2,600  
 
MLIM’s 2005 net revenues were $1.8 billion, up 14% from 2004, due primarily to higher average long-term asset values as well as increases in performance fees and an improvement in the fee profile of assets under management. Pre-tax earnings were $586 million, up 27% from 2004, driven principally by higher net revenues and continued expense discipline as non-compensation expenses were essentially unchanged from 2004. MLIM’s pre-tax profit margin was 32.4% in 2005, up from 29.1% in 2004.
Pre-tax earnings for MLIM were $460 million in 2004, up 76% from 2003. Net revenues grew 16%, to $1.6 billion, due primarily to increased asset values related to market appreciation, as well as the positive impact of currency translation. As short-term interest rates increased, investors moved assets out of retail money market funds to higher-yielding products. MLIM’s pre-tax profit margin was 29.1% in 2004, up from 19.2% in 2003, reflecting continued expense discipline, as non-interest expenses increased only 2% from 2003.
Asset Management Fees
Asset management fees primarily consist of fees earned from the management and administration of retail mutual funds and separately managed accounts for retail investors, as well as institutional funds such as pension assets. Asset management fees also include performance fees, which are generated in some cases by separately managed accounts and institutional money management arrangements.
Asset management fees were $1.6 billion, up 11% from 2004 due to higher average equity market values and an improvement in the fee profile of assets under management. In 2004, asset management fees were $1.4 billion, up 15% from 2003 as average asset values increased and the fee profile of assets under management improved.
Firmwide assets under management for each of the last three years were comprised of the following:
                         
(dollars in billions)   2005     2004     2003  
 
Assets Under Management
                       
Institutional
  $  250     $  240     $  253  
Retail
    245       218       207  
Separate Accounts(1)
    49       43       40  
     
Total
  $  544     $  501     $  500  
 
(1)  
Represents segregated portfolios for individuals, small corporations, and institutions and includes $5 billion of accounts managed by GPC in 2005 and 2004.
38
Merrill Lynch 2005 Annual Report
 


Table of Contents

(BAR CHART)
At the end of 2005, firmwide assets under management totaled $544 billion, with $539 billion managed by MLIM and its affiliates and $5 billion managed by GPC. Compared with 2004, firmwide assets under management increased 9%, due principally to positive market movement, the addition of $18 billion of assets from the acquisition of Philips’ pension business, and net new money inflows of $5 billion.
An analysis of changes in firmwide assets under management from year-end 2004 to 2005 is as follows:
                                         
          Net Changes Due To        
    Year-end             Asset             Year-end  
(dollars in billions)   2004(1)     New Money     Appreciation     Other(2)     2005(1)  
 
Assets Under Management
  $  501     $ 5     $  33     $  5     $  544  
 
(1)  
Includes $5 billion of assets managed by GPC.
(2)  
Includes $18 billion of new assets from the acquisition of Philips’ pension business, the impact of foreign exchange movement, reinvested dividends and other changes.
(PIE CHARTS)
Commissions
Commissions for MLIM principally consist of distribution fees and contingent deferred sales charges (“CDSC”) related to mutual funds. The distribution fees represent revenues earned for promoting and distributing mutual funds, and the CDSC represents fees earned when a shareholder redeems shares prior to the required holding period. Commission revenues were $105 million in 2005, down 9% from 2004. Commission revenues declined to $116 million in 2004, down 12% from 2003. These reductions reflect the decline over time in sales of rear-load shares.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Other Revenues
Other revenues primarily include net interest profit, investment gains and losses and revenues from consolidated investments. Other revenues totaled $129 million in 2005, up from $51 million in 2004 reflecting increased investment gains. Other revenues in 2003 were $(3) million and included investment losses.
Consolidated Balance Sheets
Overview
Management continually monitors and evaluates the size and composition of the Consolidated Balance Sheets. The following table summarizes the year-end and average balance sheets for 2005 and 2004:
                                 
(dollars in billions) Dec. 30, 2005     2005 Average(1)     Dec. 31, 2004     2004 Average(1)  
 
Assets
                               
Trading-Related
                               
Securities financing assets
  $  272.3     $  268.3     $  185.3     $  181.5  
Trading assets
    148.7       182.9       174.6       157.0  
Other trading-related receivables
    54.3       60.9       51.8       46.4  
     
 
    475.3       512.1       411.7       384.9  
     
Non-Trading-Related
                               
Cash
    26.5       38.7       38.6       24.5  
Investment securities
    69.3       71.2       78.5       82.6  
Loans, notes, and mortgages, net
    66.0       60.6       53.3       54.8  
Other non-trading assets
    43.9       47.8       46.0       42.9  
     
 
    205.7       218.3       216.4       204.8  
     
Total assets
  $ 681.0     $ 730.4     $ 628.1     $ 589.7  
     
Liabilities
                               
Trading-Related
                               
Securities financing liabilities
  $ 234.3     $ 272.7     $ 188.0     $ 186.8  
Trading liabilities
    88.9       105.7       99.6       93.2  
Other trading-related payables
    56.9       63.8       56.0       51.2  
     
 
    380.1       442.2       343.6       331.2  
     
Non-Trading-Related
                               
Commercial paper and other short-term borrowings
    3.9       6.5       4.0       5.8  
Deposits
    80.0       79.2       79.7       77.8  
Long-term borrowings
    132.4       122.4       119.5       100.3  
Long-term debt issued to TOPrSSM partnerships
    3.1       3.1       3.1       3.1  
Other non-trading liabilities
    45.9       43.8       46.8       41.8  
     
 
    265.3       255.0       253.1       228.8  
     
Total liabilities
    645.4       697.2       596.7       560.0  
     
Total stockholders’ equity
    35.6       33.2       31.4       29.7  
     
Total liabilities and stockholders’ equity
  $ 681.0     $ 730.4     $ 628.1     $ 589.7  
 
(1)  
Averages represent management’s daily balance sheet estimates, which may not fully reflect netting and other adjustments included in period-end balances. Balances for certain assets and liabilities are not revised on a daily basis.
The discussion that follows analyzes the changes in year-end financial statement balances and yearly average balances of the major asset and liability categories.
Trading-Related Assets and Liabilities
Trading-related balances primarily consist of securities financing transactions, trading assets and liabilities, and certain interest receivable/payable balances that result from trading activities. At December 30, 2005, total trading-related assets and liabilities were $475.3 billion and $380.1 billion, respectively. Average trading-related assets and liabilities for 2005 were $512.1 billion and $442.2 billion, respectively.
The increases in trading-related assets and liabilities in 2005 primarily reflect higher levels of securities financing activity, which includes increased client matched-book transactions. Merrill Lynch continued to expand its prime brokerage businesses during the year, which resulted in increases in securities financing transactions and other trading-related receivables.
Although trading-related balances comprise a significant portion of the Consolidated Balance Sheets, the magnitude of these balances does not necessarily result in an increase in risk. The market and credit risks associated with trading-related balances are
40
Merrill Lynch 2005 Annual Report
 


Table of Contents

mitigated through various hedging strategies, as discussed in the following section. See Note 6 to the Consolidated Financial Statements for descriptions of market and credit risks.
Merrill Lynch reduces a significant portion of the credit risk associated with trading-related assets by requiring counterparties to post cash or securities as collateral in accordance with collateral maintenance policies. Conversely, Merrill Lynch may be required to post cash or securities to counterparties in accordance with similar policies.
Securities Financing Transactions
Securities financing transactions include resale and repurchase agreements, securities borrowed and loaned transactions, securities received as collateral, and obligations to return securities received as collateral. Repurchase agreements and, to a lesser extent, securities loaned transactions are used to fund a portion of trading assets. Likewise, Merrill Lynch uses resale agreements and securities borrowed transactions to obtain the securities needed for delivery on short positions. These transactions are typically short-term in nature, with a significant portion entered into on an overnight or open basis.
Merrill Lynch also enters into these transactions to meet clients’ needs, which are known as matched-book transactions. These matched-book repurchase and resale agreements or securities borrowed and loaned transactions are entered into with different clients using the same underlying securities, generating a spread between the interest revenue on the resale agreements or securities borrowed transactions and the interest expense on the repurchase agreements or securities loaned transactions. Exposures on these transactions are limited by collateral maintenance policies and the typically short-term nature of the transactions.
Securities financing assets at 2005 year-end were $272.3 billion, up 47% from 2004 year-end, and securities financing liabilities were $234.3 billion at 2005 year-end, up 25% from year-end 2004. Average securities financing assets in 2005 were $268.3 billion, up 48% from the 2004 average. Average securities financing liabilities in 2005 were $272.7 billion, up 46% from the 2004 average.
Trading Assets and Liabilities
Trading inventory principally represents securities purchased (“long positions”), securities sold but not yet purchased (“short positions”), the fair value of derivative contracts, and commodities and related contracts. See Note 1 to the Consolidated Financial Statements for related accounting policies. These positions primarily arise from market-making, hedging, and proprietary activities.
Merrill Lynch acts as a market maker in a wide range of securities, resulting in a significant amount of trading inventory that is required to facilitate client transaction flow. Merrill Lynch also maintains proprietary trading inventory in seeking to profit from existing or projected market opportunities.
Merrill Lynch uses both “cash instruments” (e.g., securities) and derivatives to manage trading inventory market risks. As a result of these hedging techniques, a significant portion of trading assets and liabilities represents hedges of other trading positions. Long positions in U.S. Government securities, for example, may be used to hedge short positions in interest rate futures contracts. These hedging techniques, which are generally initiated at the trading unit level, are supplemented by corporate risk management policies and procedures (see the Risk Management section for a description of risk management policies and procedures).
Trading assets at year-end 2005 were $148.7 billion, down 15% from 2004, and trading liabilities at year-end 2005 were $88.9 billion, down 11% from 2004. Average trading assets in 2005 were $182.9 billion, up 16% from the 2004 average. Average trading liabilities in 2005 were $105.7 billion, up 13% from the 2004 average.
Other Trading-Related Receivables and Payables
Securities trading may lead to various customer or broker-dealer receivable and payable balances. Broker-dealer receivable and payable balances may also result from recording trading inventory on a trade date basis. Certain receivable and payable balances also arise when customers or broker-dealers fail to pay for securities purchased or fail to deliver securities sold, respectively. These receivables are generally collateralized by the securities that the customer or broker-dealer purchased but did not receive. Customer receivables also include certain commodities transactions, margin loans and similar loan arrangements collateralized by customer-owned securities held by Merrill Lynch. Collateral policies significantly limit Merrill Lynch’s credit exposure to customers and broker-dealers. Merrill Lynch, in accordance with regulatory requirements, will sell securities that have not been paid for, or purchase securities sold but not delivered, after a relatively short period of time, or will require additional margin collateral, as necessary. These measures reduce market risk exposure related to these balances.
Interest receivable and payable balances related to trading inventory are principally short-term in nature. Interest balances for resale and repurchase agreements and securities borrowed and loaned transactions are considered when determining the collateral requirements related to these transactions.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Other trading-related receivables at year-end 2005 were $54.3 billion, up 5% from 2004, and other trading-related payables were $56.9 billion at year-end 2005, up 2% from 2004. Average other trading-related receivables in 2005 were $60.9 billion, up 31% from the 2004 average. Average other trading-related payables were $63.8 billion in 2005, up 25% from the 2004 average.
Non-Trading-Related Assets and Liabilities
Non-trading-related balances primarily consist of cash; investment securities; loans, notes, and mortgages; short- and long-term borrowings; and other non-trading assets and liabilities. At December 30, 2005, total non-trading-related assets and liabilities were $205.7 billion and $265.3 billion, respectively. Average non-trading-related assets for 2005 were $218.3 billion, and average non-trading-related liabilities were $255.0 billion.
Cash
Cash includes cash, cash equivalents and securities segregated for regulatory purposes or deposited with clearing organizations. Cash at year-end 2005 was $26.5 billion, down 31% from 2004. Average cash in 2005 was $38.7 billion, up 58% from the 2004 average.
Investment Securities
Investment securities principally consist of debt securities, including those that are held for investment and liquidity and collateral management purposes; equity securities; private equity investments, including investments in partnerships and joint ventures; and other investments.
Investment securities were $69.3 billion at year-end 2005, down 12% from 2004. Average investment securities were $71.2 billion in 2005, down 14% from the 2004 average. See Note 5 to the Consolidated Financial Statements for further information.
Loans, Notes, and Mortgages, net
Merrill Lynch’s portfolio of loans, notes, and mortgages includes corporate and institutional loans, residential and commercial mortgages, asset-based loans and other loans to individuals and other businesses. Merrill Lynch maintains collateral to mitigate risk of loss in the event of default on some of these extensions of credit in the form of securities, liens on real estate, perfected security interests in other assets of the borrower or other loan parties, and guarantees. Merrill Lynch also economically hedges certain portions of commercial loans by purchasing credit default swaps. Loans, notes, and mortgages were $66.0 billion at year-end 2005, up 24% from 2004 as a result of strong market demand driven by favorable borrower fundamentals and business growth. Average loans, notes, and mortgages in 2005 were $60.6 billion, up 11% from the 2004 average. These amounts do not include loans held for trading purposes, which are included in trading assets. See Note 8 to the Consolidated Financial Statements for additional information.
Short- and Long-Term Borrowings
Portions of trading and non-trading assets are funded through deposits, long-term borrowings, and commercial paper (see the Capital and Funding section for further information on funding sources).
Commercial paper and other short-term borrowings were $3.9 billion at 2005 year-end, down 2% from 2004 year-end. The average commercial paper and other short-term borrowings balance in 2005 was $6.5 billion, up 12% from the 2004 average. Deposits were $80.0 billion at 2005 year-end, essentially unchanged from 2004 year-end. Average deposits in 2005 were $79.2 billion, up 2% from the 2004 average. Long-term borrowings, including long-term debt issued to Trust Originated Preferred SecuritiesSM (“TOPrSSM”) partnerships, were $135.5 billion at year-end 2005, up 11% from 2004 year-end. Average long-term borrowings, including long-term debt issued to TOPrSSM partnerships, in 2005 were $125.5 billion, up 21% from the 2004 average. For capital management purposes, Merrill Lynch views TOPrSSM as a component of equity capital although the long-term debt issued to TOPrSSM partnerships is recorded as a liability for accounting purposes.
Major components of the changes in long-term borrowings, including long-term debt issued to TOPrSSM partnerships, for 2005 and 2004 are as follows:
                 
(dollars in billions)   2005     2004  
 
Beginning of year
  $  122.6     $  88.4  
Issuance and resale
    49.7       50.5  
Settlement and repurchase
    (31.2 )     (23.2 )
Other(1)
    (5.6 )     6.9  
     
End of year(2)
  $  135.5     $  122.6  
 
(1)  
Primarily foreign exchange movements.
(2)  
See Note 9 to the Consolidated Financial Statements for the long-term borrowings maturity schedule.
42
Merrill Lynch 2005 Annual Report
 


Table of Contents

Total borrowings, which includes long-term borrowings, including long-term debt issued to TOPrSSM partnerships, and commercial paper and other short-term borrowings, outstanding at year-end 2005 and 2004 were issued in the following currencies:
                                 
(USD equivalent in millions)   2005             2004          
 
USD
  $  86,080       61 %   $  80,068       63 %
EUR
    27,313       20       22,446       18  
JPY
    11,225       8       11,542       9  
GBP
    8,269       6       6,970       6  
CAD
    2,377       2       1,717       1  
AUD
    2,329       2       1,906       1  
Other
    1,810       1       1,935       2  
     
Total
  $  139,403       100 %   $  126,584       100 %
 
Other Non-Trading Assets and Liabilities
Other non-trading assets, which include separate accounts assets, equipment and facilities, goodwill and other intangible assets, other non-interest receivables ($13.9 billion in 2005 and $12.5 billion in 2004) and other assets, were $43.9 billion at year-end 2005, down 5% from 2004. Average other non-trading assets in 2005 were $47.8 billion, up 11% from the 2004 average. Separate accounts assets are related to Merrill Lynch’s insurance businesses and represent segregated funds that are invested for certain policyholders and other customers. The assets of each account are legally segregated and are generally not subject to claims that arise from any other business of Merrill Lynch.
Other non-trading liabilities, which include liabilities of insurance subsidiaries, separate accounts liabilities, and other non-interest payables ($26.8 billion in 2005 and $25.0 billion in 2004), were $45.9 billion at year-end 2005, down 2% from 2004. Average other non-trading liabilities were $43.8 billion in 2005, up 5% from the 2004 average. Separate accounts liabilities represent Merrill Lynch’s obligations to its customers related to separate accounts assets.
Stockholders’ Equity
Stockholders’ equity at December 30, 2005 was $35.6 billion, up 13% from December 31, 2004. This increase primarily resulted from net earnings, preferred stock issuances and the net effect of employee stock transactions, partially offset by common stock repurchases and dividends.
At December 30, 2005, total common shares outstanding, excluding shares exchangeable into common stock, were 915.6 million, 1% lower than the 928.0 million shares outstanding at December 31, 2004. The decrease reflected common stock repurchases, partially offset by shares issued to employees.
Total shares exchangeable into common stock at year-end 2005 issued in connection with the 1998 merger with Midland Walwyn Inc., were 2.7 million, compared with 2.8 million at year-end 2004. For additional information, see Note 11 to the Consolidated Financial Statements.
Off Balance Sheet Arrangements
As a part of its normal operations, Merrill Lynch enters into various off balance sheet arrangements that may require future payments. The table below outlines the significant off balance sheet arrangements, as well as the future expiration as of December 30, 2005:
                                         
    Expiration  
(dollars in millions)   Total     Less than 1 Year     13 Years     3+5 Years     Over 5 Years  
 
Liquidity facilities with SPEs(1)
  $  25,871     $  25,453     $  397     $  21     $  
Liquidity and default facilities with SPEs(2)
    7,114       6,064       806             244  
Residual value guarantees(3)
    1,061       60       19       478       504  
Standby letters of credit and other
                                       
guarantees(4)(5)(6)
    3,291       1,313       384       886       708  
 
(1)  
Amounts relate primarily to facilities provided to municipal bond securitization SPEs.
(2)  
Amounts relate to liquidity facilities and credit default protection provided to municipal bond securitization SPEs and an asset-backed commercial paper conduit (“Conduit”) sponsored by Merrill Lynch.
(3)  
Includes residual value guarantees associated with the Hopewell campus and aircraft leases of $322 million.
(4)  
Includes $244 million of reimbursement agreements with the Mortgage 100SM program.
(5)  
Includes guarantees related to principal-protected mutual funds.
(6)  
Includes certain indemnifications related to foreign tax planning strategies.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch provides guarantees to Special Purpose Entities (“SPEs”) in the form of liquidity facilities, credit default protection and residual value guarantees for equipment leasing entities. The liquidity facilities and credit default protection relate primarily to municipal bond securitization SPEs and the Conduit. To protect against declines in value of the assets held by the SPEs for which Merrill Lynch provides either liquidity facilities or default protection, Merrill Lynch generally economically hedges its exposure through derivative positions that principally offset the risk of loss of these guarantees. The residual value guarantees are related to leasing SPEs where either Merrill Lynch or a third-party is the lessee and reimbursement agreements issued in conjunction with sales of loans originated under its Mortgage 100SM program. Merrill Lynch also makes guarantees to counterparties in the form of standby letters of credit and, at December 30, 2005, held $487 million of marketable securities as collateral to secure these guarantees. In conjunction with certain principal-protected mutual funds and managed mutual funds, Merrill Lynch guarantees the return of the initial principal investment at the termination date of the fund. Merrill Lynch also provides indemnifications related to the U.S. tax treatment of certain foreign tax planning transactions. The maximum exposure to loss associated with these transactions is $164 million; however, Merrill Lynch believes that the likelihood of loss with respect to these arrangements is remote.
The amounts in the preceding table do not necessarily represent expected future cash flow requirements. Refer to Note 7 and Note 12 to the Consolidated Financial Statements for a further discussion of these arrangements.
Contractual Obligations and Commitments
Contractual Obligations
In the normal course of business, Merrill Lynch enters into various contractual obligations that may require future cash payments. The accompanying table summarizes Merrill Lynch’s contractual obligations by remaining maturity at December 30, 2005. Excluded from this table are obligations recorded on the Consolidated Balance Sheets that are: (i) generally short-term in nature, including securities financing transactions, trading liabilities, including contractual agreements, commercial paper and other short-term borrowings and other payables; (ii) deposits; (iii) obligations that are related to Merrill Lynch’s insurance subsidiaries, including liabilities of insurance subsidiaries, which are subject to significant variability; and (iv) separate accounts liabilities, which fund separate accounts assets.
                                         
    Expiration  
(dollars in millions)   Total     Less than 1 Year     13 Years     3+5 Years     Over 5 Years  
 
Long-term borrowings(1)
    $135,501       $22,771       $40,560       $37,669       $34,501  
Operating lease commitments
    3,348       569       1,036       814       929  
Purchasing and other commitments
    5,777       4,100       820       298       559  
 
(1)  
Includes long-term debt issued to TOPrSSM partnerships.
Merrill Lynch issues U.S. and non-U.S. dollar-denominated long-term borrowings with both variable and fixed interest rates, as part of its overall funding strategy. For further information on funding and long-term borrowings, see the Capital and Funding section and Note 9 to the Consolidated Financial Statements. In the normal course of business, Merrill Lynch enters into various noncancellable long-term operating lease agreements, various purchasing commitments, commitments to extend credit and other commitments. For detailed information regarding these commitments, see Note 12 to the Consolidated Financial Statements.
Commitments
At December 30, 2005, Merrill Lynch commitments had the following expirations:
                                         
    Expiration  
(dollars in millions)   Total     Less than 1 Year     13 Years     3+5 Years     Over 5 Years  
 
Commitments to extend credit
    $67,137       $33,885       $9,754       $17,134       $6,364  
Commitments to enter into resale agreements
    3,478       3,459       19              
 
44
Merrill Lynch 2005 Annual Report
 


Table of Contents

Capital and Funding
The primary objectives of Merrill Lynch’s capital structure and funding policies are to support the successful execution of Merrill Lynch’s business strategies while ensuring:
 
sufficient equity capital to support existing businesses and future growth plans and
 
 
liquidity across market cycles and through periods of financial stress.
Capital
At December 30, 2005, equity capital, as defined by Merrill Lynch, was comprised of $32.9 billion of common equity, $2.7 billion of preferred stock, and $2.5 billion of long-term debt issued to TOPrSSM partnerships (net of related investments). Equity capital is Merrill Lynch’s view of capital available to support its businesses and differs from stockholders’ equity as defined by U.S. generally accepted accounting principles, which does not include long-term debt issued to TOPrSSM partnerships, net of related investments.
Merrill Lynch regularly reviews overall equity capital needs to ensure that its equity capital base can support the estimated risks and needs of its businesses, the regulatory and legal capital requirements of its subsidiaries, and standards pursuant to the CSE rules. Merrill Lynch determines the appropriateness of its equity capital composition, taking into account that its preferred stock and TOPrSSM are perpetual. In the event that capital is generated beyond estimated needs, Merrill Lynch returns capital to shareholders through share repurchases and dividends.
To determine equity capital needs to cover potential losses arising from market and credit risks, Merrill Lynch uses statistically based risk models, developed in conjunction with its risk management practices. Models and other tools used to estimate risks are continually modified as risk analytics are refined. The assumptions used in analytical models are reviewed regularly to ensure that they provide a reasonable and conservative assessment of risks to Merrill Lynch across a stress market cycle.
Merrill Lynch also assesses the need for equity capital to support business risks that may not be adequately measured through these risk models, such as legal and other operational risks. When deemed prudent or when required by regulations, Merrill Lynch purchases insurance to protect against some risks. Merrill Lynch also considers equity capital that may be required to support normal business growth and strategic initiatives.
Merrill Lynch’s capital adequacy planning also takes into account the regulatory environment in which Merrill Lynch operates. Many regulated businesses require various minimum levels of capital. See Note 16 to the Consolidated Financial Statements for further information. Merrill Lynch’s broker-dealer, banking, and insurance activities are subject to regulatory requirements that may restrict the free flow of funds to affiliates. Regulatory approval may be required for paying dividends in excess of certain established levels and making affiliated investments.
Merrill Lynch continued to grow its equity capital base in 2005 primarily through net earnings, additional preferred stock issuances and the net effect of employee stock transactions, partially offset by common stock repurchases and dividends. Equity capital of $38.1 billion at December 30, 2005 was 12% higher than at December 31, 2004.
During 2005, Merrill Lynch issued $2.1 billion, net of underwriting fees, of floating and fixed rate, non-cumulative, perpetual preferred stock and at December 30, 2005, Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”) held approximately $100 million of Merrill Lynch preferred stock as a result of market-making activities. Refer to Note 11 to the Consolidated Financial Statements for additional information.
On April 18, 2005, the Board of Directors declared a 25% increase in the regular quarterly dividend to 20 cents per common share, from 16 cents per common share. On January 18, 2006, the Board of Directors declared an additional 25% increase in the regular quarterly dividend to 25 cents per common share.
In 2004 and 2005, Merrill Lynch authorized three share repurchase programs to provide greater flexibility to return capital to shareholders. For the year ended December 31, 2004, Merrill Lynch repurchased a cumulative total of 54.0 million shares of common stock at a cost of $3.0 billion, completing the $2.0 billion repurchase program authorized in February 2004 and utilizing $968 million of the additional $2.0 billion repurchase program authorized in July 2004. For the year ended December 30, 2005, Merrill Lynch repurchased a cumulative total of 63.1 million shares of common stock at a cost of $3.7 billion, completing the $2.0 billion repurchase program authorized in July 2004 and utilizing $2.7 billion of the additional $4.0 billion repurchase program authorized in April 2005.
On February 26, 2006, the Finance Committee of the Board of Directors authorized an additional $6.0 billion repurchase program.
 (MERRILL LYNCH LOGO)
 


Table of Contents

The table below sets forth the information with respect to purchases made by or on behalf of Merrill Lynch or any “affiliated purchaser” of Merrill Lynch’s common stock during the year ended December 30, 2005.
                                 
(dollars in millions, except per share amounts)                   Total Number of     Approximate Dollar  
                    Shares Purchased     Value of Shares  
    Total Number     Average     as Part of Publicly     that May Yet be  
    of Shares     Price Paid     Announced     Purchased Under  
Period   Purchased     per Share     Program(1)     the Program  
 
First Quarter 2005 (Jan. 1 – Apr. 1)
                               
Capital Management Program
    17,331,900     $ 59.52       17,331,900     $  
Employee Transactions(2)
    4,531,473       59.48       N/A       N/A  
     
Second Quarter 2005 (Apr. 2 – Jul. 1)
                               
Capital Management Program
    20,175,400     $ 54.48       20,175,400     $ 2,901  
Employee Transactions(2)
    960,678       54.62       N/A       N/A  
     
Third Quarter 2005 (Jul. 2 – Sep. 30)
                               
Capital Management Program
    14,680,900     $ 58.26       14,680,900     $ 2,046  
Employee Transactions(2)
    648,178       58.61       N/A       N/A  
     
Month #10 (Oct. 1 – Nov. 4)
                               
Capital Management Program
    4,130,000     $ 61.95       4,130,000     $ 1,790  
Employee Transactions(2)
    392,260       62.57       N/A       N/A  
Month #11 (Nov. 5 – Dec. 2)
                               
Capital Management Program
    2,475,000     $ 67.32       2,475,000     $ 1,623  
Employee Transactions(2)
    144,814       66.69       N/A       N/A  
Month #12 (Dec. 3 – Dec. 30)
                               
Capital Management Program
    4,275,000     $ 68.19       4,275,000     $ 1,332  
Employee Transactions(2)
    104,191       68.18       N/A       N/A  
     
Fourth Quarter 2005 (Oct. 1 – Dec. 30)
                               
Capital Management Program
    10,880,000     $ 65.62       10,880,000     $ 1,332  
Employee Transactions(2)
    641,265       64.41       N/A       N/A  
     
Full Year 2005 (Jan. 1 – Dec. 30)
                               
Capital Management Program
    63,068,200     $ 58.67       63,068,200     $ 1,332  
Employee Transactions(2)
    6,781,594       59.17       N/A       N/A  
 
(1)  
Share repurchases under the program were made pursuant to open-market purchases, Rule 10b5-1 plans or privately negotiated transactions as market conditions warranted and at prices Merrill Lynch deemed appropriate.
(2)  
Included in the total number of shares purchased are: (1) shares purchased during the period by participants in the Merrill Lynch 401(k) Savings and Investment Plan (“401(k)”) and the Merrill Lynch Retirement Accumulation Plan (“RAP”), (2) shares delivered or attested to in satisfaction of the exercise price by holders of ML & Co. employee stock options (granted under employee stock compensation plans) and (3) Restricted Shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of Restricted Shares. ML & Co.’s employee stock compensation plans provide that the value of the shares delivered or attested, or withheld, shall be the average of the high and low price of ML & Co.’s common stock (Fair Market Value) on the date the relevant transaction occurs. See Notes 13 and 14 to the Consolidated Financial Statements for additional information on these plans.
Major components of the changes in equity capital for 2005 and 2004 are as follows:
                 
(dollars in millions)   2005     2004  
 
Beginning of year
  $ 33,914     $ 31,523  
Net earnings
    5,116       4,436  
Issuance of preferred stock, net of redemptions and repurchases
    2,043       205  
Common and preferred stock dividends
    (777 )     (643 )
Common stock repurchases
    (3,700 )     (2,968 )
Net effect of employee stock transactions and other(1)
    1,548       1,361  
     
End of year
  $ 38,144     $ 33,914  
 
(1)  
Includes effect of accumulated other comprehensive loss and other items.
46
Merrill Lynch 2005 Annual Report
 


Table of Contents

Balance Sheet Leverage
Asset-to-equity leverage ratios are commonly used to assess a company’s capital adequacy. When assessing its capital adequacy, Merrill Lynch considers the risk profiles of the assets, the impact of hedging, off-balance sheet exposures, operational risk and other considerations. As leverage ratios are not risk sensitive, Merrill Lynch does not rely on them as a measure of capital adequacy.
Merrill Lynch believes that a leverage ratio adjusted to exclude certain assets considered to have low risk profiles and assets in customer accounts financed primarily by customer liabilities provides a more meaningful measure of balance sheet leverage in the securities industry than an unadjusted ratio. Adjusted assets are calculated by reducing total assets by (1) securities financing transactions and securities received as collateral less trading liabilities net of contractual agreements and (2) segregated cash and securities and separate account assets.
The following table provides calculations of Merrill Lynch’s leverage ratios at December 30, 2005 and December 31, 2004:
                 
(dollars in millions)   2005     2004  
 
Total assets
  $ 681,015     $ 628,098  
Less: Receivables under resale agreements
    163,021       78,853  
     Receivables under securities borrowed transactions
    92,484       94,498  
     Securities received as collateral
    16,808       11,903  
Add: Trading liabilities, at fair value, excluding contractual agreements
    60,178       63,859  
     
Sub-total
    468,880       506,703  
Less: Segregated cash and securities balances
    11,949       17,784  
     Separate account assets
    16,185       18,641  
     
Adjusted assets
    440,746       470,278  
Less: Goodwill and other intangible assets
    6,035       6,162  
     
Tangible adjusted assets
  $ 434,711     $ 464,116  
 
               
Stockholders’ equity
  $ 35,600     $ 31,370  
Long-term debt issued to TOPrSSM partnerships, net of related investments(1)
    2,544       2,544  
     
Equity capital
  $ 38,144     $ 33,914  
Tangible equity capital(2)
  $ 32,109     $ 27,752  
Leverage ratio(3)
    17.9x       18.5x  
Adjusted leverage ratio(4)
    11.6x       13.9x  
Tangible adjusted leverage ratio(5)
    13.5x       16.7x  
 
(1)  
Due to the perpetual nature of TOPrSSM and other considerations, Merrill Lynch views the long-term debt issued to TOPrSSM partnerships (net of related investments) as a component of equity capital. However, the Long-term debt issued to TOPrSSM partnerships is reported as a liability for accounting purposes. TOPrSSM related investments were $548 million at December 30, 2005 and December 31, 2004.
(2)  
Equity capital less goodwill and other intangible assets.
(3)  
Total assets divided by equity capital.
(4)  
Adjusted assets divided by equity capital.
(5)  
Tangible adjusted assets divided by tangible equity capital.
Funding
Liquidity Risk Management
Merrill Lynch seeks to assure liquidity across market cycles and through periods of financial stress. Merrill Lynch’s primary liquidity objective is to ensure that all unsecured debt obligations maturing within one year can be repaid without issuing new unsecured debt or requiring liquidation of business assets. Toward this goal, Merrill Lynch has established a set of liquidity practices that are outlined below. In addition, Merrill Lynch maintains a contingency funding plan that outlines actions that would be taken in the event of a funding disruption.
Maintain sufficient long-term capital: Merrill Lynch regularly reviews its mix of assets, liabilities and commitments to ensure the maintenance of adequate long-term capital sources to meet long-term capital requirements. Merrill Lynch’s long-term capital sources include equity capital, long-term debt obligations and certain deposit liabilities in banking subsidiaries which are considered by management to be long-term or stable in nature.
 (MERRILL LYNCH LOGO)
 


Table of Contents

At December 30, 2005 and December 31, 2004, Merrill Lynch’s long-term capital was comprised of the following:
                 
  December 30,   December 31,  
(dollars in billions) 2005   2004  
 
Equity capital
  $ 38.1     $ 33.9  
Long-term debt obligations(1)
    99.3       89.2  
Deposit liabilities(2)
    69.9       73.7  
     
Total long-term capital
  $ 207.3     $ 196.8  
 
(1)  
Total long-term borrowings less (1) the current portion and (2) other subsidiary financing — non-recourse. Borrowings that mature in more than one year, but contain provisions whereby the holder has the option to redeem the obligations within one year, are reflected as current portion of long-term borrowings and are not included in long-term capital. Management believes, however, that a portion of such borrowings will remain outstanding beyond their earliest redemption date.
(2)  
Includes $60.2 billion and $9.7 billion of deposits in U.S. and non-U.S. banking subsidiaries, respectively, in 2005, and $65.4 billion and $8.3 billion of deposits, respectively, in 2004 that are considered by management to be long-term.
The following items are generally financed with long-term capital:
 
The portion of assets that cannot be self-funded in the secured financing markets, considering stressed market conditions, including long-term, illiquid assets such as certain loans, goodwill and other intangible assets and fixed assets;
 
 
Subsidiaries’ regulatory capital;
 
 
Collateral on derivative contracts that may be required in the event of changes in Merrill Lynch’s ratings or movements in underlying instruments; and
 
 
Portions of commitments to extend credit based on management’s estimate of the probability of drawdown.
At December 30, 2005, Merrill Lynch’s long-term capital sources of $207.3 billion exceeded Merrill Lynch’s estimated long-term capital requirements.
In assessing the appropriateness of its long-term capital, Merrill Lynch seeks to: (1) ensure sufficient matching of its assets based on factors such as holding period, contractual maturity and regulatory restrictions and (2) limit the amount of liabilities maturing in any particular period. Merrill Lynch also considers circumstances that might cause contingent funding obligations, including early repayment of debt.
The following chart presents Merrill Lynch’s long-term borrowings maturity profile as of December 30, 2005 (quarterly for two years and annually thereafter):
(BAR GRAPH)
(1)  
Extendibles are debt instruments with an extendible maturity date. Unless debt holders instruct Merrill Lynch to redeem their debt with at least a one-year notification period, the maturity date of these instruments is automatically extended. Extendibles are included in long-term borrowings if the earliest maturity date is at least one year away. Based on past experience, the majority of Merrill Lynch’s extendibles are expected to remain outstanding beyond their earliest maturity date.
At December 30, 2005, senior debt issued by ML & Co. or by subsidiaries and guaranteed by ML & Co. totaled $124.6 billion. Except for the $2.3 billion of zero-coupon contingent convertible debt (Liquid Yield Option™ notes or “LYONs®") that were outstanding at December 30, 2005, senior debt obligations issued by ML & Co. and senior debt issued by subsidiaries and guaranteed by ML & Co. do not contain provisions that could, upon an adverse change in ML & Co.’s credit rating, financial ratios, earnings, cash flows, or stock price, trigger a requirement for an early payment, additional collateral support, changes in terms, acceleration of maturity, or the creation of an additional financial obligation. Refer to Note 9 to the Consolidated Financial Statements for additional information.
Included in its debt obligations are structured notes issued by Merrill Lynch with returns linked to other debt or equity securities, indices, or currencies. Merrill Lynch could be required to immediately settle certain structured note obligations for cash or other securities
48
Merrill Lynch 2005 Annual Report
 


Table of Contents

under certain circumstances, which is taken into account for liquidity planning purposes. Merrill Lynch typically hedges these notes with positions in derivatives and/or in the underlying instruments.
Merrill Lynch’s bank subsidiaries that take deposits have liquidity policies as well as guidelines and practices in place aimed at ensuring sufficient liquidity is available at each bank to meet deposit obligations under stressed market conditions.
Maintain sufficient funding to repay short-term obligations: The main alternative funding sources to unsecured borrowings are repurchase agreements, securities loaned, other secured borrowings, which require pledging unencumbered securities held for trading or investment purposes, or collateral and proceeds from maturing loans and other assets. Nonetheless, a key funding assumption is accessibility to a repurchase market for highly rated government, agency and certain other securities.
Merrill Lynch maintains a liquidity portfolio of U.S. Government and agency obligations and other instruments of high credit quality that is funded with debt with a maturity greater than one year. The carrying value of this portfolio, net of related hedges, was $18.0 billion and $14.9 billion at December 30, 2005 and December 31, 2004, respectively. ML & Co. also maintained cash and cash equivalents, investments in short-term money market mutual funds, and certain highly liquid unencumbered securities of $7.4 billion and $6.9 billion at December 30, 2005 and December 31, 2004, respectively.
In addition to its liquidity portfolio and cash balances, Merrill Lynch monitors the extent to which other unencumbered assets are available to ML & Co. as a source of funds, considering that some subsidiaries are restricted in their ability to upstream unencumbered assets to ML & Co. At December 30, 2005, unencumbered assets, including amounts that may be restricted, were in excess of $136 billion, including the carrying value of the liquidity portfolio and cash balances.
For liquidity planning purposes, Merrill Lynch considers as short-term debt obligations: (i) commercial paper and other short-term borrowings and (ii) the current portion of long-term borrowings. At December 30, 2005 and December 31, 2004, these short-term obligations are as follows.
                 
  December 30,   December 31,  
(dollars in billions) 2005   2004  
 
Commercial paper and other short-term borrowings
  $ 3.9     $ 4.0  
Current portion of long-term borrowings
    22.8       21.1  
     
Total short-term obligations
  $  26.7     $  25.1  
 
Certain long-term borrowing agreements contain provisions whereby the borrowings are redeemable at the option of the holder at specified dates prior to maturity. Maturities of such borrowings are reported based on their put dates, rather than their contractual maturities. Management believes, however, that a portion of such borrowings will remain outstanding beyond their earliest redemption date.
At December 30, 2005, Merrill Lynch’s liquidity portfolio, cash balances, maturing short-term assets and other unencumbered assets, some of which may be held in regulated entities but which management believes may be reasonably upstreamed to ML & Co., were more than the amount that would be required to repay Merrill Lynch’s short-term obligations and other contingent cash outflows.
In addition to the aforementioned sources of funding available to meet short-term obligations, Merrill Lynch maintains credit facilities that are available to cover immediate funding needs. Merrill Lynch replaced the unsecured bank facility that totaled $3.0 billion at December 31, 2004 with a new committed, multi-currency, unsecured bank credit facility that totaled $4.0 billion at December 30, 2005. This 364-day facility permits borrowings by ML & Co. and select subsidiaries and expires in June 2006. The facility includes a one year term-out feature that allows ML & Co., at its option, to extend borrowings under the facility for a further year beyond the expiration date in June 2006. At December 30, 2005 there were no borrowings outstanding under this credit facility, although Merrill Lynch borrows regularly from this facility.
In 2005, Merrill Lynch added two committed, secured credit facilities which totaled $5.5 billion at December 30, 2005. The facilities expire in May 2006 and December 2006 respectively. Both facilities include a one year term-out option that allows ML & Co. to extend borrowings under the facilities for a further year beyond their respective expiration dates. The secured facilities permit borrowings by ML & Co. and select subsidiaries, secured by a broad range of collateral. At December 30, 2005 there were no borrowings outstanding under either facility.
In addition, Merrill Lynch maintains a committed, secured credit facility with a financial institution that totaled $6.25 billion at December 30, 2005 and December 31, 2004. The secured facility may be collateralized by government obligations eligible for pledging. The facility expires in 2014, but may be terminated with at least nine months notice by either party. At December 30, 2005 and December 31, 2004, there were no borrowings outstanding under this facility.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Concentrate unsecured financing at ML & Co.: ML & Co. is the primary issuer of all unsecured, non-deposit financing instruments that are used primarily to fund assets in subsidiaries, some of which are regulated. The benefits of this strategy are greater control, reduced financing costs, wider name recognition by creditors, and greater flexibility to meet variable funding requirements of subsidiaries. Where regulations, time zone differences, or other business considerations make this impractical, some subsidiaries enter into their own financing arrangements.
While Merrill Lynch concentrates excess funds at ML & Co., Merrill Lynch recognizes that regulatory restrictions may limit the free flow of funds from subsidiaries where assets are held to ML & Co. and also between subsidiaries. For example, a portion of deposits held by Merrill Lynch bank subsidiaries funds securities that can be sold or pledged to provide immediate liquidity for the banks. In addition, a portion of deposits are utilized to fund the long-term capital requirements of the banks. However, there are regulatory restrictions on the use of this liquidity for ML & Co. and non-bank affiliates of Merrill Lynch. Merrill Lynch takes these and other restrictions into consideration when evaluating the liquidity of individual legal entities and ML & Co. See Note 9 to the Consolidated Financial Statements for more information on borrowings.
Diversify unsecured funding sources: Merrill Lynch strives to continually expand and globally diversify its funding programs, its markets, and its investor and creditor base to minimize reliance on any one investor base or region. Merrill Lynch diversifies its borrowings by maintaining various limits, including a limit on the amount of commercial paper held by a single investor. Merrill Lynch benefits by distributing a significant portion of its debt issuances through its own sales force to a large, diversified global client base. Merrill Lynch also makes markets buying and selling its debt instruments.
Adhere to prudent governance processes: In order to ensure that both daily and strategic funding activities are appropriate and subject to senior management review and control, liquidity management is reviewed in Asset/Liability Committee meetings with Treasury management and is presented to Merrill Lynch’s Risk Oversight Committee (“ROC”), ML & Co. executive management and the Finance Committee of the Board of Directors. Merrill Lynch also manages the growth and composition of its assets and sets limits on the level of unsecured funding at any time.
Asset and Liability Management
Merrill Lynch routinely issues debt in a variety of maturities and currencies to achieve low cost financing and an appropriate liability maturity profile. The cost and availability of unsecured funding may be impacted by general market conditions or by matters specific to the financial services industry or Merrill Lynch.
Merrill Lynch uses derivative transactions to more closely match the duration of borrowings to the duration of the assets being funded, thereby enabling interest rate risk to be managed within limits set by the Global Liquidity and Risk Management Group (“GLRM”). Interest rate swaps also serve to adjust Merrill Lynch’s interest expense and effective borrowing rate principally to floating rate. Merrill Lynch also enters into currency swaps to hedge assets that are not financed through debt issuance in the same currency. Investments in subsidiaries in non-U.S. dollar currencies are also hedged in whole or in part to mitigate translation adjustments in the accumulated other comprehensive loss. See Notes 1 and 6 to the Consolidated Financial Statements for further information.
Credit Ratings
The cost and availability of unsecured funding are also impacted by credit ratings. In addition, credit ratings are important when competing in certain markets and when seeking to engage in long-term transactions including OTC derivatives. Factors that influence Merrill Lynch’s credit ratings include the credit rating agencies’ assessment of the general operating environment, relative positions in the markets in which Merrill Lynch competes, reputation, level and volatility of earnings, corporate governance, risk management policies, liquidity and capital management.
The senior debt and preferred stock ratings of ML & Co. and the ratings of preferred securities issued by subsidiaries on February 27, 2006 are as follows. Rating agencies express outlooks from time to time on these ratings. Each of these ratings agencies describes its current outlook as stable, except for Standard & Poor’s whose outlook on ML & Co. was raised to positive from stable on January 23, 2006.
                 
    Senior Debt     Preferred  
Rating Agency   Ratings     Stock Ratings  
 
Dominion Bond Rating Service Ltd.
  AA (low)     Not Rated  
Fitch Ratings
  AA–       A+  
Moody’s Investors Service, Inc.
  Aa3       A2  
Rating & Investment Information, Inc. (Japan)
  AA       A+  
Standard & Poor’s Ratings Services
    A+       A–  
 
50
Merrill Lynch 2005 Annual Report
 


Table of Contents

In connection with certain OTC derivatives transactions and other trading agreements, Merrill Lynch could be required to provide additional collateral to certain counterparties in the event of a downgrade of the senior debt ratings of ML & Co. At December 30, 2005, the amount of additional collateral that would be required for such derivatives transactions and trading agreements was approximately $360 million in the event of a one-notch downgrade and approximately $860 million in the event of a two-notch downgrade of ML & Co.’s long term senior debt credit rating. Merrill Lynch considers additional collateral on derivative contracts that may be required in the event of changes in ML & Co.’s ratings as part of its liquidity management practices.
Risk Management
Risk Management Philosophy
Risk-taking is integral to many of the core businesses in which Merrill Lynch operates. In the course of conducting its business operations, Merrill Lynch is exposed to a variety of risks including market, credit, liquidity, operational and other risks that are material and require comprehensive controls and ongoing oversight. Senior managers of Merrill Lynch’s core businesses are responsible and accountable for management of the risks associated with their business activities. In addition, GLRM includes the independent control groups which manage market risk, credit risk, liquidity risk and operational risk, among other functions. GLRM falls under the management responsibility of the Deputy Chief Financial Officer and ultimately the Chief Financial Officer. Along with other control units these disciplines work to ensure risks are properly identified, measured, monitored, and managed throughout Merrill Lynch. To accomplish this, Merrill Lynch has established a risk management process, which includes:
 
A formal risk governance organization that defines the oversight process and its components;
 
 
A regular review of the risk management process by the Audit Committee of the Board of Directors (“the Audit Committee”);
 
 
Clearly defined risk management policies and procedures supported by a rigorous analytical framework;
 
 
Communication and coordination among the business, executive management, and risk functions while maintaining strict segregation of responsibilities, controls, and oversight; and
 
 
Clearly articulated risk tolerance levels as defined by the ROC, which are regularly reviewed to ensure that Merrill Lynch’s risk-taking is consistent with its business strategy, capital structure, and current and anticipated market conditions.
The risk management and control process ensures that Merrill Lynch’s risk tolerance is well-defined and understood by the firm’s businesses as well as by its executive management. Other groups, including Corporate Audit, Finance, and the Office of General Counsel, interact with GLRM to establish and maintain this overall risk management control process. While no risk management system can ever be absolutely complete, the goal of these control groups is to make certain that risk-related losses occur within acceptable, predefined levels.
Risk Governance Structure
Merrill Lynch’s risk governance structure is comprised of the Audit Committee and the Finance Committee of the Board of Directors, the Executive Committee (a group composed of Merrill Lynch executive management), the ROC, the business units, GLRM, and various corporate governance committees.
The Audit Committee, which is comprised entirely of independent directors, approves the ROC charter and has authorized the ROC to establish Merrill Lynch’s risk management policies. The ROC reports to the Executive Committee and has provided the Audit Committee with regular market and credit risk updates during 2005. The Finance Committee, which is also comprised entirely of independent directors, is responsible for reviewing Merrill Lynch’s policies and procedures for managing exposure to market, credit and liquidity risk, including framework limits for both market and credit risk, Value at Risk (“VaR”), liquidity and funding analyses, and/or other relevant models.
The ROC establishes risk tolerance levels for the firm and authorizes material changes in Merrill Lynch’s risk profile and also ensures that the risks assumed by Merrill Lynch are managed within these tolerance levels and verifies that Merrill Lynch has implemented appropriate policies for the effective management of risks. The Executive Committee must approve risk levels and all substantive changes to risk policies proposed by the ROC. The Executive Committee pays particular attention to risk concentrations and liquidity concerns.
The ROC is comprised of the heads of the key business segments and senior business and control managers and is chaired by the Chief Financial Officer. It oversees Merrill Lynch’s risk-taking and ensures that the business units create and implement processes to identify, measure, and monitor their risks. Additionally, the ROC assists the Executive Committee in determining risk tolerance levels for the firm’s business units and monitors the activities of Merrill Lynch’s corporate governance committees, reporting significant issues and transactions to the Executive Committee and the Audit Committee.
 (MERRILL LYNCH LOGO)
 


Table of Contents

The ROC also reports substantive Market and Credit Risk Framework Limits changes to the Audit Committee. These Framework Limits are reviewed and approved annually by the Executive Committee, which must also approve certain intra-year changes. During 2005, the risk parameters that define these Frameworks were reviewed by the Audit Committee; currently, they are reviewed by the Finance Committee in the context of its evaluation of Market and Credit Risk exposures. Risk Framework exceptions and violations are reported and investigated at pre-defined and appropriate levels of management.
Various other governance committees exist to create policy, review activity, and ensure that new and existing business initiatives remain within established risk tolerance levels. Representatives of the principal independent control functions participate as voting members of these committees.
The overall effectiveness of Merrill Lynch’s risk processes and policies can be seen on a broader level when analyzing daily net trading revenues over time. Merrill Lynch’s policies and procedures of monitoring and controlling risk, combined with the businesses’ focus on customer order-flow-driven revenues and selective proprietary positioning have helped Merrill Lynch to reduce earnings volatility within its trading portfolios. While no guarantee can be given regarding future earnings volatility, Merrill Lynch will continue to pursue policies and procedures that assist the firm in measuring and monitoring its risks. The histogram below shows the distribution of daily net revenues from Merrill Lynch’s trading businesses (principal transactions and net interest profit) for 2005.
(BAR CHART)
Market Risk
Market risk is defined as the potential change in value of financial instruments caused by fluctuations in interest rates, exchange rates, equity and commodity prices, credit spread, and/or other risks. The Market Risk Framework defines and communicates Merrill Lynch’s market risk tolerance and broad overall limits across the firm by defining and constraining exposure to specific asset classes, market risk factors and VaR. VaR is a statistical measure of the potential loss in the fair value of a portfolio due to adverse movements in underlying risk factors.
The Market Risk Management Group is responsible for approving the products and markets in which Merrill Lynch’s major business units and functions will transact and take risk. Moreover, it is responsible for identifying the risks to which these business units will be exposed in these approved products and markets. Market Risk Management uses a variety of quantitative methods to assess the risk of Merrill Lynch’s positions and portfolios. In particular, Market Risk Management quantifies the sensitivities of Merrill Lynch’s current portfolios to changes in market variables. These sensitivities are then utilized in the context of historical data to estimate earnings and loss distributions that Merrill Lynch’s current portfolios would have incurred throughout the historical period. From these distributions, Market Risk Management derives a number of useful risk statistics, including VaR.
The VaR disclosed in the accompanying table is an estimate of the amount that Merrill Lynch’s current trading portfolios could lose with a specified degree of confidence, over a given time interval. The VaR for Merrill Lynch’s overall portfolios is less than the sum of the VaRs for individual risk categories because movements in different risk categories occur at different times and, historically, extreme movements have not occurred in all risk categories simultaneously. The difference between the sum of the VaRs for individual risk categories and the VaR calculated for all risk categories is shown in the following table and may be viewed as a measure of the diversification within Merrill Lynch’s portfolios. Market Risk Management believes that the tabulated risk measures provide broad guidance as to the amount Merrill Lynch could lose in future periods, and Market Risk Management works continually to improve its measurement and the methodology of the firm’s VaR. However, the calculation of VaR requires numerous assumptions and thus VaR should not be viewed as a precise measure of risk. In addition, VaR is not intended to capture worst case scenario losses.
To complement VaR and in recognition of its inherent limitations, Merrill Lynch uses a number of additional risk measurement methods and tools as part of its overall market risk management process. These include stress testing and event risk analysis, which examine portfolio behavior under significant adverse market conditions, including scenarios that would result in material losses for the firm.
52
Merrill Lynch 2005 Annual Report
 


Table of Contents

To calculate VaR, Market Risk Management aggregates sensitivities to market risk factors and combines them with a database of historical market factor movements to simulate a series of profits and losses. The level of loss that is exceeded in that series 5% of the time is used as the estimate for the 95% confidence level VaR. The overall total VaR amounts are presented across major risk categories, which include exposure to volatility risk found in certain products, such as options.
The table that follows presents Merrill Lynch’s average and year-end VaR for trading instruments for 2005 and 2004. Additionally, high and low VaR for 2005 is presented independently for each risk category and overall. Because high and low VaR numbers for these risk categories may have occurred on different days, high and low numbers for diversification benefit would not be meaningful.
                                                 
          Daily                           Daily  
  Year-end   Average   High   Low   Year-end   Average  
(dollars in millions) 2005   2005   2005   2005   2004   2004  
 
Trading Value-at-Risk(1)
                                               
Interest rate and credit spread
  $ 41     $ 40     $  56     $  26     $ 39     $ 31  
Equity
    16       12       29       3       5       9  
Commodity
    6       8       15       4       8       2  
Currency
    2       3       6             2       3  
     
 
    65       63                       54       45  
Diversification benefit
    (25 )     (25 )                     (20 )     (17 )
     
Overall(2)
  $ 40     $ 38     $ 61     $ 21     $ 34     $ 28  
 
(1)  
Based on a 95% confidence level and a one-day holding period.
(2)  
Overall trading VaR using a 95% confidence level and a one-week holding period was $77 million and $62 million at year-end 2005 and 2004, respectively.
Trading VaR increased during 2005 due to increased interest rate and credit spread and equity exposures. If market conditions are favorable, Merrill Lynch may increase its risk taking in a number of its businesses, including certain proprietary trading activities and principal investments. These activities provide revenue opportunities while also increasing the loss potential under certain market conditions. GLRM monitors these risk levels on a daily basis to ensure they remain within corporate risk guidelines and tolerance levels.
Non-Trading Market Risk
Non-trading market risk includes the risks associated with certain non-trading activities, including investment securities, securities financing transactions and equity investments. Also included are the risks related to treasury funding activities. Risks related to lending activities are covered in the Credit Risk section that follows.
The primary market risk of non-trading investment securities, and non-trading repurchase and reverse repurchase agreements is expressed as sensitivity to changes in the general level of credit spreads which are defined as the differences in the yields on debt instruments from relevant LIBOR/Swap rates. Non-trading investment securities include securities available-for-sale and held-to-maturity as well as investments of insurance subsidiaries. At year-end 2005, the total credit spread sensitivity of these instruments is a pre-tax loss of $19 million in fair market value for an increase of one basis point, which is one one-hundredth of a percent, in credit spreads, compared to a pre-tax loss of $20 million at year-end 2004. This change in fair market value is a measurement of economic risk which may differ significantly in magnitude and timing from the actual profit or loss that would be realized under generally accepted accounting principles.
The interest rate risk associated with the foregoing non-trading positions, together with treasury funding activities is expressed as sensitivity to changes in the general level of interest rates. Treasury funding activities include LYONs® and TOPrSSM and other long-term debt together with interest rate hedges. At year-end 2005, the net interest rate sensitivity of these positions is a pre-tax loss in fair market value of $1 million for a parallel one basis point increase in interest rates across all yield curves, compared to negligible profit or loss for a parallel one basis point increase at year-end 2004. This change in fair market value is a measurement of economic risk which may differ significantly in magnitude and timing from the actual profit or loss that would be realized under generally accepted accounting principles.
Other non-trading equity investments include direct private equity interests, private equity fund investments, hedge fund interests, and certain direct and indirect real estate investments. These investments are broadly sensitive to general price levels in the equity or commercial real estate markets as well as to specific business, financial and credit factors which influence the performance and valuation of each investment uniquely. Refer to Note 5 to the Consolidated Financial Statements for additional information on these investments.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Credit Risk
Credit risk is defined as the potential for loss that can occur as a result of an individual, counterparty or issuer being unable or unwilling to honor its contractual obligations to Merrill Lynch. The Credit Risk Framework is the primary tool used to communicate firmwide limits and monitor exposure by constraining the magnitude and tenor of exposure to counterparty and issuer families. Additionally, country risk limits ensure that total aggregate exposure across all counterparties and issuers (including sovereign entities) for a given country do not exceed predefined tolerance levels.
The Global Credit and Commitments Group assesses the creditworthiness of existing and potential individual clients, institutional counterparties and issuers, and determines firmwide credit risk levels within the Credit Risk Framework among other tools. The group reviews and monitors specific transactions as well as portfolio and other credit risk concentrations both within and across businesses. The group is also responsible for ongoing monitoring of credit quality and limit compliance and actively works with all the business units of Merrill Lynch to manage and mitigate credit risk.
The Global Credit and Commitments Group uses a variety of methodologies to set limits on exposure resulting from an individual, counterparty or issuer failing to fulfill its contractual obligations. The group performs analysis in the context of industrial, regional, and global economic trends and incorporates portfolio and concentration effects when determining tolerance levels. Credit risk limits take into account measures of both current and potential exposure and are set and monitored by broad risk type, product type, and maturity. Credit risk mitigation techniques include, where appropriate, the right to require initial collateral or margin, the right to terminate transactions or to obtain collateral should unfavorable events occur, the right to call for collateral when certain exposure thresholds are exceeded, the right to call for third party guarantees and the purchase of credit default protection. With senior management involvement, Merrill Lynch conducts regular portfolio reviews, monitors counterparty creditworthiness, and evaluates potential transaction risks with a view toward early problem identification and protection against unacceptable credit-related losses. In 2005, the Global Credit and Commitments Group continued investing additional resources to enhance its methods and policies in order to assist in the management of Merrill Lynch’s credit risk.
Senior members of the Global Credit and Commitments Group chair various commitment committees with membership across business and support units. These committees review and approve commitments, underwritings and syndication strategies related to debt, syndicated loans, equity, real estate and asset based finance among other products and activities.
Commercial Lending
Commercial lending conducted by Merrill Lynch consists primarily of corporate and institutional lending, asset-based finance, commercial finance, and commercial real estate related activities. In evaluating certain potential commercial lending transactions, Merrill Lynch utilizes a risk adjusted return on capital model in addition to other methodologies. Corporate and institutional lending facilities are commonly used by clients for general corporate purposes, backup liquidity lines, bridge financings, and acquisition related activities. Corporate and institutional loans are often syndicated down from original levels through assignments and participations to unaffiliated third parties. While these facilities may be supported by credit enhancing arrangements such as property liens or claims on operating assets, repayment is generally expected through other sources including cash flow and/or recapitalization. The Global Credit and Commitments Group’s Loan Execution and Management Division selectively hedges exposure in the corporate and institutional lending portfolio by purchasing single name and basket credit default swaps as well as evaluating and selectively executing loan sales in the secondary markets.
Asset-based finance facilities are typically secured by financial assets such as mortgages, auto loans, leases, credit card and other receivables. Clients often use these facilities for the origination and purchase of assets during a warehousing period leading up to securitization. Credit assessment for these facilities relies primarily on the amount, asset type, quality, and liquidity of the supporting collateral.
Commercial finance activities consist of corporate finance, healthcare finance, equipment finance and commercial real estate lending to qualifying business clients. These facilities are substantially secured by liens on property, plant, and equipment, third party guarantees or other similar arrangements. Other commercial real estate related activities consist of commercial mortgage originations and other extensions of credit connected to the financing of commercial properties or portfolios of properties. These exposures may be reduced or eliminated through third-party syndications or securitizations. Assessment of creditworthiness and credit approval is highly dependent upon the anticipated performance of the underlying property and/or associated cash flows.
The following table presents a distribution of commercial loans and closed commitments for year-end 2005, gross of allowances for loan losses and reserves, without considering the impact of purchased credit protection. Closed commitments represent the unfunded portion of existing commitments available for draw down and do not include contingent commitments extended but not yet closed. As of December 30, 2005, Merrill Lynch’s largest commercial lending industry concentration was to financial institutions including banks, insurance companies, finance companies, investment managers and other diversified financial institutions. Commercial borrowers
54
Merrill Lynch 2005 Annual Report
 


Table of Contents

were predominantly domiciled in the United States or had principal operations tied to the United States or its economy. The majority of all outstanding commercial loan balances had a remaining maturity of less than three years. Additional detail on Merrill Lynch’s commercial lending related activities can be found in Note 8 to the Consolidated Financial Statements. The following table depicts Merrill Lynch’s commercial lending balances by credit quality, industry and country at December 30, 2005.
                                 
(dollars in millions)            
By Credit Quality(1)   Loans     Closed Commitments  
 
    Secured   Unsecured     Secured   Unsecured  
         
Investment grade
  $ 19,993     $ 3,283     $ 11,170     $ 22,061  
Non-investment grade
    16,578       869       8,083       980  
         
Total
  $ 36,571     $ 4,152     $ 19,253     $ 23,041  
 
(1)  
Based on credit rating agency equivalent of internal credit ratings.
                                 
By Industry   Loans     Closed Commitments  
 
    Secured   Unsecured     Secured   Unsecured  
         
Financial Institutions
    44 %     15 %     49 %     31 %
Consumer Goods and Services
    16       44       17       21  
Real Estate
    10       17       6       3  
Energy/Utilities
    1       5       2       17  
Technology/Media/Telecommunications
    2       11       3       12  
Industrial/Manufacturing Goods and Services
    3       3       7       9  
All Other
    24       5       16       7  
         
Total
    100 %     100 %     100 %     100 %
 
                                 
By Country   Loans     Closed Commitments  
 
    Secured   Unsecured     Secured   Unsecured  
         
United States
    69 %     73 %     83 %     75 %
United Kingdom
    14       5       6       6  
Germany
    3                   8  
France
    2             2       1  
Canada
          2       2       3  
All Other
    12       20       7       7  
         
Total
    100 %     100 %     100 %     100 %
 
Residential Mortgage Lending
Merrill Lynch originates and purchases residential mortgage loans, certain of which include features that may result in additional credit risk when compared to more traditional types of mortgages. The potential additional credit risk arising from these mortgages is addressed through adherence to underwriting guidelines as described below. Credit risk is closely monitored in order to ensure that reserves are sufficient and valuations are appropriate. These loans are predominantly extended to high credit quality borrowers and include:
 
Loans where the borrower is subject to payment increases over the life of the loan including:
   
Interest-only loans where the borrower makes no principal payments on the loan during an initial period and is required to make both interest and principal payments either during the later stages of the loan or in one lump sum at maturity. These loans therefore may require the borrower to make larger payments later in the life of the loans if the loans are not otherwise repaid through a refinancing or sale of the property. These loans are underwritten based on a variety of factors including, for example, the borrower’s credit history, the debt to income ratio, employment, the loan-to-value (“LTV”) ratio on the property, and the borrower’s disposable income and cash reserves; typically using a qualifying formula that assesses the borrower’s ability to make interest payments at a minimum of 2% above the initial rate. In instances where the borrower is of lower credit standing, the loans are typically underwritten to have a lower LTV ratio and/or other mitigating factors. Interest-only loans are the significant majority of the loans held by Merrill Lynch where the borrower may be subject to payment increases.
 
   
Loans with low rates early in the loan term. These loans are offered by Merrill Lynch primarily in the United Kingdom. The loans are underwritten based on the borrower’s ability to make the principal and interest payments, and borrowers of a lower credit standing are typically underwritten to a lower LTV ratio.
 
High LTV ratio loans where the principal amount of the loan is greater than 80% of the value of the mortgaged property and the borrower is not required to obtain private mortgage insurance (“PMI”), and/or loans where a mortgage and home equity loan are simultaneously established for the same property. Under Merrill Lynch’s policy, the maximum LTV ratio for originated residential mortgages with no PMI or other security is 95%. High LTV ratio loans also include Merrill Lynch’s Mortgage100SM product. The Mortgage100SM product permits
 (MERRILL LYNCH LOGO)
 


Table of Contents

   
borrowers to pledge securities in lieu of a cash down payment. The securities are subject to daily monitoring and additional collateral is required if the value of the pledged securities declines below certain levels. The LTV on real estate collateral in the Mortgage 100SM program typically does not exceed 70%.
As suggested in recent SEC guidance, the following table shows the percentages of these types of loans compared to the overall residential mortgage portfolio held in loans, notes, and mortgages:
                 
    Loan and Unfunded     Originated/Purchased  
    Commitment Balance as a % of     loans as a % of all  
    all Residential Mortgages and     Residential Mortgages  
    Unfunded Residential     Originated/Purchased  
    Commitments at December 30, 2005(2)     during 2005  
 
Loans where borrowers may be subject to payment increases(1)
    61 %     69 %
Loans with high LTV ratios
    6 %     5 %
Loans with both high LTV ratios and loans where borrowers may be subject to payment increases
    14 %     13 %
     
Total
    81 %     87 %
 
(1)  
Includes interest-only loans and loans with low initial rates.
(2)  
Total residential mortgages were $18.2 billion and unfunded commitments were $6.4 billion as of December 30, 2005.
Approximately half of the high LTV ratio loans were made to borrowers in the United Kingdom; the majority of the remaining loans were made to borrowers in the United States. Approximately 5% of the loans where the borrower is subject to payment increases were made to borrowers in the United Kingdom; the majority of the remaining loans were made to borrowers in the United States. The majority of these loans are with high credit quality borrowers.
Merrill Lynch does not currently originate or purchase residential mortgage loans that allow for minimum monthly payments less than the interest accrued on the loan (i.e., negative amortizing loans) or option adjustable rate mortgages.
Derivatives
Merrill Lynch enters into International Swaps and Derivatives Association, Inc. master agreements or their equivalent (“master netting agreements”) with substantially all of its derivative counterparties as soon as possible. Agreements are negotiated bilaterally and can require complex terms. While every effort is taken to execute such agreements, it is possible that a counterparty may be unwilling to sign such an agreement and, as a result, would subject Merrill Lynch to additional credit risk. Master netting agreements provide protection in bankruptcy in certain circumstances and, in some cases, enable receivables and payables with the same counterparty to be offset for risk management purposes. However, the enforceability of master netting agreements under bankruptcy laws in certain countries or in certain industries is not free from doubt, and receivables and payables with counterparties in these countries or industries are accordingly recorded on a gross basis.
In addition, to reduce the risk of loss, Merrill Lynch requires collateral, principally cash and U.S. Government and agency securities, on certain derivative transactions. From an economic standpoint, Merrill Lynch evaluates risk exposures net of related collateral. During 2005, Merrill Lynch began netting cash collateral received against the derivatives inventory on the Consolidated Balance Sheets. See Note 1 to the Consolidated Financial Statements for additional information. The following is a summary of counterparty credit ratings for the replacement cost (net of $12.3 billion of collateral, of which $7.9 billion represented cash collateral) of OTC trading derivatives in a gain position by maturity at December 30, 2005.
                                                 
(dollars in millions)   Years to Maturity     Cross-        
Credit                                   Maturity        
Rating(1)   03     3+–5     5+7     Over 7     Netting(2)     Total  
 
AAA
  $  1,645     $  228     $  248     $  2,387     $  (1,036 )   $  3,472  
AA
    2,891       628       774       2,487       (1,808 )     4,972  
A
    2,706       1,100       700       2,282       (1,747 )     5,041  
BBB
    1,607       394       587       1,044       (911 )     2,721  
Other
    2,414       522       397       559       (265 )     3,627  
     
Grand Total
  $  11,263     $  2,872     $  2,706     $  8,759     $  (5,767 )   $  19,833  
 
(1)  
Represents credit rating agency equivalent of internal credit ratings.
(2)  
Represents netting of payable balances with receivable balances for the same counterparty across maturity band categories. Receivable and payable balances with the same counterparty in the same maturity category, however, are net within the maturity category.
In addition to obtaining collateral, Merrill Lynch attempts to mitigate its default risk on derivatives whenever possible by entering into transactions with provisions that enable Merrill Lynch to terminate or reset the terms of its derivative contracts.
56
Merrill Lynch 2005 Annual Report
 


Table of Contents

Operational Risk
Merrill Lynch defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This is consistent with the definitions used by regulators, and as specified in the Basel II accord.
The primary responsibility for managing operational risk on a day-to-day basis lies with Merrill Lynch’s businesses and support groups. Each business and support group has processes and systems in place to address operational risks within their unit. These include the use of technology to automate processes and key controls, the provision of business continuity plans to protect against major disruptions, and the establishment of control committees to ensure the ongoing effectiveness of controls.
Merrill Lynch also employs independent control groups and governance committees to ensure effective management of operational risk. The Operational Risk Management Group is part of GLRM and is responsible for the monitoring and reporting of operational risk loss events, as well as putting in place the tools and techniques for the reporting and mitigation of operational risk exposure. In addition, this group is responsible for updating the ROC on the status of the Operational Risk program.
Corporate Audit and Compliance are key partners in the management of operational risk through independent reviews of the controls of the firm, and ensuring compliance with applicable rules and regulations.
Liquidity Risk
Liquidity risk relates to the ability of a company to repay short-term borrowings with new borrowings or assets that can be quickly converted into cash while meeting other obligations and continuing to operate as a going concern. Liquidity risk is particularly important for financial services firms and includes both the potential inability to raise funding with appropriate maturity and interest rate characteristics as well as the inability to liquidate an asset in a timely manner at a reasonable price. For more information on how Merrill Lynch manages liquidity risk, see the Capital and Funding section.
Other Risks
Merrill Lynch encounters a variety of other risks, which could have the ability to impact the viability, profitability, and cost-effectiveness of present or future transactions. Such risks include political, tax, and regulatory risks that may arise due to changes in local laws, regulations, accounting standards, or tax statutes. To assist in the mitigation of such risks, Merrill Lynch rigorously reviews new and pending legislation and regulations. Additionally, Merrill Lynch employs professionals in jurisdictions in which Merrill Lynch operates to actively follow issues of potential concern or impact to the firm and to participate in related interest groups.
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 are defined as debt and preferred equity securities rated lower than BBB 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 replicate 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. On a selected basis, Merrill Lynch provides extensions of credit to leveraged companies, in the form of senior and subordinated debt, as well as bridge financing. In addition, Merrill Lynch syndicates loans for non-investment grade companies or in connection with highly leveraged transactions and may retain a portion of these loans.
 (MERRILL LYNCH LOGO)
 


Table of Contents

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 selective basis.
Trading Exposures
The following table summarizes trading exposures to non-investment grade or highly leveraged corporate issuers or counterparties at year-end 2005 and 2004:
                 
(dollars in millions)   2005     2004  
 
Trading assets:
               
Cash instruments
  $ 15,578     $ 11,929  
Derivatives
    6,750       4,884  
Trading liabilities — cash instruments
    (3,400 )     (2,721 )
Collateral on derivative assets
    (3,123 )     (2,641 )
     
Net trading asset exposure
  $ 15,805     $ 11,451  
 
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 30, 2005, the carrying value of such debt and equity securities totaled $900 million, of which 61% resulted from Merrill Lynch’s market-making activities in such securities. This compared with $539 million at December 31, 2004, of which 45% related to market-making activities. Also included are distressed bank loans totaling $290 million and $176 million at year-end 2005 and 2004, respectively.
Non-Trading Exposures
The following table summarizes Merrill Lynch’s non-trading exposures to non-investment grade or highly leveraged corporate issuers or counterparties at year-end 2005 and 2004. This table excludes lending-related exposures which are included in the Credit Risk section of Risk Management.
                 
(dollars in millions)   2005     2004  
 
Investment securities
  $  515     $  455  
Other investments(1):
               
Partnership interests
     2,186        1,534  
Other equity Investments(2)
    2,069       691  
Other assets
    76        
 
(1)  
Includes a total of $556 million and $491 million in investments held by employee partnerships at year-end 2005 and 2004, respectively, for which a portion of the market risk of the investments rests with the participating employees.
(2)  
Includes investments in 171 and 192 enterprises at year-end 2005 and 2004, respectively.
In addition, Merrill Lynch had commitments to non-investment grade or highly leveraged corporate issuers or counterparties of $1.2 billion and $1.3 billion at year-end 2005 and 2004, respectively, which primarily relate to commitments to invest in partnerships.
At December 30, 2005, Merrill Lynch’s single largest non-investment grade industry exposure was to the Industrial/Manufacturing Goods and Services sector, principally consisting of chemicals.
58
Merrill Lynch 2005 Annual Report
 


Table of Contents

Recent Developments
New Accounting Pronouncements
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140. This Statement will be effective for Merrill Lynch beginning in the first quarter of 2007. Earlier adoption is permitted. The statement permits interests in hybrid financial assets that contain an embedded derivative that would require bifurcation to be accounted for as a single financial instrument at fair value with changes in fair value recognized in earnings. This election is permitted on an instrument-by-instrument basis for all hybrid financial instruments held, obtained, or issued as of the adoption date. Merrill Lynch is currently assessing the impact and timing of adoption of the proposed guidance.
In December 2005, the FASB issued FASB Staff Position (“FSP”) SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. The guidance requires the disclosure of concentrations of loans with certain features that may increase the creditor’s exposure to risk of nonpayment or realization. These loans are often referred to as “non-traditional” loans and include features such as high LTV ratios, terms that permit payments smaller than the interest accruals and loans where the borrower is subject to significant payment increases over the life of the loan. Merrill Lynch adopted the provisions of this guidance in the fourth quarter of 2005. See Note 8 to the Consolidated Financial Statements for this disclosure.
In November 2005, the FASB issued FSP 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which in conjunction with EITF 03-1 resulted in additional disclosures for securities in an unrealized loss position effective for year-end 2003. Merrill Lynch previously implemented the disclosure requirements of EITF 03-1 in its December 26, 2003 Consolidated Financial Statements. See Note 5 to the Consolidated Financial Statements for additional information.
In June 2005, the FASB ratified the consensus reached by the EITF on Issue 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”). EITF 04-5 presumes that a general partner controls a limited partnership, and should therefore consolidate a limited partnership, unless the limited partners have the substantive ability to remove the general partner without cause based on a simple majority vote or can otherwise dissolve the limited partnership, or unless the limited partners have substantive participating rights over decision making. The guidance in EITF 04-5 was effective immediately for all new limited partnership agreements and any limited partnership agreements that are modified. The guidance is effective for existing partnership agreements for financial reporting periods beginning after December 15, 2005 and may be reported as either a cumulative effect of a change in accounting principle or via retroactive restatement. The adoption of the guidance is not expected to have a material impact on the Consolidated Financial Statements.
On December 21, 2004, the FASB issued FSP 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The FSP provides guidance on the impact of the new tax law’s one-time deduction for qualifying repatriations of foreign earnings made in 2005. The deduction can result in a lower tax rate on repatriation of certain foreign earnings, where deferred taxes were previously established. To the extent that the cumulative undistributed earnings of non-U.S. subsidiaries were permanently reinvested, no deferred U.S. federal income taxes have been provided. Accordingly, net earnings in 2005 included tax expense of $97 million ($113 million of tax expense recorded in the fourth quarter, less a $16 million tax benefit recorded in the second quarter) associated with the foreign earnings repatriation of $1.8 billion.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123R”). In April 2005, the SEC delayed the effective date for SFAS No. 123R until the first fiscal year beginning after June 15, 2005. As a result of the SEC ruling, Merrill Lynch expects to adopt the provisions of SFAS No. 123R in the first quarter of 2006. Merrill Lynch adopted the provisions of SFAS No. 123 in the first quarter of 2004. Under the provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date based on the fair value of the award. Merrill Lynch recognizes expense over the vesting period stipulated in the grant for all employees. Such employees include those that have satisfied retirement eligibility criteria but are subject to a non-compete agreement that applies from the date of retirement through each applicable vesting period. Should a retirement-eligible employee actually leave Merrill Lynch, all previously unvested awards are immediately charged to expense. SFAS No. 123R clarifies and amends the guidance of SFAS No. 123 in several areas, including measuring fair value, classifying an award as equity or as a liability, attributing compensation cost to service periods and accounting for forfeitures of awards. Merrill Lynch currently expects that the impact of adopting SFAS No. 123R will reduce after-tax net income by approximately $350 million in the first quarter of 2006. See Note 14 to the Consolidated Financial Statements for further information on share-based compensation arrangements.
 (MERRILL LYNCH LOGO)


Table of Contents

Activities of Principal Subsidiaries
Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”) in the United States, acts as a broker (i.e., agent) for corporate, institutional, government, and private clients and as a dealer (i.e., principal) in the purchase and sale of corporate securities, primarily equity and debt securities traded on exchanges or in the OTC markets. MLPF&S also acts as a broker and/or a dealer in the purchase and sale of mutual funds, money market instruments, government securities, high yield bonds, municipal securities, financial futures contracts and options. The futures business and foreign exchange activities are conducted through MLPF&S and other subsidiaries. MLPF&S holds memberships and/or has third-party clearing relationships with all major commodity and financial futures exchanges and clearing associations in the United States and it also carries positions reflecting trades executed on exchanges outside of the United States through affiliates and/or third-party clearing brokers. As a leading investment banking firm, MLPF&S provides corporate, institutional, and government clients with a wide variety of financial services including underwriting the sale of securities to the public, structured and derivative financing, private placements, mortgage and lease financing and financial advisory services, including advice on mergers and acquisitions.
MLPF&S also provides securities clearing services for its own account and for unaffiliated broker-dealers through its Broadcort Correspondent Clearing Division and through its subsidiary Merrill Lynch Professional Clearing Corp. (“ML Pro”). ML Pro is involved in Merrill Lynch’s prime brokerage business and also makes a market in listed option contracts on various options exchanges.
MLPF&S also provides discretionary and non-discretionary investment advisory services. These advisory services include Merrill Lynch Consults® Service, the Personal Investment Advisory Program, the Merrill Lynch Mutual Fund Advisor® program, the Merrill Lynch Mutual Fund Advisor Selects® program, and Merrill Lynch Global Selects. MLPF&S also offers fee-based financial planning services, including the Financial Foundation® report. MLPF&S provides financing to clients, including margin lending and other extensions of credit. Through the Beyond Banking® account, a Merrill Lynch customer has access to a special securities account product designed for everyday transactions, savings and cash management that combines Visa, check writing and ATM access with available advice and guidance. Merrill Lynch also offers Merrill Lynch branded credit cards in partnership with MBNA America Bank, N.A.
Through its retirement group, MLPF&S provides a wide variety of investment and custodial services to individuals through Individual Retirement Accounts and small business retirement programs. MLPF&S also provides investment, administration, communications, and consulting services to corporations and their employees for their retirement programs, including 401(k), pension, profit-sharing and non-qualified deferred compensation plans.
Merrill Lynch International (“MLI”) is a United Kingdom-based dealer in equity and fixed income securities of a significant number of global issuers, sovereign government obligations and asset-backed securities, and in loans and related financial instruments. Outside the United States, MLI is a registered market maker and regularly makes a market in the equity securities of the more actively traded non-U.S. corporations. MLI is also Merrill Lynch’s primary non-U.S. credit and equity derivatives and futures product dealer.
Merrill Lynch Government Securities, Inc. (“MLGSI”) is a primary dealer in obligations issued or guaranteed by the U.S. Government and regularly makes a market in securities issued by Federal agencies and other government-sponsored entities, such as, among others, Government National Mortgage Association, Fannie Mae and Freddie Mac. MLGSI deals in mortgage-backed pass-through instruments issued by certain of these entities and also in related futures, options, and forward contracts for its own account, to hedge its own risk, and to facilitate customers’ transactions. As a primary dealer, MLGSI acts as a counterparty to the Federal Reserve Bank of New York (“FRBNY”) in the conduct of open market operations and regularly reports positions and activities to the FRBNY. An integral part of MLGSI’s business involves entering into repurchase agreements and securities lending transactions.
60
Merrill Lynch 2005 Annual Report
 


Table of Contents

Merrill Lynch Capital Services, Inc. (“MLCS”) and Merrill Lynch Derivative Products AG (“MLDP”) are Merrill Lynch’s primary interest rate and currency derivative product dealers. MLCS primarily acts as a counterparty for certain derivative financial products, including interest rate and currency swaps, caps and floors and options. MLCS maintains positions in interest-bearing securities, financial futures and forward contracts to hedge its interest rate and currency risk related to derivative exposures. In the normal course of its business, MLCS enters into repurchase and resale agreements with certain affiliated companies. MLDP acts as an intermediary for certain derivative products, including interest rate and currency swaps, between MLCS and counterparties that are highly rated or otherwise acceptable to MLDP. Its activities address certain swap customers’ preference to limit their trading to those dealers having the highest credit quality. MLDP has been assigned the Aaa, AAA and AAA counterparty rating by the rating agencies Moody’s Investors Service, Standard & Poor’s Ratings Services and Fitch Ratings, respectively. Customers meeting certain credit criteria enter into swaps with MLDP and, in turn, MLDP enters into offsetting mirror swaps with MLCS. However, MLCS is required to provide MLDP with collateral to mitigate certain exposures MLDP may have to MLCS. In addition, MLCS’s subsidiaries, Merrill Lynch Commodities, Inc., Merrill Lynch Commodities (Europe) Trading Limited and other Merrill Lynch subsidiaries trade as principal in physically and financially settled contracts in energy, weather and a broad range of other commodities. These subsidiaries also provide asset optimization and other energy management and risk management services for third parties.
Merrill Lynch Investment Managers, L.P., Fund Asset Management, L.P., and Merrill Lynch Investment Managers Limited are the principal subsidiaries engaged in asset management activities conducted through the MLIM brand name. MLIM is an asset manager with portfolio managers located in the United States, the United Kingdom, Japan and Australia. MLIM manages a variety of investment products and offers a wide array of taxable and tax-exempt fixed income, equity and balanced mutual funds and segregated accounts to a diverse global clientele. MLIM offers a wide assortment of index-based equity and alternative investment products. MLIM’s clients include institutions, high-net-worth individuals, retail investors, mutual funds and other investment vehicles.
Merrill Lynch Bank USA (“MLBUSA”) and Merrill Lynch Bank & Trust Co. (“MLB&T”) are part of the Merrill Lynch Global Bank Group, which provides the management platform for Merrill Lynch’s banking products and services. Merrill Lynch, primarily through MLBUSA, provides syndicated and bridge financing, asset-based lending, commercial real estate lending, equipment financing, and standby or “backstop” credit in various forms for large institutional clients generally in connection with their commercial paper programs. MLBUSA also offers securities-based loans primarily to individual clients. MLBUSA and MLB&T are state-chartered depository institutions insured by the Federal Deposit Insurance Corporation (“FDIC”), and both are wholesale banks for Community Reinvestment Act purposes. MLBUSA and MLB&T offer certificates of deposit, transaction accounts and money market deposit accounts and issue VISA debit cards.
MLBUSA, through its subsidiary Merrill Lynch Credit Corporation, offers residential mortgage financing throughout the United States enabling clients to purchase and refinance their homes as well as to manage their other personal credit needs. In addition, Merrill Lynch Business Financial Services Inc. (“MLBFS”), a subsidiary of MLBUSA, originates commercial financing for qualifying small- and mid-size businesses, including lines of credit and reducing revolver loans through the WCMA Commercial Line of Credit and the WCMA Reducing RevolverSM Loan, respectively. MLBFS also assists its qualifying business clients with equipment financing, owner-occupied commercial real estate and other specialized financing needs.
Financial Data Services Inc., a wholly-owned subsidiary of MLB&T, is a registered transfer agent and provides support and services for both Merrill Lynch and non-Merrill Lynch mutual fund products.
Merrill Lynch has submitted regulatory applications to the Office of Thrift Supervision, the FDIC and the Utah Department of Financial Institutions for purposes of internally reorganizing certain bank businesses, including the merger of MLB&T into Merrill Lynch Trust Company, FSB, with the latter expected to be the surviving entity.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch International Bank Limited (“MLIB”), an authorized credit institution under the U.K. Financial Services and Markets Act 2000, provides collateralized (including mortgage) lending, letters of credit, guarantee and foreign exchange services to, and accepts deposits from, international clients. In addition, it has a number of branch offices in which FAs are located. MLIB, through its subsidiary, Mortgages plc, provides mortgage lending, administration and servicing in the U.K. nonconforming residential mortgage market.
Merrill Lynch Bank (Suisse) S.A., a subsidiary of MLIB, is a Swiss licensed bank that provides a full array of banking, asset management and brokerage products and services to international clients, including securities trading and custody, secured loans and overdrafts, fiduciary deposits, foreign exchange trading and portfolio management services.
Merrill Lynch Capital Markets Bank Limited (“MLCMBL”), an Ireland-based bank with branch offices in London, Frankfurt and Milan, acts primarily as a credit intermediary for swaps, options and other derivative transactions, and secondarily as a principal for debt derivative transactions. MLCMBL also engages in advisory, lending, loan trading, and institutional sales activities.
Merrill Lynch Mortgage Capital Inc. (“MLMCI”) is a dealer in syndicated commercial loans. As an integral part of its business, MLMCI enters into repurchase agreements whereby it obtains funds by pledging its own whole loans as collateral. The repurchase agreements provide financing for MLMCI’s inventory and serve as short-term investments for MLMCI’s customers. MLMCI also enters into reverse repurchase agreements through which it provides funds to customers collateralized by whole loan mortgages, thereby providing the customers with temporary liquidity. MLMCI, through its subsidiary Merrill Lynch Mortgage Lending, Inc. (“MLML”), is a dealer in whole loan mortgages, mortgage loan participations, mortgage loan servicing and a commercial mortgage conduit that makes, and purchases from lenders, both commercial and multi-family mortgage loans and then securitizes these loans for sale to investors. MLML purchases prime, subprime, nonperforming and subperforming residential mortgage loans from originators of these loans and aggregates these loans for sale in the securitization market. Wilshire Credit Corporation, a subsidiary of MLMCI, services subprime, nonperforming and reperforming residential mortgages.
Merrill Lynch Japan Securities Co., Ltd. (“MLJS”) is a Japan-based broker-dealer that provides institutional and private clients with a variety of financial services, including the purchase and sale of equity and fixed income securities, futures and options. MLJS also acts as an underwriter and seller of securities in both publicly registered transactions and private placements.
Merrill Lynch Life Insurance Company and ML Life Insurance Company of New York issue annuity products. The sale of non-proprietary insurance products and proprietary and non-proprietary annuity products are made through Merrill Lynch Life Agency Inc. and other affiliated insurance agencies operating in the United States.
ML IBK Positions, Inc. is a U.S.-based entity involved in private equity and principal investing that makes proprietary investments in all levels of the capital structure of U.S. and non-U.S. companies, and in special purpose companies owning real estate, mortgage loans, consumer receivables and other assets, and may make direct equity investments in real estate assets, mortgage loans and other assets. In addition, through its subsidiary, Merrill Lynch Capital Corporation, it provides senior and subordinated financing to certain companies.
62
Merrill Lynch 2005 Annual Report
 


Table of Contents

Management’s Discussion of Financial Responsibility, Disclosure Controls and Procedures, and Report On Internal Control Over Financial Reporting
Financial Responsibility
Oversight is provided by independent units within Merrill Lynch, working together to maintain Merrill Lynch’s internal control standards. Corporate Audit reports directly to the Audit Committee of the Board of Directors, providing independent appraisals of Merrill Lynch’s internal controls and compliance with established policies and procedures. Finance management establishes accounting policies and procedures, measures and monitors financial risk, and independently from the businesses prepares financial statements that fairly present the underlying transactions and events of Merrill Lynch. GLRM monitors capital adequacy and liquidity management and has oversight responsibility for Merrill Lynch’s market and credit risks independent from business line management. This group has clear authority to enforce trading and credit limits using various systems and procedures to monitor positions and risks. The Office of the General Counsel serves in a counseling and advisory role to Management and the business groups. In this role, the group develops policies; monitors compliance with internal policies, external rules, and industry regulations; and provides legal advice, representation, execution, and transaction support to the businesses.
ML & Co. has established a Disclosure Committee to assist the Chief Executive Officer and Chief Financial Officer in fulfilling their responsibilities for overseeing the accuracy and timeliness of disclosures made by ML & Co. The Disclosure Committee is made up of senior representatives of Merrill Lynch’s Finance, Investor Relations, Office of the General Counsel, Treasury, Tax and GLRM groups, and is responsible for implementing and evaluating disclosure controls and procedures on an ongoing basis. The Disclosure Committee meets at least eight times a year. Meetings are held as needed to review key events and disclosures impacting the period throughout each fiscal quarter and prior to the filing of ML & Co.’s Form 10-K and 10-Q reports and proxy statement with the SEC.
The Board of Directors designated Merrill Lynch’s Guidelines for Business Conduct as the Company’s code of ethics for directors, officers and employees in performing their duties. The Guidelines set forth written standards for employee conduct with respect to conflicts of interest, disclosure obligations, compliance with applicable laws and rules and other matters. The Guidelines also set forth information and procedures for employees to report ethical or accounting concerns, misconduct or violations of the Guidelines in a confidential manner. The Board of Directors adopted Merrill Lynch’s Code of Ethics for Financial Professionals in 2003. The Code, which applies to all Merrill Lynch professionals who participate in the Company’s public disclosure process, supplements our Guidelines for Business Conduct and is designed to promote honest and ethical conduct, full, fair and accurate disclosure and compliance with applicable laws.
The independent registered public accounting firm, Deloitte & Touche LLP, performs annual audits of Merrill Lynch’s financial statements in accordance with the Standards of the Public Company Accounting Oversight Board (United States). They openly discuss with the Audit Committee their views on the quality of the financial statements and related disclosures and the adequacy of Merrill Lynch’s internal accounting controls. Quarterly review reports on the unaudited interim financial statements are also issued by Deloitte & Touche LLP. The Audit Committee appoints the independent registered public accounting firm. The independent registered public accounting firm is given unrestricted access to all financial records and related data, including minutes of meetings of stockholders, the Board of Directors, and committees of the Board.
As part of their oversight role, committees of the Board supervise management in the formulation of corporate policies, procedures and controls. The Audit Committee, which consists of five independent directors, oversees Merrill Lynch’s system of internal accounting controls and the internal audit function. In addition, the Audit Committee oversees adherence to risk management and compliance policies, procedures, and functions. It also reviews the annual Consolidated Financial Statements with Management and Merrill Lynch’s independent registered public accounting firm, and evaluates the performance, independence and fees of our independent registered public accounting firm and the professional services it provides. The Audit Committee also has the sole authority to appoint or replace the independent registered public accounting firm.
The Finance Committee, which consists of four independent directors, reviews, recommends, and approves policies regarding financial commitments and other expenditures. It also reviews and approves certain financial commitments, acquisitions, divestitures, and proprietary investments. In addition, the Finance Committee oversees balance sheet and capital management, corporate funding policies and financing plans. It also reviews Merrill Lynch’s policies and procedures for managing exposure to market and credit risk.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Disclosure Controls and Procedures
ML & Co.’s Disclosure Committee assists with implementing, monitoring and evaluating our disclosure controls and procedures. ML & Co.’s Chief Executive Officer, Chief Financial Officer and Disclosure Committee have evaluated the effectiveness of ML & Co.’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Report. Based on that evaluation, ML & Co.’s Chief Executive Officer and Chief Financial Officer have concluded that ML & Co.’s disclosure controls and procedures are effective as of the end of the period covered by this Report.
No change in ML & Co.’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during the fourth fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, ML & Co.’s internal control over financial reporting, except that during 2005, Merrill Lynch completed a company-wide implementation of a new general ledger system. As of December 30, 2005, substantially all of Merrill Lynch’s business units were using the new system. We have reviewed the internal controls affected by the implementation of this system and made changes to those impacted by the new system. We believe that the internal controls surrounding the new general ledger system as modified, are appropriate and functioning effectively.
Report on Internal Control Over Financial Reporting

Management recognizes its responsibility for establishing and maintaining adequate internal control over financial reporting and has designed internal controls and procedures to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements and related notes in accordance with generally accepted accounting principles in the United States of America. Management assessed the effectiveness of Merrill Lynch’s internal control over financial reporting as of December 30, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment, management believes that Merrill Lynch maintained effective internal control over financial reporting as of December 30, 2005.
The audited consolidated financial statements of Merrill Lynch include the results of The Advest Group Inc., but management’s assessment does not include an assessment of the internal control over financial reporting of this entity because it was acquired on December 2, 2005. This approach is consistent with published SEC guidance on the permissible scope of management’s internal control report. The financial statements for this entity reflect total assets and revenues constituting less than one percent of the related consolidated financial statement amounts as of and for the year ended December 30, 2005. See Note 17 to the Consolidated Financial Statements for additional information regarding this acquisition.
Deloitte & Touche LLP, Merrill Lynch’s independent registered public accounting firm, has issued an attestation report on management’s assessment of Merrill Lynch’s internal control over financial reporting and on the effectiveness of Merrill Lynch’s internal control over financial reporting. This report appears under “Report of Independent Registered Public Accounting Firm” on the following page.



New York, New York
February 27, 2006
64
Merrill Lynch 2005 Annual Report
 


Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Merrill Lynch & Co., Inc.:
We have audited management’s assessment, included in the accompanying Report on Internal Control Over Financial Reporting, that Merrill Lynch & Co., Inc. and subsidiaries (“Merrill Lynch”) maintained effective internal control over financial reporting as of December 30, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in the Report on Internal Control Over Financial Reporting, management excluded from their assessment the internal control over financial reporting at The Advest Group Inc., which was acquired on December 2, 2005, and whose financial statements reflect total assets and revenues constituting less than one percent of the related consolidated financial statement amounts as of and for the year ended December 30, 2005. Accordingly, our audit did not include the internal control over financial reporting at The Advest Group, Inc. Merrill Lynch’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of Merrill Lynch’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Merrill Lynch maintained effective internal control over financial reporting as of December 30, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, Merrill Lynch maintained, in all material respects, effective internal control over financial reporting as of December 30, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 30, 2005 of Merrill Lynch and our report dated February 27, 2006 expressed an unqualified opinion on those financial statements.
(DELOITTE & TOUCHE LLP)

New York, New York
February 27, 2006
 (MERRILL LYNCH LOGO)
 


Table of Contents

Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Merrill Lynch & Co., Inc.:
We have audited the accompanying consolidated balance sheets of Merrill Lynch & Co., Inc. and subsidiaries (“Merrill Lynch”) as of December 30, 2005 and December 31, 2004, and the related consolidated statements of earnings, changes in stockholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 30, 2005. These financial statements are the responsibility of Merrill Lynch’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Merrill Lynch as of December 30, 2005 and December 31, 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 30, 2005, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Merrill Lynch’s internal control over financial reporting as of December 30, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of Merrill Lynch’s internal control over financial reporting and an unqualified opinion on the effectiveness of Merrill Lynch’s internal control over financial reporting.
(DELOITTE & TOUCHE LLP)
New York, New York
February 27, 2006
66
Merrill Lynch 2005 Annual Report
 


Table of Contents

Consolidated Statements of Earnings
                         
    Year Ended Last Friday in December  
  2005   2004   2003  
(dollars in millions, except per share amounts) (52 weeks)   (53 weeks)   (52 weeks)  
 
Net Revenues
                       
Asset management and portfolio service fees
  $ 6,031     $ 5,440     $ 4,698  
Commissions
    5,371       4,874       4,299  
Investment banking
    3,594       3,268       2,643  
Principal transactions
    3,583       2,248       3,065  
Revenues from consolidated investments
    438       346       70  
Other
    2,195       1,454       1,492  
     
 
     21,212        17,630        16,267  
 
                       
Interest and dividend revenues
    26,571       14,989       11,657  
Less interest expense
    21,774       10,560       8,024  
     
Net interest profit
    4,797       4,429       3,633  
     
Total Net Revenues
    26,009       22,059       19,900  
     
 
                       
Non-Interest Expenses
                       
Compensation and benefits
    12,441       10,663       9,886  
Communications and technology
    1,608       1,461       1,457  
Occupancy and related depreciation
    938       893       889  
Brokerage, clearing, and exchange fees
    842       773       676  
Professional fees
    727       715       598  
Advertising and market development
    599       533       429  
Expenses of consolidated investments
    258       231       68  
Office supplies and postage
    210       203       197  
Other
    1,155       751       627  
Net recoveries related to September 11
                (147 )
     
Total Non-Interest Expenses
    18,778       16,223       14,680  
     
 
                       
Earnings Before Income Taxes
    7,231       5,836       5,220  
Income Tax Expense
    2,115       1,400       1,384  
     
 
                       
Net Earnings
  $ 5,116     $ 4,436     $ 3,836  
Preferred Stock Dividends
    70       41       39  
     
Net Earnings Applicable to Common Stockholders
  $ 5,046     $ 4,395     $ 3,797  
     
Earnings Per Common Share
                       
Basic
  $ 5.66     $ 4.81     $ 4.22  
     
Diluted
  $ 5.16     $ 4.38     $ 3.87  
 
See Notes to Consolidated Financial Statements.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Consolidated Balance Sheets
                 
(dollars in millions, except per share amounts) Dec. 30, 2005   Dec. 31, 2004  
 
Assets
               
Cash and cash equivalents
  $ 14,586     $ 20,790  
Cash and securities segregated for regulatory purposes or deposited with clearing organizations
    11,949       17,784  
Securities financing transactions
               
Receivables under resale agreements
    163,021       78,853  
Receivables under securities borrowed transactions
    92,484       94,498  
     
 
    255,505       173,351  
     
 
               
Trading assets, at fair value (includes securities pledged as collateral that can be sold or repledged of $44,261 in 2005 and $47,067 in 2004)
               
Equities and convertible debentures
    32,933       27,644  
Mortgages, mortgage-backed, and asset-backed
    29,233       26,877  
Corporate debt and preferred stock
    27,436       32,793  
Contractual agreements
    26,216       35,875  
Non-U.S. governments and agencies
    15,157       29,887  
U.S. Government and agencies
    8,936       13,861  
Municipals and money markets
    5,694       6,538  
Commodities and related contracts
    3,105       1,102  
     
 
    148,710       174,577  
     
 
               
Investment securities (includes securities pledged as collateral that can be sold or repledged of $0 in 2005 and $3,806 in 2004)
    69,273       78,460  
 
               
Securities received as collateral
    16,808       11,903  
 
               
Other receivables
               
Customers (net of allowance for doubtful accounts of $46 in 2005 and $51 in 2004)
    40,451       38,224  
Brokers and dealers
    12,127       12,109  
Interest and other
    15,619       13,954  
     
 
    68,197       64,287  
     
 
               
Loans, notes, and mortgages (net of allowance for loan losses of $406 in 2005 and $283 in 2004)
    66,041       53,262  
 
               
Separate accounts assets
    16,185       18,641  
 
               
Equipment and facilities (net of accumulated depreciation and amortization of $4,865 in 2005 and $5,259 in 2004)
    2,313       2,508  
 
               
Goodwill and other intangible assets
    6,035       6,162  
 
               
Other assets
    5,413       6,373  
     
 
               
Total Assets
  $ 681,015     $ 628,098  
 
68  
Merrill Lynch 2005 Annual Report


Table of Contents

Consolidated Balance Sheets
                 
(dollars in millions, except per share amounts) Dec. 30, 2005   Dec. 31, 2004  
 
 
Liabilities
               
Securities financing transactions
               
Payables under repurchase agreements
  $ 198,152     $ 153,843  
Payables under securities loaned transactions
    19,335       22,236  
     
 
    217,487       176,079  
     
 
               
Commercial paper and other short-term borrowings
    3,902       3,979  
Deposits
    80,016       79,746  
Trading liabilities, at fair value
               
Contractual agreements
    28,755       35,734  
Non-U.S. governments and agencies
    19,217       22,271  
Equities and convertible debentures
    19,119       15,131  
U.S. Government and agencies
    12,478       16,496  
Corporate debt and preferred stock
    6,203       8,058  
Commodities and related contracts
    2,029       767  
Municipals, money markets and other
    1,132       1,136  
     
 
    88,933       99,593  
     
Obligation to return securities received as collateral
    16,808       11,903  
Other payables
               
Customers
    35,619       34,381  
Brokers and dealers
    19,528       20,133  
Interest and other
    28,501       26,510  
     
 
    83,648       81,024  
     
Liabilities of insurance subsidiaries
    2,935       3,158  
Separate accounts liabilities
    16,185       18,641  
Long-term borrowings
    132,409       119,513  
Long-term debt issued to TOPrSSM partnerships
    3,092       3,092  
     
Total Liabilities
    645,415       596,728  
     
 
               
Commitments and Contingencies
               
Stockholders’ Equity
               
Preferred Stockholders’ Equity (liquidation preference of $30,000 per share; issued:
               
2005 – 93,000 shares; 2004 – 21,000 shares)
    2,773       630  
Less: Treasury stock, at cost (2005 – 3,315 shares; 2004 – 0 shares)
    100        
     
Total Preferred Stockholders’ Equity
    2,673       630  
     
Common Stockholders’ Equity
               
Shares exchangeable into common stock
    41       41  
Common stock (par value $1.331/3 per share; authorized: 3,000,000,000 shares; issued: 2005 – 1,148,714,008 shares and 2004 – 1,098,991,806 shares)
    1,531       1,465  
Paid-in capital
    15,012       12,332  
Accumulated other comprehensive loss (net of tax)
    (844 )     (481 )
Retained earnings
    26,824       22,485  
     
 
    42,564       35,842  
     
Less: Treasury stock, at cost (2005 – 233,112,271 shares; 2004 – 170,955,057 shares)
    7,945       4,230  
Unamortized employee stock grants
    1,692       872  
     
Total Common Stockholders’ Equity
    32,927       30,740  
     
Total Stockholders’ Equity
    35,600       31,370  
     
 
               
Total Liabilities and Stockholders’ Equity
  $ 681,015     $ 628,098  
 
See Notes to Consolidated Financial Statements.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Consolidated Statements of Changes in Stockholders’ Equity
                                                 
    Year Ended Last Friday in December  
    Amounts     Shares  
(dollars in millions)   2005     2004     2003     2005     2004     2003  
 
Preferred Stock, net
                                               
Balance, beginning of year
  $ 630     $ 425     $ 425       21,000       42,500       42,500  
Issuances
    2,143       630             72,000       21,000        
Redemptions
          (425 )                 (42,500 )      
Shares repurchased
    (100 )                 (3,315 )            
         
Balance, end of year
    2,673       630       425       89,685       21,000       42,500  
         
Common Stockholders’ Equity
                                               
Shares Exchangeable into Common Stock
                                               
Balance, beginning of year
    41       43       58       2,782,712       2,899,923       3,911,041  
Exchanges
          (2 )     (15 )     (74,915 )     (117,211 )     (1,011,118 )
         
Balance, end of year
    41       41       43       2,707,797       2,782,712       2,899,923  
         
Common Stock
                                               
Balance, beginning of year
    1,465       1,417       1,311       1,098,991,806       1,063,205,274       983,502,078  
Shares issued to employees
    66       48       106       49,722,202       35,786,532       79,703,196  
         
Balance, end of year
    1,531       1,465       1,417       1,148,714,008       1,098,991,806       1,063,205,274  
         
Paid-in Capital
                                               
Balance, beginning of year
    12,332       10,676       9,102                          
Employee stock plan activity
    2,680       1,656       1,574                          
                             
Balance, end of year
    15,012       12,332       10,676                          
                             
Accumulated Other Comprehensive Loss
                                               
Foreign Currency Translation Adjustment (net of tax)
                                               
Balance, beginning of year
    (289 )     (301 )     (320 )                        
Translation adjustment
    (218 )     12       19                          
                             
Balance, end of year
    (507 )     (289 )     (301 )                        
                             
Net Unrealized Gains (Losses) on Available-for-Sale Securities (net of tax)
                                               
Balance, beginning of year
    (91 )     (111 )     (145 )                        
Net unrealized gains (losses) on available-for-sale
    (156 )     30       27                          
Other adjustments(1)
    66       (10 )     7                          
                             
Balance, end of year
    (181 )     (91 )     (111 )                        
                             
Deferred Gains (Losses) on Cash Flow Hedges (net of tax)
                                               
Balance, beginning of year
    21       11       20                          
Net deferred gains on cash flow hedges
    (1 )           43                          
Reclassification adjustment to earnings
    (23 )     10       (52 )                        
                             
Balance, end of year
    (3 )     21       11                          
                             
Minimum Pension Liability (net of tax)
                                               
Balance, beginning of year
    (122 )     (150 )     (125 )                        
Net minimum pension liability adjustment
    (31 )     28       (25 )                        
                             
Balance, end of year
    (153 )     (122 )     (150 )                        
                             
Balance, end of year
    (844 )     (481 )     (551 )                        
                             
Retained Earnings
                                               
Balance, beginning of year
    22,485       18,692       15,491                          
Net earnings
    5,116       4,436       3,836                          
Preferred stock dividends declared
    (70 )     (41 )     (39 )                        
Common stock dividends declared
    (707 )     (602 )     (596 )                        
                             
Balance, end of year
    26,824       22,485       18,692                          
                             
Treasury Stock, at cost
                                               
Balance, beginning of year
    (4,230 )     (1,195 )     (961 )     (170,955,057 )     (117,294,392 )     (116,211,158 )
Shares repurchased
    (3,700 )     (2,968 )           (63,068,200 )     (54,029,600 )      
Shares issued to (reacquired from) employees(2)
    (18 )     (74 )     (273 )     836,071       251,724       (2,094,352 )
Share exchanges
    3       7       39       74,915       117,211       1,011,118  
         
Balance, end of year
    (7,945 )     (4,230 )     (1,195 )     (233,112,271 )     (170,955,057 )     (117,294,392 )
         
Unamortized Employee Stock Grants
                                               
Balance, beginning of year
    (872 )     (623 )     (775 )                        
Net issuance of employee stock grants
    (1,507 )     (765 )     (440 )                        
Amortization of employee stock grants
    687       516       592                          
                             
Balance, end of year
    (1,692 )     (872 )     (623 )                        
                             
Total Common Stockholders’ Equity
    32,927       30,740       28,459                          
                             
Total Stockholders’ Equity
  $ 35,600     $ 31,370     $ 28,884                          
 
(1)  
Other adjustments relate to policyholder liabilities, deferred policy acquisition costs, and income taxes.
(2)  
Share amounts are net of reacquisitions from employees of 4,360,607 shares, 4,982,481 shares and 8,355,168 shares in 2005, 2004 and 2003, respectively.
See Notes to Consolidated Financial Statements.
70
Merrill Lynch 2005 Annual Report
 


Table of Contents

Consolidated Statements of Comprehensive Income
                         
    Year Ended Last Friday in December  
(dollars in millions)   2005     2004     2003  
 
 
                       
Net Earnings
  $ 5,116     $ 4,436     $ 3,836  
Other Comprehensive Income (Loss)
                       
Foreign currency translation adjustment:
                       
Foreign currency translation gains (losses)
    129       (359 )     (392 )
Income tax (expense) benefit
    (347 )     371       411  
     
Total
    (218 )     12       19  
     
 
                       
Net unrealized gains (losses) on investment securities available-for-sale:
                       
Net unrealized holding gains arising during the period
    184       365       598  
Reclassification adjustment for realized gains included in net earnings
    (340 )     (335 )     (571 )
     
 
                       
Net unrealized gains (losses) on investment securities available-for-sale
    (156 )     30       27  
     
Adjustments for:
                       
Policyholder liabilities
    12       19       8  
Deferred policy acquisition costs
    (2 )           (1 )
Income tax (expense) benefit
    56       (29 )      
     
Total
    (90 )     20       34  
     
 
                       
Deferred gains (losses) on cash flow hedges
                       
Deferred gains (losses) on cash flow hedges
    (2 )     (7 )     37  
Income tax benefit
    1       7       6  
Reclassification adjustment to earnings
    (23 )     10       (52 )
     
Total
    (24 )     10       (9 )
     
 
                       
Minimum pension liability
                       
Minimum pension liability adjustment
    (46 )     38       (38 )
Income tax (expense) benefit
    15       (10 )     13  
     
Total
    (31 )     28       (25 )
     
Total Other Comprehensive Income (Loss)
    (363 )     70       19  
     
 
                       
Comprehensive Income
  $ 4,753     $ 4,506     $ 3,855  
 
See Notes to Consolidated Financial Statements.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Consolidated Statements of Cash Flows
                         
    Year Ended Last Friday in December  
(dollars in millions)   2005     2004     2003  
 
Cash Flows from Operating Activities
                       
 
                       
Net Earnings
  $ 5,116     $ 4,436     $ 3,836  
Noncash items included in earnings:
                       
Depreciation and amortization
    473       506       570  
Stock compensation expense
    1,003       876       998  
Deferred taxes
    232       2       361  
Policyholder reserves
    129       144       156  
Undistributed earnings from equity investments
    (417 )     (400 )     (179 )
Other
    888       23       (30 )
Changes in operating assets and liabilities:
                       
Trading assets
    25,902       (46,918 )     (21,141 )
Cash and securities segregated for regulatory purposes or deposited with clearing organizations
    3,259       (5,466 )     466  
Receivables under resale agreements
    (84,166 )     (17,835 )     (406 )
Receivables under securities borrowed transactions
    2,014       (38,426 )     71  
Customer receivables
    (2,217 )     (7,041 )     (667 )
Brokers and dealers receivables
    (19 )     (4,768 )     1,139  
Trading liabilities
    (17,007 )     14,447       6,304  
Payables under repurchase agreements
    44,309       58,197       10,400  
Payables under securities loaned transactions
    (2,901 )     11,155       3,441  
Customer payables
    1,238       12,141       (1,459 )
Brokers and dealers payables
    (605 )     1,024       2,568  
Other, net
    (2,889 )     2,962       2,228  
     
Cash Provided by (used for) Operating Activities
    (25,658 )     (14,941 )     8,656  
     
 
                       
Cash Flows from Investing Activities
                       
Proceeds from (payments for):
                       
Maturities of available-for-sale securities
    25,452       26,602       31,345  
Sales of available-for-sale securities
    36,574       27,983       56,448  
Purchases of available-for-sale securities
    (51,283 )     (54,498 )     (81,639 )
Maturities of held-to-maturity securities
    16       37       1,337  
Purchases of held-to-maturity securities
          (4 )     (1,062 )
Loans, notes, and mortgages, net
    (12,977 )     (2,234 )     (12,625 )
Other investments and other assets
    (1,442 )     (1,854 )     (4,110 )
Equipment and facilities, net
    (278 )     (402 )     (102 )
     
Cash Used for Investing Activities
    (3,938 )     (4,370 )     (10,408 )
     
 
                       
Cash Flows from Financing Activities
                       
Proceeds from (payments for):
                       
Commercial paper and other short-term borrowings
    (77 )     (1,021 )     (353 )
Deposits
    270       289       (2,385 )
Issuance and resale of long-term borrowings
    49,703       50,535       29,754  
Settlement and repurchase of long-term borrowings
    (31,195 )     (23,231 )     (26,454 )
Derivative financing transactions
    6,347       6,642       584  
Issuance of common stock
    858       589       624  
Issuance of preferred stock, net
    2,043       205        
Common stock repurchases
    (3,700 )     (2,968 )      
Other common stock transactions
    (80 )     41       69  
Dividends
    (777 )     (643 )     (635 )
     
Cash Provided by Financing Activities
    23,392       30,438       1,204  
     
Increase (Decrease) in Cash and Cash Equivalents
    (6,204 )     11,127       (548 )
Cash and Cash Equivalents, beginning of year
    20,790       9,663       10,211  
     
Cash and Cash Equivalents, end of year
  $ 14,586     $ 20,790     $ 9,663  
 
 
                       
Supplemental Disclosures
                       
Cash paid for:
                       
Income taxes
  $ 1,443     $ 661     $ 205  
Interest
    21,519       10,345       7,898  
     
See Notes to Consolidated Financial Statements.
72
Merrill Lynch 2005 Annual Report
 


Table of Contents

Notes to Consolidated Financial Statements
NOTE 1  
Summary of Significant Accounting Policies
Description of Business
Merrill Lynch & Co., Inc. (“ML & Co.”) and subsidiaries (“Merrill Lynch”) provide investment, financing, insurance, and related services to individuals and institutions on a global basis through its broker, dealer, banking, insurance, and other financial services subsidiaries. Its principal subsidiaries include:
 
Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”), a U.S.-based broker-dealer in securities and futures commission merchant;
 
 
Merrill Lynch International (“MLI”), a U.K.-based broker-dealer in securities and dealer in equity and credit derivatives;
 
 
Merrill Lynch Government Securities Inc. (“MLGSI”), a U.S.-based dealer in U.S. Government securities;
 
 
Merrill Lynch Capital Services, Inc., a U.S.-based dealer in interest rate, currency, credit derivatives and commodities;
 
 
Merrill Lynch Investment Managers, LP, a U.S.-based asset management company;
 
 
Merrill Lynch Investment Managers Limited, a U.K.-based asset management company;
 
 
Merrill Lynch Bank USA (“MLBUSA”), a U.S.-based Federal Deposit Insurance Corporation (“FDIC”)-insured depository institution;
 
 
Merrill Lynch Bank & Trust Co. (“MLB&T”), a U.S.-based FDIC-insured depository institution;
 
 
Merrill Lynch International Bank Limited (“MLIB”), a U.K.-based bank;
 
 
Merrill Lynch Capital Markets Bank Limited (“MLCMBL”), an Ireland-based bank;
 
 
Merrill Lynch Mortgage Capital, Inc., a U.S.-based dealer in syndicated commercial loans;
 
 
Merrill Lynch Japan Securities Co., Ltd. (“MLJS”), a Japan-based broker-dealer;
 
 
Merrill Lynch Life Insurance Company (“MLLIC”), a U.S.-based provider of annuity products;
 
 
ML Life Insurance Company of New York (“ML Life”), a U.S.-based provider of annuity products;
 
 
Merrill Lynch Derivative Products, AG, a Switzerland-based derivatives dealer; and
 
 
ML IBK Positions Inc., a U.S.-based entity involved in private equity and principal investing.
Services provided to clients by Merrill Lynch and other activities include:
 
Securities brokerage, trading and underwriting;
 
 
Investment banking, strategic advisory services (including mergers and acquisitions) and other corporate finance activities;
 
 
Wealth management products and services, including financial, retirement and generational planning;
 
 
Asset management and investment advisory and related record-keeping services;
 
 
Origination, brokerage, dealer, and related activities in swaps, options, forwards, exchange-traded futures, other derivatives, commodities and foreign exchange products;
 
 
Securities clearance, settlement financing services and prime brokerage;
 
 
Private equity and other principal investing activities;
 
 
Proprietary trading of securities, derivatives and loans;
 
 
Banking, trust, and lending services, including deposit-taking, consumer and commercial lending, including mortgage loans, and related services;
 
 
Insurance and annuities sales; and
 
 
Research across the following disciplines: global equity strategy and economics, global fixed income and equity-linked research, global fundamental equity research, and global wealth management strategy.
Basis of Presentation
The Consolidated Financial Statements include the accounts of Merrill Lynch, whose subsidiaries are generally controlled through a majority voting interest but may be controlled by means of a significant minority ownership, by contract, lease or otherwise. In certain cases, Merrill Lynch subsidiaries (i.e., Variable Interest Entities (“VIEs”) may also be consolidated based on a risks and rewards approach as required by Financial Accounting Standards Board (“FASB”) revised Interpretation No. 46 (“FIN 46R”). See Note 7 to the Consolidated Financial Statements for further discussion regarding the consolidation of VIEs.
The Consolidated Financial Statements are presented in accordance with accounting principles generally accepted in the United States of America, which include industry practices. Intercompany transactions and balances have been eliminated.
The Consolidated Financial Statements are presented in U.S. dollars. Many non-U.S. subsidiaries have a functional currency (i.e., the currency in which activities are primarily conducted) that is other than the U.S. dollar, often the currency of the country in which a subsidiary is domiciled. Subsidiaries’ assets and liabilities are translated to U.S. dollars at year-end exchange rates, while revenues and expenses are translated at average exchange rates during the year. Adjustments that result from translating amounts in a subsidiary’s functional currency and related hedging, net of related tax effects, are reported in stockholders’ equity as a component
 (MERRILL LYNCH LOGO)
 


Table of Contents

of accumulated other comprehensive loss. All other translation adjustments are included in earnings. Merrill Lynch uses derivatives to manage the currency exposure arising from activities in non-U.S. subsidiaries. (See the Derivatives section for additional information on accounting for derivatives.)
Certain reclassifications and format changes have been made to prior year amounts to conform to the current year presentation. In the second quarter of 2005, Merrill Lynch elected, under FASB Interpretation No. 39 (“FIN 39”), Offsetting of Amounts Related to Certain Contracts, to net cash collateral paid or received under credit support annexes associated with legally enforceable master netting agreements against derivatives inventory. Merrill Lynch believes this accounting presentation is preferable as compared to a gross presentation as it is a better representation of Merrill Lynch’s exposure relating to these derivative contracts. Amounts as of December 31, 2004 have been restated to conform to the current period presentation. The amounts netted at December 31, 2004 reduced total assets and total liabilities by $19.0 billion. Additionally, the December 31, 2004 Consolidated Balance Sheet reflects an immaterial restatement to correctly classify certain securities, amounting to $430 million, from cash and cash equivalents to investment securities-non-qualifying, a reclassification of $1.1 billion to properly reflect investment securities-trading, which were previously included in trading assets, as well as a reclassification of $953 million, to properly reflect payables under repurchase agreements, which were previously included in investment securities-held-to-maturity.
Certain hybrid instruments with embedded derivatives were reclassified on the Consolidated Balance Sheets from trading liabilities to long term borrowings to correct their classification. This reclassification amounted to $3.0 billion at December 31, 2004. The associated interest charge was also reclassified from principal transactions revenues to interest expense. The amounts reclassified to interest expense were not material to the Consolidated Statements of Earnings.
In 2005, Merrill Lynch changed its policy for recording the changes in fair value of foreign exchange contracts used to economically hedge foreign denominated assets or liabilities that are translated at the spot rate. In prior periods, Merrill Lynch recorded the change in fair value associated with the difference between the spot translation rate and the contracted forward translation rate in interest revenue or expense, and the revaluation of the contract related to changes in the spot rate was recorded in other expense or principal transactions revenues. In 2005, Merrill Lynch changed its policy to record the entire change in fair value for these contracts in other revenues in the Consolidated Statements of Earnings. Merrill Lynch made a similar change to the classification of foreign exchange contracts that qualified as hedges of a net investment in a foreign operation under Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities. In prior periods, changes in the fair value of the hedge instruments that are associated with the difference between the spot translation rate and the contracted forward translation rate (i.e., the ineffectiveness) were recorded in interest revenue or expense. Consistent with the above change, these amounts are now reflected in other revenues. Merrill Lynch believes this accounting presentation is more appropriate as it more accurately reflects the overall changes in the fair value of the contracts. In addition, in prior periods the changes related to the translation of foreign-denominated assets and liabilities were recorded in other expense; these amounts have now been reclassified to other revenues. All prior periods presented have been reclassified to conform to the current period presentation. The amounts reclassified to other revenues were not material to the Consolidated Statements of Earnings.
Use of Estimates
In presenting the Consolidated Financial Statements, management makes estimates regarding:
 
Valuations of assets and liabilities requiring fair value estimates including:
   
Trading inventory and investment securities;
 
   
Private equity investments;
 
   
Loans and allowance for loan losses;
 
The outcome of litigation;
 
 
The realization of deferred taxes and tax reserves;
 
 
Assumptions and cash flow projections used in determining whether variable interest entities (“VIEs”) should be consolidated and the determination of the qualifying status of special purpose entities (“QSPEs”);
 
 
The carrying amount of goodwill and other intangible assets;
 
 
Valuation of employee stock options;
 
 
Insurance reserves and recovery of insurance deferred acquisition costs;
 
 
Other matters that affect the reported amounts and disclosure of contingencies in the financial statements.
Estimates, by their nature, are based on judgment and available information. Therefore, actual results could differ from those estimates and could have a material impact on the Consolidated Financial Statements, and it is possible that such changes could occur in the near term. A discussion of certain areas in which estimates are a significant component of the amounts reported in the Consolidated Financial Statements follows:
74
Merrill Lynch 2005 Annual Report
 


Table of Contents

Trading Assets and Liabilities
Trading assets and liabilities are accounted for at fair value with realized and unrealized gains and losses reported in earnings. Fair values of trading securities are based on quoted market prices, pricing models (utilizing indicators of general market conditions and other economic measurements), or management’s estimates of amounts to be realized on settlement, assuming current market conditions and an orderly disposition over a reasonable period of time. Estimating the fair value of certain illiquid securities requires significant management judgment. Merrill Lynch values trading security assets at the institutional bid price and recognizes bid-offer revenues when assets are sold. Trading security liabilities are valued at the institutional offer price and bid-offer revenues are recognized when the positions are closed.
Fair values for over-the-counter (“OTC”) derivative financial instruments, principally forwards, options, and swaps, represent the present value of amounts estimated to be received from or paid to a third-party in settlement of these instruments. These derivatives are valued using pricing models based on the net present value of estimated future cash flows and directly observed prices from exchange-traded derivatives, other OTC trades, or external pricing services, while taking into account the counterparty’s credit ratings, or Merrill Lynch’s own credit ratings, as appropriate. Obtaining the fair value for OTC derivatives contracts requires the use of management judgment and estimates.
New and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation often incorporate significant estimates and assumptions, which may impact the results of operations reported in the Consolidated Financial Statements. For long-dated and illiquid contracts, extrapolation methods are applied to observed market data in order to estimate inputs and assumptions that are not directly observable. This enables Merrill Lynch to mark-to-market all positions consistently when only a subset of prices are directly observable. Values for OTC derivatives are verified using observed information about the costs of hedging the risk and other trades in the market. As the markets for these products develop, Merrill Lynch continually refines its pricing models based on experience to correlate more closely to the market risk of these instruments. Unrealized gains at the inception of the derivative contract are not recognized unless the valuation model incorporates significant observable market inputs.
Valuation adjustments are an integral component of the fair valuation process and may be taken where either the sheer size of the trade or other specific features of the trade or particular market (such as counterparty credit quality or concentration or market liquidity) requires the valuation to be based on more than simple application of the pricing models.
Investment Securities
ML & Co. and certain of its non-broker-dealer subsidiaries follow the guidance prescribed by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, when accounting for investments in debt and publicly traded equity securities. Merrill Lynch classifies those debt securities that it has the intent and ability to hold to maturity as held-to-maturity securities, which are carried at cost unless a decline in value is deemed other-than-temporary, in which case the carrying value is reduced. Those securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and marked to fair value through earnings. All other qualifying securities are classified as available-for-sale with unrealized gains and losses reported in accumulated other comprehensive loss. Any unrealized losses deemed other-than-temporary are included in current period earnings and removed from accumulated other comprehensive loss.
Investment securities are reviewed for other-than-temporary impairment on a quarterly basis. The determination of other-than-temporary impairment will often depend on several factors, including the severity and duration of the decline in value of the investment securities and the financial condition of the issuer, and requires judgment. To the extent that Merrill Lynch has the ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investment, no impairment charge will be recognized.
Restricted Investments
Merrill Lynch holds investments that may have quoted market prices but that are subject to restrictions (e.g., requires consent of the issuer or other investors to sell) that may limit Merrill Lynch’s ability to realize the quoted market price. Restricted investments may be recorded in either trading assets or investment securities. Merrill Lynch estimates the fair value of these securities taking into account the restrictions using pricing models based on projected cash flows, earnings multiples, comparisons based on similar transactions, and/or review of underlying financial conditions and other market factors. Such estimation may result in a fair value for a security that is less than its quoted market price.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Private Equity Investments
Certain private equity investments are held at fair value. Private equity investments held by non-broker-dealer subsidiaries, which have defined exit strategies and are held for capital appreciation and/or current income are accounted for under the AICPA Accounting and Auditing Guide, Investment Companies (“Investment Company Guide”) and carried at fair value. Investments are initially carried at original cost, and are adjusted when changes in the underlying fair values are readily ascertainable, generally based on observable evidence.
Loans and Allowance for Loan Losses
Certain loans held by Merrill Lynch are carried at fair value or lower of cost or market (“LOCOM”) and estimation is required in determining these fair values. The fair value of loans made in connection with commercial lending activity, consisting primarily of senior debt, is primarily estimated using discounted cash flows or the market value of publicly issued debt instruments. Merrill Lynch’s estimate of fair value for other loans, notes, and mortgages is determined based on the individual loan characteristics. For certain homogeneous categories of loans, including residential mortgages and home equity loans, fair value is estimated using market price quotations or previously executed transactions for securities backed by similar loans, adjusted for credit risk and other individual loan characteristics. For Merrill Lynch’s variable-rate loan receivables, carrying value approximates fair value.
Loans held for investment are carried at cost, less a provision for loan losses. This provision for loan losses is based on management’s estimate of the amount necessary to maintain the allowance at a level adequate to absorb probable incurred loan losses. Management’s estimate of loan losses is influenced by many factors, including adverse situations that may affect the borrower’s ability to repay, current economic conditions, prior loan loss experience, and the estimated fair value of any underlying collateral. The fair value of collateral is generally determined by third-party appraisals in the case of residential mortgages or quoted market prices for securities, or estimates of fair value for other assets. Management’s estimates of loan losses include considerable judgment about collectibility based on available facts and evidence at the balance sheet date, and the uncertainties inherent in those assumptions. While management uses the best information available on which to base its estimates, future adjustments to the allowance may be necessary based on changes in the economic environment or variances between actual results and the original assumptions used by management.
Legal and Other Reserves
Merrill Lynch is a party in various actions, some of which involve claims for substantial amounts. Amounts are accrued for the financial resolution of claims that have either been asserted or are deemed probable of assertion if, in the opinion of management, it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. In many cases, it is not possible to determine whether a liability has been incurred or to estimate the ultimate or minimum amount of that liability until years after the litigation has been commenced, in which case no accrual is made until that time. Accruals are subject to significant estimation by management with input from outside counsel.
Income Taxes
Deferred tax assets and liabilities are recorded for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the Consolidated Financial Statements. Merrill Lynch assesses its ability to realize deferred tax assets primarily based on the earnings history and future earnings potential of the legal entities through which the deferred tax assets will be realized as discussed in SFAS No. 109, Accounting for Income Taxes. See Note 15 to the Consolidated Financial Statements for further discussion of income taxes.
Variable Interest Entities
In the normal course of business, Merrill Lynch enters into a variety of transactions with VIEs. The applicable accounting guidance requires Merrill Lynch to perform a qualitative and/or quantitative analysis of a VIE to determine whether it is the primary beneficiary of the VIE and therefore must consolidate the VIE. In performing this analysis, Merrill Lynch makes assumptions regarding future performance of assets held by the VIE, taking into account estimates of credit risk, estimates of the fair value of assets, timing of cash flows, and other significant factors. It should also be noted that although a VIE’s actual results may differ from projected outcomes, a revised consolidation analysis is not required. If a VIE meets the conditions to be considered a QSPE, it is typically not required to be consolidated by Merrill Lynch. A QSPE’s activities must be significantly limited. A servicer of the assets held by a QSPE may have discretion in restructuring or working out assets held by the QSPE as long as the discretion is significantly limited and the parameters of that discretion are fully described in the legal documents that established the QSPE. Determining whether the activities of a QSPE and its servicer meet these conditions requires the use of judgment by management.
Impairment of Goodwill and Other Intangibles
SFAS No. 142, Goodwill and Other Intangible Assets, requires Merrill Lynch to make certain subjective and complex judgments, including assumptions and estimates used to determine the fair value of its reporting units. The majority of Merrill Lynch’s goodwill
76
Merrill Lynch 2005 Annual Report
 


Table of Contents

is related to the 1997 purchase of the Mercury Asset Management Group and resides in the Merrill Lynch Investment Managers (“MLIM”) segment. The fair value of the MLIM segment is measured based on a discounted expected future cash flows approach. The estimates used in preparing these cash flows are based upon historical experience, current knowledge, and available external information about future trends.
Employee Stock Options
The fair value of stock options is estimated as of the grant date based on a Black-Scholes option pricing model. The Black-Scholes model takes into account the exercise price and expected life of the option, the current price of the underlying stock and its expected volatility, expected dividends, and the risk-free interest rate for the expected term of the option. Judgment is required in determining certain of the inputs to the model. The expected life of the option is based on an analysis of historical employee exercise behavior. The expected volatility is based on Merrill Lynch’s historical monthly stock price volatility for the same number of months as the expected life of the option. The fair value of the option estimated at grant date is not adjusted for subsequent changes in assumptions.
Insurance Reserves and Deferred Acquisition Costs Relating to Insurance Policies
Merrill Lynch records reserves related to life insurance and annuity contracts. Included in these reserves is a mortality reserve that is determined by projecting expected guaranteed benefits under multiple scenarios. Merrill Lynch uses estimates for mortality and surrender assumptions based on actual and projected experience for each contract type. These estimates are consistent with the estimates used in the calculation of deferred policy acquisition costs.
Merrill Lynch records deferred policy acquisition costs that are amortized in proportion to the estimated future gross profits for each group of contracts over the anticipated life of the insurance contracts, utilizing an effective yield methodology. These future gross profit estimates are subject to periodic evaluation by Merrill Lynch, with necessary revisions applied against amortization to date.
Fair Value
At December 30, 2005, $613 billion, or 90%, of Merrill Lynch’s total assets and $622 billion, or 96%, of Merrill Lynch’s total liabilities were carried at fair value or at amounts that approximate fair value. At December 31, 2004, $569 billion, or 91%, of Merrill Lynch’s total assets and $574 billion, or 96%, of Merrill Lynch’s total liabilities were carried at fair value or at amounts that approximate such values. Financial instruments that are carried at fair value include cash and cash equivalents, cash and securities segregated for regulatory purposes or deposited with clearing organizations, trading assets and liabilities, securities received as collateral and obligation to return securities received as collateral, available-for-sale and trading securities included in investment securities, certain private equity investments, certain investments of insurance subsidiaries and certain other investments.
Financial instruments recorded at amounts that approximate fair value include receivables under resale agreements, receivables under securities borrowed transactions, other receivables, payables under repurchase agreements, payables under securities loaned transactions, commercial paper and other short-term borrowings, deposits, other payables, and long-term borrowings. The fair value of these items is not materially sensitive to shifts in market interest rates because of the short-term nature of many of these instruments and/or their variable interest rates.
The fair value amounts for financial instruments are disclosed in each respective Note to the Consolidated Financial Statements.
Revenue Recognition
Asset management and portfolio service fees consist of:
 
Management fees, which represent a percentage of client assets under management, and are accrued ratably over the service period. Management fees are presented net of payments made to distributors of MLIM funds;
 
 
Account fees, which generally represent a fixed annual charge and are recognized ratably over the period in which services are provided; and
 
 
Performance fees, which are earned if investment performance exceeds predetermined levels, and are generally accrued based on performance to date.
Commissions revenues includes commissions, mutual fund distribution fees and contingent deferred sale charge revenue, which are all accrued as earned. Commissions revenues also includes mutual fund redemption fees, which are recognized at the time of redemption. Commissions revenues earned from certain customer equity transactions are recorded net of related brokerage, clearing and exchange fees.
Principal transactions revenues include both realized and unrealized gains and losses on trading assets and trading liabilities and investment securities classified as trading investments. Realized gains and losses are recognized on a trade date basis.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Investment banking revenues include underwriting revenues and fees for merger and acquisition advisory services, which are accrued when services for the transactions are substantially completed. Transaction-related expenses are deferred to match revenue recognition. Investment banking and advisory services revenues are presented net of transaction-related expenses.
Revenues from consolidated investments and expenses of consolidated investments are related to investments that are consolidated under SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries, and FIN 46R. Expenses of consolidated investments primarily consist of minority interest expense and cost of goods sold related to manufacturing entities that are consolidated and are part of Merrill Lynch’s private equity and principal investment activities.
Balance Sheet Captions
The following are descriptions of specific balance sheet captions. Refer to the related Notes to the Consolidated Financial Statements for additional information.
Cash and Cash Equivalents
Merrill Lynch defines cash equivalents as short-term, highly liquid securities, federal funds sold, and interest-earning deposits with maturities, when purchased, of 90 days or less, that are not used for trading purposes.
Cash and Securities Segregated for Regulatory Purposes or Deposited with Clearing Organizations
Merrill Lynch maintains relationships with clients around the world and, as a result, it is subject to various regulatory regimes. As a result of its client activities, Merrill Lynch is obligated by rules mandated by its primary regulators, including the Securities and Exchange Commission (“SEC”) and the Commodities Futures Trading Commission (“CFTC”) in the United States and the Financial Services Authority (“FSA”) in the United Kingdom to segregate or set aside cash and/or qualified securities to satisfy these regulations, which have been promulgated to protect customer assets. In addition, Merrill Lynch is a member of various clearing organizations at which it maintains cash and/or securities required for the conduct of its day-to-day clearance activities.
Securities Financing Transactions
Merrill Lynch enters into repurchase and resale agreements and securities borrowed and loaned transactions to accommodate customers (also referred to as “matched-book transactions”), and earn residual interest rate spreads, obtain securities for settlement and finance inventory positions. Merrill Lynch also engages in securities financing for customers through margin lending (see the customer receivables and payables section).
Resale and repurchase agreements are accounted for as collateralized financing transactions and are recorded at their contractual amounts plus accrued interest. Merrill Lynch’s policy is to obtain possession of collateral with a market value equal to or in excess of the principal amount loaned under resale agreements. To ensure that the market value of the underlying collateral remains sufficient, collateral is valued daily, and Merrill Lynch may require counterparties to deposit additional collateral or return collateral pledged, when appropriate.
Substantially all repurchase and resale activities are transacted under master netting agreements that give Merrill Lynch the right, in the event of default, to liquidate collateral held and to offset receivables and payables with the same counterparty. Merrill Lynch offsets certain repurchase and resale agreement balances with the same counterparty on the Consolidated Balance Sheets.
Merrill Lynch may use securities received as collateral for resale agreements to satisfy regulatory requirements such as Rule 15c3-3 of the SEC.
Securities borrowed and loaned transactions are recorded at the amount of cash collateral advanced or received. Securities borrowed transactions require Merrill Lynch to provide the counterparty with collateral in the form of cash, letters of credit, or other securities. Merrill Lynch receives collateral in the form of cash or other securities for securities loaned transactions. For these transactions, the fees received or paid by Merrill Lynch are recorded as interest revenue or expense. On a daily basis, Merrill Lynch monitors the market value of securities borrowed or loaned against the collateral value, and Merrill Lynch may require counterparties to deposit additional collateral or return collateral pledged, when appropriate. Although substantially all securities borrowing and lending activities are transacted under master netting agreements, such receivables and payables with the same counterparty are not offset on the Consolidated Balance Sheets.
All firm-owned securities pledged to counterparties where the counterparty has the right, by contract or custom, to sell or repledge the securities are disclosed parenthetically in trading assets and investment securities on the Consolidated Balance Sheets.
78
Merrill Lynch 2005 Annual Report
 


Table of Contents

In transactions where Merrill Lynch acts as the lender in a securities lending agreement and receives securities that can be pledged or sold as collateral, it recognizes an asset on the Consolidated Balance Sheets, representing the securities received (securities received as collateral), and a liability for the same amount, representing the obligation to return those securities (obligation to return securities received as collateral). The amounts on the Consolidated Balance Sheets result from non-cash transactions.
Trading Assets and Liabilities
Merrill Lynch’s trading activities consist primarily of securities brokerage and trading; derivatives dealing and brokerage; commodities trading and brokerage; and securities financing transactions. Trading assets and trading liabilities consist of cash instruments (such as securities and loans) and derivative instruments used for trading purposes or for managing risk exposures in other trading inventory. See the Derivatives section for additional information on accounting policy for derivatives. Trading assets and trading liabilities also include commodities inventory.
Trading securities and other cash instruments (e.g., loans held for trading purposes) are recorded on a trade date basis at fair value. Included in trading liabilities are securities that Merrill Lynch has sold but did not own and will therefore be obligated to purchase at a future date (“short sales”). Commodities inventory is recorded at the lower of cost or market value. Changes in fair value of trading assets and liabilities (i.e., unrealized gains and losses) are recognized as principal transactions revenues in the current period. Realized gains and losses and any related interest amounts are included in principal transactions revenues and interest revenues and expenses, depending on the nature of the instrument.
Fair values of trading assets and liabilities are based on quoted market prices, pricing models (utilizing indicators of general market conditions or other economic measurements), or management’s best estimates of amounts to be realized on settlement, assuming current market conditions and an orderly disposition over a reasonable period of time. As previously noted, estimating the fair value of certain trading assets and liabilities requires significant management judgment.
Derivatives
A derivative is an instrument whose value is “derived” from an underlying instrument or index such as a future, forward, swap, or option contract, or other financial instrument with similar characteristics. Derivative contracts often involve future commitments to exchange interest payment streams or currencies based on a notional or contractual amount (e.g., interest rate swaps or currency forwards) or to purchase or sell other financial instruments at specified terms on a specified date (e.g., options to buy or sell securities or currencies). Derivative activity is subject to Merrill Lynch’s overall risk management policies and procedures. See Note 6 to the Consolidated Financial Statements for further information.
Accounting for Derivatives and Hedging Activities
SFAS No. 133, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (“embedded derivatives”) and for hedging activities. SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in the Consolidated Balance Sheets and measure those instruments at fair value. The fair value of all derivatives is recorded on a net-by-counterparty basis on the Consolidated Balance Sheets where management believes a legal right of setoff exists under an enforceable netting agreement.
The accounting for changes in fair value of a derivative instrument depends on its intended use and if it is designated and qualifies as an accounting hedging instrument.
Merrill Lynch enters into derivatives to facilitate client transactions, for proprietary trading and financing purposes, and to manage its risk exposures arising from trading assets and liabilities. Derivatives entered into for these purposes are recognized at fair value on the Consolidated Balance Sheets as trading assets and liabilities in contractual agreements and the change in fair value is reported in current period earnings as principal transactions revenues.
Merrill Lynch also enters into derivatives in order to manage its risk exposures arising from assets and liabilities not carried at fair value as follows:
1.  
Merrill Lynch routinely issues debt in a variety of maturities and currencies to achieve the lowest cost financing possible. In addition, Merrill Lynch’s regulated bank entities accept time deposits of varying rates and maturities. Merrill Lynch enters into derivative transactions to hedge these liabilities. Derivatives used most frequently include swap agreements that:
   
Convert fixed-rate interest payments into variable payments
 
   
Change the underlying interest rate basis or reset frequency
 
   
Change the settlement currency of a debt instrument.
2.  
Merrill Lynch enters into hedges on marketable investment securities to manage the interest rate risk, currency risk, and net duration of its investment portfolios.
 (MERRILL LYNCH LOGO)
 


Table of Contents

3.  
Merrill Lynch enters into fair value hedges of long-term fixed rate resale and repurchase agreements to manage the interest rate risk of these assets and liabilities.
 
4.  
Merrill Lynch uses foreign-exchange forward contracts, foreign-exchange options, currency swaps, and foreign-currency-denominated debt to hedge its net investments in foreign operations. These derivatives and cash instruments are used to mitigate the impact of changes in exchange rates.
 
5.  
Merrill Lynch enters into futures and forwards to manage the price risk of certain commodity inventory.
Derivatives entered into by Merrill Lynch to hedge its funding, marketable investment securities and net investments in foreign subsidiaries are reported at fair value in other assets or interest and other payables in the Consolidated Balance Sheets at December 30, 2005 and December 31, 2004. Derivatives used to hedge commodity inventory are included in trading assets and trading liabilities on the Consolidated Balance Sheets at December 30, 2005 and December 31, 2004.
Derivatives that qualify as accounting hedges under the guidance in SFAS No. 133 are designated, on the date they are entered into, as either:
1.  
A hedge of the fair value of a recognized asset or liability (“fair value” hedge). Changes in the fair value of derivatives that are designated and qualify as fair value hedges of interest rate risk, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings as interest revenue or expense. Changes in the fair value of derivatives that are designated and qualify as fair value hedges of commodity price risk, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings in principal transactions.
 
2.  
A hedge of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge). Changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recorded in accumulated other comprehensive loss until earnings are affected by the variability of cash flows of the hedged asset or liability (e.g., when periodic interest accruals on a variable-rate asset or liability are recorded in earnings).
 
3.  
A hedge of a net investment in a foreign operation. Changes in the fair value of derivatives that are designated and qualify as hedges of a net investment in a foreign operation are recorded in the foreign currency translation adjustment account within accumulated other comprehensive loss. Changes in the fair value of the hedge instruments that are associated with the difference between the spot translation rate and the forward translation rate are recorded in current period earnings in other revenues.
Merrill Lynch formally assesses, both at the inception of the hedge and on an ongoing basis, whether the hedging derivatives are highly effective in offsetting changes in fair value or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge, Merrill Lynch discontinues hedge accounting. Under the provisions of SFAS No. 133, 100% hedge effectiveness is assumed for those derivatives whose terms meet the conditions of SFAS No. 133 “short-cut method.”
As noted above, Merrill Lynch enters into fair value hedges of interest rate exposure associated with certain investment securities and debt issuances. Merrill Lynch uses interest rate swaps to hedge this exposure. Hedge effectiveness testing is required for certain of these hedging relationships on a quarterly basis. Merrill Lynch assesses effectiveness on a prospective basis by comparing the expected change in the price of the hedge instrument to the expected change in the value of the hedged item under various interest rate shock scenarios. In addition, Merrill Lynch assesses effectiveness on a retrospective basis using the Dollar-Offset ratio approach. When assessing hedge effectiveness, there are no attributes of the derivatives used to hedge the fair value exposure that are excluded from the assessment. In addition, the amount of hedge ineffectiveness on fair value hedges reported in earnings was not material for all periods presented. Merrill Lynch also enters into fair value hedges of commodity price risk associated with certain commodity inventory. For these hedges, Merrill Lynch assesses effectiveness on a prospective and retrospective basis using regression techniques. The difference between the spot rate and the contracted forward rate which represents the time value of money is excluded from the assessment of hedge effectiveness and is recorded in principal transactions. The amount of hedge ineffectiveness on these fair value hedges reported in earnings was not material for all periods presented.
The majority of deferred net gains (losses) on derivative instruments designated as cash flow hedges that were in accumulated other comprehensive loss at December 30, 2005 are expected to be reclassified into earnings over the next three years. The amount of ineffectiveness related to these hedges reported in earnings was not material for all periods presented.
For the years ended 2005 and 2004, respectively, $731 million and $458 million of net losses related to non-U.S. dollar hedges of investments in non-U.S. dollar subsidiaries were included in accumulated other comprehensive loss on the Consolidated Balance Sheets. These amounts were substantially offset by net gains on the hedged investments.
80
Merrill Lynch 2005 Annual Report
 


Table of Contents

Changes in the fair value of derivatives that are economically used to hedge non-trading assets and liabilities, but that do not meet the criteria in SFAS No. 133 to qualify as an accounting hedge, are reported in current period earnings as either principal transactions revenues, other revenues or expenses, or interest revenues or expenses, depending on the nature of the transaction.
Embedded Derivatives
Merrill Lynch issues debt and certificates of deposit whose coupons or repayment terms are linked to the performance of debt or equity securities, indices or currencies. The contingent payment components of these obligations may meet the definition in SFAS No. 133 of an “embedded derivative.” These debt instruments are assessed to determine if the embedded derivative requires separate reporting and accounting, and if so, the embedded derivative is accounted for at fair value and reported in long-term borrowings or deposits on the Consolidated Balance Sheets along with the debt obligation. Changes in the fair value of the embedded derivative and related economic hedges are reported in principal transactions revenues. Separating an embedded derivative from its host contract requires careful analysis, judgment, and an understanding of the terms and conditions of the instrument.
Merrill Lynch may also purchase financial instruments that contain embedded derivatives. These instruments may be part of either trading inventory or trading marketable investment securities. These instruments are generally accounted for at fair value in their entirety; the embedded derivative is not separately accounted for, and all changes in fair value are reported in principal transactions revenues.
Derivatives that Contain a Significant Financing Element
In the ordinary course of trading activities, Merrill Lynch enters into certain transactions that are documented as derivatives where a significant cash investment is made by one party. These transactions can be in the form of simple interest rate swaps where the fixed leg is prepaid or may be in the form of equity-linked or credit-linked transactions where the initial investment equals the notional amount of the derivative. In accordance with SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, certain derivative instruments entered into or modified after June 30, 2003 that contain a significant financing element at inception and where Merrill Lynch is deemed to be the borrower, are included in financing activities in the Consolidated Statements of Cash Flows. Prior to July 1, 2003, the activity associated with such derivative instruments is included in operating activities in the Consolidated Statements of Cash Flows. In addition, the cash flows from all other derivative transactions that do not contain a significant financing element at inception are included in operating activities.
Investment Securities
Investment securities consist of marketable investment securities, investments of Merrill Lynch insurance subsidiaries, and other investments.
Marketable Investment Securities
ML & Co. and certain of its non-broker-dealer subsidiaries hold debt and equity investments, which are primarily classified as available-for-sale.
Debt and marketable equity securities classified as available-for-sale are reported at fair value. Unrealized gains or losses on these securities are reported in stockholders’ equity as a component of accumulated other comprehensive loss, net of income taxes and other related items. However, to the extent that Merrill Lynch enters into interest rate swaps to hedge the interest rate exposure of certain available-for-sale investment securities, the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the investment security, are recorded in current period earnings as interest revenue or expense. (Refer to the Derivatives section for additional information.) Any unrealized losses deemed other-than-temporary are included in current period earnings.
Debt securities that Merrill Lynch has the positive intent and ability to hold to maturity are classified as held-to-maturity. These investments are recorded at amortized cost unless a decline in value is deemed other-than-temporary, in which case the carrying value is reduced. The amortization of premiums or accretion of discounts and any unrealized losses deemed other-than-temporary are included in current period earnings.
Debt and marketable equity securities purchased principally for the purpose of resale in the near term are classified as trading investments and are reported at fair value. Unrealized gains or losses on these investments are included in current period earnings.
Realized gains and losses on all investment securities are included in current period earnings. For purposes of computing realized gains and losses, the cost basis of each investment sold is generally based on the average cost method.
Investments of Insurance Subsidiaries and Related Liabilities
Insurance liabilities are future benefits payable under annuity and life insurance contracts and include deposits received plus interest credited during the contract accumulation period, the present value of future payments for contracts that have annuitized, and a
 (MERRILL LYNCH LOGO)
 


Table of Contents

mortality provision for certain products. Certain policyholder liabilities are also adjusted for those investments classified as available-for-sale. Liabilities for unpaid claims consist of the mortality benefit for reported claims and an estimate of unreported claims based upon actual and projected experience for each contract type.
Substantially all security investments of insurance subsidiaries are classified as available-for-sale and recorded at fair value. These investments support Merrill Lynch’s in-force, universal life-type contracts. Merrill Lynch records adjustments to deferred policy acquisition costs and policyholder account balances which, when combined, are equal to the gain or loss that would have been recorded if those available-for-sale investments had been sold at their estimated fair values and the proceeds reinvested at current yields. The corresponding credits or charges for these adjustments are recorded in stockholders’ equity as a component of accumulated other comprehensive loss, net of applicable income taxes.
Certain variable costs related to the sale or acquisition of new and renewal insurance contracts have been deferred, to the extent deemed recoverable, and amortized over the estimated lives of the contracts in proportion to the estimated gross profit for each group of contracts.
Other Investments
Other investments primarily consist of private equity investments. Refer to Note 5 to the Consolidated Financial Statements for further information.
Other Receivables and Payables
Customer Receivables and Payables
Customer securities transactions are recorded on a settlement date basis. Receivables from and payables to customers include amounts due on cash and margin transactions, including futures contracts transacted on behalf of Merrill Lynch customers. Securities owned by customers, including those that collateralize margin or other similar transactions, are not reflected on the Consolidated Balance Sheets.
Brokers and Dealers Receivables and Payables
Receivables from brokers and dealers include amounts receivable for securities not delivered by Merrill Lynch to a purchaser by the settlement date (“fails to deliver”), margin deposits, commissions, and net receivables arising from unsettled trades. Payables to brokers and dealers include amounts payable for securities not received by Merrill Lynch from a seller by the settlement date (“fails to receive”). Brokers and dealers receivables and payables also include amounts related to futures contracts on behalf of Merrill Lynch customers as well as net payables and receivables from unsettled trades.
Interest and Other Receivables and Payables
Interest and other receivables include interest receivable on corporate and governmental obligations, customer or other receivables, and stock-borrowed transactions. Also included are receivables from income taxes, underwriting and advisory fees, commissions and fees, and other receivables. Interest and other payables include interest payable for stock-loaned transactions, and short-term and long-term borrowings. Also included are amounts payable for employee compensation and benefits, income taxes, minority interest, non-trading derivatives, dividends, other reserves, and other payables.
Loans, Notes, and Mortgages, Net
Merrill Lynch’s lending and related activities include loan originations, syndications, and securitizations. Loan originations include corporate and institutional loans, residential and commercial mortgages, asset-based loans, and other loans to individuals and businesses. Merrill Lynch also engages in secondary market loan trading and margin lending (see trading assets and liabilities and customer receivables and payables sections, respectively). Loans included in loans, notes, and mortgages are classified for accounting purposes as loans held for investment and loans held for sale.
Loans held for investment purposes include:
 
commercial loans
 
 
small business loans and some consumer loans
 
 
certain residential mortgage loans.
These loans are carried at their principal amount outstanding. An allowance for loan losses is established through provisions that are based on management’s estimate of probable incurred losses. Loans are charged off against the allowance for loan losses when management determines that the loan is uncollectible. The loan loss provision related to loans held for investment is included in interest revenue in the Consolidated Statements of Earnings. In general, loans are evaluated for impairment when they are greater than 90 days past due or exhibit credit quality weakness. Loans are considered impaired when it is probable that Merrill Lynch will not be able to collect all principal and interest due from the borrower. All payments received on impaired loans are applied to principal until the principal balance has been reduced to a level where collection of the remaining recorded investment is not in doubt. Typically, when collection of principal on an impaired loan is not in doubt, contractual interest will be credited to interest income when received.
82
Merrill Lynch 2005 Annual Report
 


Table of Contents

Loans held for sale include:
 
commercial loans that are in the process of being syndicated
 
 
certain purchased automobile loans
 
 
certain residential mortgage loans which are typically sold via securitization.
These loans are reported at LOCOM. Declines in the carrying value of loans held for sale are included in other revenues in the Consolidated Statements of Earnings.
Nonrefundable loan origination fees, loan commitment fees, and “draw down” fees received in conjunction with financing arrangements are generally deferred and recognized over the contractual life of the loan as an adjustment to the yield. If, at the outset, or any time during the term of the loan, it becomes highly probable that the repayment period will be extended, the amortization is recalculated using the expected remaining life of the loan. When the loan contract does not provide for a specific maturity date, management’s best estimate of the repayment period is used. At repayment of the loan, any unrecognized deferred fee is immediately recognized in earnings.
Separate Accounts Assets and Liabilities
Merrill Lynch maintains separate accounts representing segregated funds held for purposes of funding variable life and annuity contracts. The separate accounts assets are not subject to general claims of Merrill Lynch. These accounts and the related liabilities are recorded as separate accounts assets and separate accounts liabilities on the Consolidated Balance Sheets.
Absent any contract provision wherein Merrill Lynch guarantees either a minimum return or account value upon death or annuitization, the net investment income and net realized and unrealized gains and losses attributable to separate accounts assets supporting variable life and annuity contracts accrue directly to the contract owner and are not reported as revenue in the Consolidated Statements of Earnings. Mortality, policy administration and withdrawal charges associated with separate accounts products are included in other revenues in the Consolidated Statements of Earnings.
Equipment and Facilities
Equipment and facilities consist primarily of technology hardware and software, leasehold improvements, and owned facilities. Equipment and facilities are reported at historical cost, net of accumulated depreciation and amortization, except for land, which is reported at historical cost.
Depreciation and amortization are computed using the straight-line method. Equipment is depreciated over its estimated useful life, while leasehold improvements are amortized over the lesser of the improvement’s estimated economic useful life or the term of the lease. Maintenance and repair costs are expensed as incurred.
Included in the occupancy and related depreciation expense category was depreciation and amortization of $200 million, $198 million, and $209 million in 2005, 2004, and 2003, respectively. Depreciation and amortization recognized in the communications and technology expense category was $273 million, $308 million, and $361 million for 2005, 2004, and 2003, respectively.
Qualifying costs incurred in the development of internal-use software are capitalized when costs exceed $5 million and are amortized over the useful life of the developed software, generally not exceeding three years.
Goodwill and Other Intangibles
In accordance with SFAS No. 142, goodwill and indefinite-lived intangible assets are tested annually (or more frequently under certain conditions) for impairment. Other intangible assets are amortized over their useful lives.
As of December 30, 2005, goodwill and other intangible assets of $6,035 million was comprised of net goodwill of $5,803 million and net intangible assets of $232 million. As of December 31, 2004, goodwill and other intangible assets of $6,162 million was comprised of net goodwill of $6,035 million and net intangible assets of $127 million. There were no intangible assets that were considered to be indefinite-lived at December 30, 2005 and December 31, 2004. The majority of the goodwill, and related accumulated amortization, is denominated in sterling, and as a result has changed from 2004 due to exchange rate changes. Goodwill and other intangibles also includes the impact of the acquisition of The Advest Group, Inc. (“Advest”) in 2005, as well as goodwill and other intangibles from other smaller acquisitions. Refer to Note 17 to the Consolidated Financial Statements for further information.
Accumulated amortization of goodwill and other intangible assets amounted to $1,076 million and $1,124 million at year-end 2005 and 2004, respectively. The change is primarily due to changes in exchange rates.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch has reviewed its goodwill in accordance with SFAS No. 142 and determined that the fair value of the reporting units to which goodwill relates exceeded the carrying value of such reporting units. Accordingly, no goodwill impairment loss has been recognized. The majority of the goodwill is related to the 1997 purchase of the Mercury Asset Management Group and was tested for impairment at the MLIM segment level since this business has been fully integrated into MLIM.
Other Assets
Other assets includes unrealized gains on derivatives used to hedge Merrill Lynch’s non-trading borrowing and investing activities. All of these derivatives are recorded at fair value with changes reflected in earnings or accumulated other comprehensive loss (refer to the Derivatives section for more information). Other assets also includes prepaid pension expense related to plan contributions in excess of obligations, other prepaid expenses, and other deferred charges. Refer to Note 13 to the Consolidated Financial Statements for further information.
In addition, real estate purchased for investment purposes is also included in this category. Real estate held in this category may be classified as either held and used or held for sale depending on the facts and circumstances. Real estate held and used is valued at cost, less depreciation, and real estate held for sale is valued at the lower of cost or fair value, less estimated cost to sell.
Commercial Paper and Short- and Long-Term Borrowings
Merrill Lynch’s unsecured general-purpose funding is principally obtained from medium-term and long-term borrowings. Commercial paper, when issued at a discount, is recorded at the proceeds received and accreted to its par value. Long-term borrowings are carried at the principal amount borrowed, net of unamortized discounts or premiums, adjusted for the effects of fair-value hedges.
Merrill Lynch is an issuer of debt whose coupons or repayment terms are linked to the performance of equity, debt, a basket of securities or other indices. These debt instruments must be separated into a debt host and an embedded derivative if the derivative is not considered clearly and closely related under the criteria established in SFAS No. 133. Embedded derivatives are recorded at fair value and changes in fair value are reflected in earnings. Beginning in 2004, in accordance with SEC guidance, Merrill Lynch amortizes any observable upfront profit associated with the embedded derivative into income as a yield adjustment over the life of the related debt instrument or certificate of deposit. This resulted in deferred revenue, net of related amortization, of $126 million and $184 million for the years ended December 30, 2005 and December 31, 2004, respectively. See the Embedded Derivatives section above for additional information.
Merrill Lynch uses derivatives to manage the interest rate, currency, equity, and other risk exposures of its borrowings. See the Derivatives section for additional information on accounting policy for derivatives.
Deposits
Savings deposits are interest-bearing accounts that have no maturity or expiration date, whereby the depositor is not required by the deposit contract, but may at any time be required by the depository institution, to give written notice of an intended withdrawal not less than seven days before withdrawal is made. Time deposits are accounts that have a stipulated maturity and interest rate. Depositors holding time deposits may recover their funds prior to the stated maturity but may pay a penalty to do so. In certain cases, Merrill Lynch enters into interest rate swaps to hedge the fair value risk in these time deposits. See the Derivatives section above for additional information.
Stock-Based Compensation
Merrill Lynch accounts for stock-based compensation in accordance with the fair value method in SFAS No. 123, Accounting for Stock-Based Compensation. Under the fair value recognition provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense on a straight-line basis over the vesting period. The unamortized portion of the grant value for certain of these plans is reflected as a reduction of stockholders’ equity in unamortized employee stock grants on the Consolidated Balance Sheets. See Note 14 to the Consolidated Financial Statements for additional disclosures related to stock-based compensation.
Income Taxes
ML & Co. and certain of its wholly-owned subsidiaries file a consolidated U.S. federal income tax return. Certain other Merrill Lynch entities file tax returns in their local jurisdictions.
Merrill Lynch provides for income taxes on all transactions that have been recognized in the Consolidated Financial Statements in accordance with SFAS No. 109. Accordingly, deferred taxes are adjusted to reflect the tax rates at which future taxable amounts will likely be settled or realized. The effects of tax rate changes on future deferred tax liabilities and deferred tax assets, as well as other changes in income tax laws, are recognized in net earnings in the period during which such changes are enacted. Deferred tax assets and liabilities are included in interest and other receivables and interest and other payables, respectively, on the Consolidated
84
Merrill Lynch 2005 Annual Report
 


Table of Contents

Balance Sheets. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. See Note 15 to the Consolidated Financial Statements for further information.
New Accounting Pronouncements
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140. This Statement will be effective for Merrill Lynch beginning in the first quarter of 2007. Earlier adoption is permitted. The statement permits interests in hybrid financial assets that contain an embedded derivative that would require bifurcation to be accounted for as a single financial instrument at fair value with changes in fair value recognized in earnings. This election is permitted on an instrument-by-instrument basis for all hybrid financial instruments held, obtained, or issued as of the adoption date. Merrill Lynch is currently assessing the impact and timing of adoption of the proposed guidance.
In December 2005, the FASB issued FASB Staff Position (“FSP”) SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. The guidance requires the disclosure of concentrations of loans with certain features that may increase the creditor’s exposure to risk of nonpayment or realization. These loans are often referred to as “non-traditional” loans and include features such as high loan-to-value (“LTV”) ratios, terms that permit payments smaller than the interest accruals and loans where the borrower is subject to significant payment increases over the life of the loan. Merrill Lynch adopted the provisions of this guidance in the fourth quarter of 2005. See Note 8 to the Consolidated Financial Statements for this disclosure.
In November 2005, the FASB issued FSP 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which in conjunction with the Emerging Issues Task Force (“EITF”) 03-1 resulted in additional disclosures for securities in an unrealized loss position effective for year-end 2003. Merrill Lynch previously implemented the disclosure requirements of EITF 03-1 in its December 26, 2003 Consolidated Financial Statements. See Note 5 to the Consolidated Financial Statements for additional information.
In June 2005, the FASB ratified the consensus reached by the EITF on Issue 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”). EITF 04-5 presumes that a general partner controls a limited partnership, and should therefore consolidate a limited partnership, unless the limited partners have the substantive ability to remove the general partner without cause based on a simple majority vote or can otherwise dissolve the limited partnership, or unless the limited partners have substantive participating rights over decision making. The guidance in EITF 04-5 was effective immediately for all new limited partnership agreements and any limited partnership agreements that are modified. The guidance is effective for existing partnership agreements for financial reporting periods beginning after December 15, 2005 and may be reported as either a cumulative effect of a change in accounting principle or via retroactive restatement. The adoption of this guidance is not expected to have a material impact on the Consolidated Financial Statements.
On December 21, 2004, the FASB issued FSP 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The FSP provides guidance on the impact of the new tax law’s one-time deduction for qualifying repatriations of foreign earnings made in 2005. The deduction can result in a lower tax rate on repatriation of certain foreign earnings, where deferred taxes were previously established. To the extent that the cumulative undistributed earnings of non-U.S. subsidiaries were permanently reinvested, no deferred U.S. federal income taxes have been provided. Accordingly, net earnings in 2005 included tax expense of $97 million ($113 million of tax expense recorded in the fourth quarter, less a $16 million tax benefit recorded in the second quarter), associated with the foreign earnings repatriation of $1.8 billion.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123R”). In April 2005, the SEC delayed the effective date for SFAS No. 123R until the first fiscal year beginning after June 15, 2005. As a result of the SEC ruling, Merrill Lynch expects to adopt the provisions of SFAS No. 123R in the first quarter of 2006. Merrill Lynch adopted the provisions of SFAS No. 123 in the first quarter of 2004. Under the provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date based on the fair value of the award. Merrill Lynch recognizes expense over the vesting period stipulated in the grant for all employees. Such employees include those that have satisfied retirement eligibility criteria but are subject to a non-compete agreement that applies from the date of retirement through each application vesting period. Should a retirement-eligible employee actually leave Merrill Lynch, all previously unvested awards are immediately charged to expense. SFAS No. 123R clarifies and amends the guidance of SFAS No. 123 in several areas, including measuring fair value, classifying an award as equity or as a liability, attributing compensation cost to service periods and accounting for forfeitures of awards. Merrill Lynch currently expects that the impact of adopting SFAS No. 123R will reduce after-tax net income by approximately $350 million in the first quarter of 2006. See Note 14 to the Consolidated Financial Statements for further information on share-based compensation arrangements.
 (MERRILL LYNCH LOGO)


Table of Contents

In December of 2003, the AICPA issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses revenue recognition and impairment assessments for certain loans and debt securities that were purchased at a discount that was at least in part due to credit quality. SOP 03-3 states that where expected cash flows from the loan or debt security can be reasonably estimated, the difference between the purchase price and the expected cash flows (i.e., the “accretable yield”) should be accreted into income. In addition, the SOP prohibits the recognition of an allowance for loan losses on the purchase date. Further, the SOP requires that the allowance for loan losses be supported through a cash flow analysis, on either an individual or on a pooled basis, for all loans that fall within the scope of the guidance. Merrill Lynch adopted SOP 03-3 as of the beginning of fiscal year 2005. The adoption of the guidance did not have a material impact on the Consolidated Financial Statements.
On May 19, 2004, the FASB issued FSP 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which supersedes FSP 106-1 of the same title issued in January 2004. FSP 106-2 provides guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) that was signed into law on December 8, 2003. The Act allows for a tax-free government subsidy to employers providing “actuarially equivalent” prescription drug benefits to its Medicare eligible retirees. Management concluded that the benefits provided under Merrill Lynch’s plan are “actuarially equivalent” to Medicare Part D and qualify for the subsidy provided by the Act. Effective for the third quarter of 2004, Merrill Lynch adopted FSP 106-2 using the prospective application method. As a result, Merrill Lynch’s accumulated postretirement benefit obligation has been reduced by approximately $45 million and the net periodic postretirement benefit cost for the third and fourth quarters of 2004 decreased by $2.6 million.
NOTE 2  
Subsequent Events
On February 15, 2006, Merrill Lynch announced that it had signed a definitive agreement under which it would transfer its MLIM investment management business to BlackRock, Inc. (“BlackRock”) in exchange for a 49.8% interest in the combined firm, including a 45% voting interest. Based on the value of this transaction at the time of the announcement, it is expected to result in an after-tax gain to Merrill Lynch upon closing of over $1 billion. This transaction is expected to close during the third quarter of 2006. The actual gain will be contingent upon BlackRock’s share price at closing, as well as closing adjustments. Merrill Lynch plans to account for its investment in BlackRock under the equity method of accounting. Refer to Note 3 to the Consolidated Financial Statements for further information on MLIM.
On February 16, 2006, Merrill Lynch entered into agreements-in-principle settling 23 class actions that challenged the objectivity of Merrill Lynch’s research recommendations related to securities of Internet companies. As a result of this settlement and an accrual for other litigation-related matters in accordance with SFAS No. 5, Accounting for Contingencies, Merrill Lynch has recorded a pre-tax charge of $170 million ($102 million after-tax, and $0.11 per diluted share). This amount has been included in the Consolidated Statements of Earnings in other expenses. See Note 12 to the Consolidated Financial Statements for information regarding this and other litigation matters.
NOTE 3  
Segment and Geographic Information
Segment Information
In reporting to management during 2005, Merrill Lynch’s operating results were categorized into three business segments: Global Markets and Investment Banking (“GMI”), Global Private Client (“GPC”), and MLIM. Prior period amounts have been reclassified to conform to the current period presentation.
The principal methodology used in preparing the segment results in the table that follows is:
 
Revenues and expenses are assigned to segments where directly attributable.
 
 
Principal transactions, net interest and investment banking revenues and related costs resulting from the client activities of GPC are allocated among GMI and GPC based on production credits, share counts, trade counts, and other measures which estimate relative value.
 
 
MLIM receives a net advisory fee from GPC relating to certain MLIM-branded products offered through GPC’s 401(k) product offering.
 
 
Revenues and expenses related to mutual fund shares bearing a contingent deferred sales charge are reflected in segment results as if MLIM and GPC were unrelated entities.
 
 
Interest (cost of carry) is allocated based on management’s assessment of the relative liquidity of segment assets and liabilities.
86
Merrill Lynch 2005 Annual Report
 


Table of Contents

 
Acquisition financing costs, other corporate interest and September 11-related expenses are not attributed to segments because management excludes these items from segment operating results in evaluating segment performance. The elimination of inter-segment revenues and expenses is also included in Corporate items.
 
 
Residual expenses (i.e., those related to overhead and support units) are attributed to segments based on specific methodologies (e.g., headcount, square footage, intersegment agreements).
Management believes that the following information by business segment provides a reasonable representation of each segment’s contribution to the consolidated net revenues and pre-tax earnings:
                                         
                          Corporate Items        
                          (including        
                          intersegment        
(dollars in millions)   GMI     GPC     MLIM   eliminations)     Total  
 
2005
                                       
Non-interest revenues
  $ 10,325     $ 9,069     $ 1,780     $ 38 (1)   $ 21,212  
Net interest profit(2)
    3,544       1,695       27        (469) (3)     4,797  
     
Net revenues
    13,869       10,764       1,807       (431 )     26,009  
Non-interest expenses
    8,841       8,587       1,221       129 (1)     18,778  
     
Pre-tax earnings (loss)
  $ 5,028     $ 2,177     $ 586     $ (560 )   $ 7,231  
     
Year-end total assets
  $ 590,054     $ 76,908     $ 7,470     $  6,583     $ 681,015  
     
 
                                       
2004
                                       
Non-interest revenues
  $ 7,519     $ 8,547     $ 1,567     $ (3 )(1)   $ 17,630  
Net interest profit(2)
    3,544       1,280       13       (408 )(3)     4,429  
     
Net revenues
    11,063       9,827       1,580       (411 )     22,059  
Non-interest expenses
    7,194       7,954       1,120       (45 )(1)     16,223  
     
Pre-tax earnings (loss)
  $ 3,869     $ 1,873     $ 460     $ (366 )   $ 5,836  
     
Year-end total assets
  $  537,124     $  74,849     $ 9,415     $ 6,710     $  628,098  
     
 
                                       
2003
                                       
Non-interest revenues
  $ 7,280     $ 7,639     $ 1,356     $ (8 )(1)   $ 16,267  
Net interest profit(2)
    2,737       1,259       6       (369 ) (3)     3,633  
     
Net revenues
    10,017       8,898       1,362       (377 )     19,900  
Non-interest expenses
    6,246       7,369       1,101       (36 ) (1)     14,680  
     
Pre-tax earnings (loss)
  $ 3,771     $ 1,529     $ 261     $ (341 )   $ 5,220  
     
Year-end total assets
  $ 392,853     $ 75,089     $ 6,913     $ 5,378     $ 480,233  
 
(1)  
Primarily represents the elimination of intersegment revenues and expenses.
(2)  
Management views interest income net of interest expense in evaluating results.
(3)  
Represents acquisition financing costs and other corporate interest, including the impact of Trust Originated Preferred Securities (“TOPrSSM”).
Geographic Information
Merrill Lynch operates in both U.S. and non-U.S. markets. Merrill Lynch’s non-U.S. business activities are conducted through offices in four regions:
 
Europe, Middle East, and Africa;
 
 
Pacific Rim;
 
 
Latin America; and
 
 
Canada.
The principal methodology used in preparing the geographic data in the table that follows is:
 
Revenue and expenses are generally recorded based on the location of the employee generating the revenue or incurring the expense;
 
 
Earnings before income taxes include the allocation of certain shared expenses among regions; and
 
 
Intercompany transfers are based primarily on service agreements.
 (MERRILL LYNCH LOGO)
 


Table of Contents

The information that follows, in management’s judgment, provides a reasonable representation of each region’s contribution to the consolidated net revenues and pre-tax earnings:
                         
(dollars in millions)   2005     2004     2003  
 
Net revenues
                       
Europe, Middle East, and Africa
  $ 4,860     $ 3,392     $ 3,350  
Pacific Rim
    2,725       2,351       2,040  
Latin America
    823       664       562  
Canada
    230       248       224  
     
Total Non-U.S.
    8,638       6,655       6,176  
United States
    17,802       15,815       14,101  
Corporate
    (431 )     (411 )     (377 )
     
Total
  $ 26,009     $ 22,059     $ 19,900  
     
 
                       
Earnings (loss) before income taxes
                       
Europe, Middle East, and Africa
  $ 1,374     $ 632     $ 835  
Pacific Rim
    973       885       789  
Latin America
    332       236       191  
Canada
    45       76       63  
     
Total Non-U.S.
    2,724       1,829       1,878  
United States
    5,067       4,373       3,683  
Corporate
    (560 )     (366 )     (341 )
     
Total
  $ 7,231     $ 5,836     $ 5,220  
 
NOTE 4  
Securities Financing Transactions
Merrill Lynch enters into secured borrowing and lending transactions in order to meet customers’ needs and earn residual interest rate spreads, obtain securities for settlement and finance trading inventory positions.
Under these transactions, Merrill Lynch either receives or provides collateral, including U.S. Government and agencies, asset-backed, corporate debt, equity, and non-U.S. governments and agencies securities. Merrill Lynch receives collateral in connection with resale agreements, securities borrowed transactions, customer margin loans, and other loans. Under many agreements, Merrill Lynch is permitted to sell or repledge the securities received (e.g., use the securities to secure repurchase agreements, enter into securities lending transactions, or deliver to counterparties to cover short positions). At December 30, 2005 and December 31, 2004, the fair value of securities received as collateral where Merrill Lynch is permitted to sell or repledge the securities was $538 billion and $375 billion, respectively, and the fair value of the portion that has been sold or repledged was $403 billion and $300 billion, respectively. Merrill Lynch may use securities received as collateral for resale agreements to satisfy regulatory requirements such as Rule 15c3-3 of the SEC. At December 30, 2005 and December 31, 2004, the fair value of collateral used for this purpose was $15.5 billion, and $12.6 billion, respectively.
Merrill Lynch pledges firm-owned assets to collateralize repurchase agreements and other secured financings. Pledged securities that can be sold or repledged by the secured party are parenthetically disclosed in trading assets and investment securities on the Consolidated Balance Sheets. The carrying value and classification of securities owned by Merrill Lynch that have been pledged to counterparties where those counterparties do not have the right to sell or repledge at year-end 2005 and 2004 are as follows:
                 
(dollars in millions)   2005     2004  
 
Trading asset category
               
Corporate debt and preferred stock
  $ 10,868     $ 11,248  
Mortgages, mortgage-backed, and asset-backed securities
    9,189       10,302  
U.S. Government and agencies
    6,711       9,199  
Equities and convertible debentures
    4,019       3,685  
Non-U.S. Governments and agencies
    3,547       2,031  
Municipals and money markets
    100       1,544  
     
Total
  $ 34,434     $ 38,009  
 
88
Merrill Lynch 2005 Annual Report
 


Table of Contents

NOTE 5  
Investment Securities
Investment securities on the Consolidated Balance Sheets include:
 
SFAS No. 115 investments held by ML & Co. and certain of its non-broker dealer entities, including Merrill Lynch banks and insurance subsidiaries. SFAS No. 115 investments consist of:
   
Debt securities, including debt held for investment and liquidity and collateral management purposes that are classified as available-for-sale, debt securities held for trading purposes, and debt securities that Merrill Lynch intends to hold until maturity;
 
   
Marketable equity securities, which are generally classified as available-for-sale;
 
Non-qualifying investments that do not fall within the scope of SFAS No. 115. Non-qualifying investments consist principally of:
   
Private equity investments, including investments in partnerships and joint ventures. Private equity investments that Merrill Lynch holds for capital appreciation and/or current income are accounted for in accordance with the Investment Company Guide. The investments are initially carried at cost and are adjusted when changes in the underlying fair values are readily ascertainable. Merrill Lynch began applying the Investment Company Guide in the second quarter of 2005, acknowledging the growth in its private equity business. Changes in value associated with private equity investments were not material in prior periods.
 
     
Private equity investments held outside of investment companies, which are held for strategic purposes, are generally accounted for at LOCOM or under the equity method depending on Merrill Lynch’s ability to exercise significant influence.
 
   
Investments of insurance subsidiaries, which primarily represent insurance policy loans and are accounted for at amortized cost.
 
   
Deferred compensation hedges, which are investments economically hedging deferred compensation liabilities and are accounted for at fair value.
 
   
Investments in TOPrSSM partnerships, which are deconsolidated trusts of Merrill Lynch used as part of general purpose funding and are accounted for under the equity method.
Fair value for non-qualifying investments is estimated using a number of methods, including earnings multiples, discounted cash flow analyses, and review of underlying financial conditions and other market factors. These instruments may be subject to restrictions (e.g., sale requires consent of other investors to sell) that may limit Merrill Lynch’s ability to currently realize the estimated fair value. Accordingly, Merrill Lynch’s current estimate of fair value and the ultimate realization for these instruments may differ. The fair value of other non-qualifying investment securities approximated the carrying amounts at year-end 2005 and 2004, respectively.
Investment securities reported on the Consolidated Balance Sheets at December 30, 2005 and December 31, 2004 are as follows:
                 
(dollars in millions)   2005     2004  
 
Investment securities
               
Available-for-sale(1)
  $ 54,471     $ 66,224  
Trading
    5,666       7,736  
Held-to-maturity
    271       278  
Non-qualifying
               
Equity investments
    9,795       7,346  
Investments of insurance subsidiaries
    1,174       1,354  
Deferred compensation hedges
    1,457       1,419  
Investments in TOPrSSM partnerships and other investments
    738       978  
     
Total
  $ 73,572     $ 85,335  
 
(1)  
At December 30, 2005 and December 31, 2004, includes $4.3 billion and $6.9 billion, respectively, of investment securities reported in cash and securities segregated for regulatory purposes or deposited with clearing organizations.
Investment securities accounted for under SFAS No. 115 are classified as available-for-sale, held-to-maturity, or trading as described in Note 1 to the Consolidated Financial Statements.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Information regarding investment securities subject to SFAS No. 115 follows:
                                                                 
    December 30, 2005     December 31, 2004  
  Cost/   Gross   Gross   Estimated   Cost/   Gross   Gross   Estimated  
  Amortized   Unrealized   Unrealized   Fair   Amortized   Unrealized   Unrealized   Fair  
(dollars in millions) Cost   Gains   Losses   Value   Cost   Gains   Losses   Value  
 
Available-for-Sale
                                                               
Mortgage- and asset-backed
  $ 44,726     $ 80     $ (400 )   $ 44,406     $ 52,719     $ 306     $ (209 )   $ 52,816  
Corporate debt
    5,044       15       (37 )     5,022       5,708       61       (17 )     5,752  
U.S. Government and agencies
    2,930       1       (40 )     2,891       4,315       57       (20 )     4,352  
Non-U.S. Governments and agencies
    262       8       (1 )     269       1,088       41       (1 )     1,128  
Other
    158       6       (3 )     161       263       9       (4 )     268  
     
Total debt securities
    53,120       110       (481 )     52,749       64,093       474       (251 )     64,316  
Equity securities
    1,669       63       (10 )     1,722       1,895       20       (7 )     1,908  
     
Total
  $ 54,789     $ 173     $ (491 )   $ 54,471     $ 65,988     $ 494     $ (258 )   $ 66,224  
     
 
                                                               
Held-to-Maturity
                                                               
Municipals
  $ 254     $     $     $ 254     $ 246     $     $     $ 246  
Mortgage- and asset-backed
    17                   17       20                   20  
Corporate debt
                            11                   11  
U.S. Government and agencies
                            1                   1  
     
Total
  $ 271     $     $     $ 271     $ 278     $     $     $ 278  
 
The following table presents fair value and unrealized losses, after hedges, for available-for-sale securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position at December 30, 2005 and December 31, 2004.
                                                 
(dollars in millions)   Less than 1 Year     More than 1 Year     Total  
  Estimated           Estimated           Estimated      
  Fair   Unrealized   Fair   Unrealized   Fair   Unrealized  
Asset category Value   Losses   Value   Losses   Value   Losses  
 
December 30, 2005
                                               
Mortgage- and asset-backed
  $ 20,867     $ (186 )   $ 6,843     $ (158 )   $ 27,710     $ (344 )
U.S. Government and agencies
    2,369       (32 )     228       (3 )     2,597       (35 )
Corporate debt
    3,570       (18 )     519       (17 )     4,089       (35 )
Non-U.S. Governments and agencies
    2             206       (8 )     208       (8 )
Other
    3             133       (3 )     136       (3 )
     
Total debt securities
    26,811       (236 )     7,929       (189 )     34,740       (425 )
Equity securities
    1,278       (7 )     3       (3 )     1,281       (10 )
     
Total temporarily impaired securities
  $ 28,089     $ (243 )   $ 7,932     $ (192 )   $ 36,021     $ (435 )
     
 
                                               
December 31, 2004
                                               
Mortgage- and asset-backed
  $ 23,758     $ (105 )   $ 7,408     $ (109 )   $ 31,166     $ (214 )
U.S. Government and agencies
    2,745       (4 )     1,461       (24 )     4,206       (28 )
Corporate debt
    2,529       (13 )     177       (4 )     2,706       (17 )
Non-U.S. Governments and agencies
    77       (1 )     899       (21 )     976       (22 )
Other
                193       (3 )     193       (3 )
     
Total debt securities
    29,109       (123 )     10,138       (161 )     39,247       (284 )
Equity securities
    9       (2 )     19       (4 )     28       (6 )
     
Total temporarily impaired securities
  $ 29,118     $ (125 )   $ 10,157     $ (165 )   $ 39,275     $ (290 )
 
The majority of the unrealized losses relate to mortgage- and asset-backed securities. The majority of the investments are AAA-rated debentures and mortgage-backed securities issued by U.S. agencies. These investments are not considered other-than-temporarily impaired because Merrill Lynch has the ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investment.
During 2003, other revenues included a write-down of $114 million related to certain available-for-sale securities that were considered to be impaired on an other-than-temporary basis. Unrealized losses on these securities were previously included in accumulated other comprehensive loss. During 2003, the write-down was charged to earnings and removed from accumulated other comprehensive loss.
90
Merrill Lynch 2005 Annual Report
 


Table of Contents

The amortized cost and estimated fair value of debt securities at December 30, 2005 by contractual maturity, for available-for-sale and held-to-maturity investments follow:
                                 
  Available-for-Sale   Held-to-Maturity  
          Estimated           Estimated  
  Amortized   Fair   Amortized   Fair  
(dollars in millions) Cost   Value   Cost   Value  
 
Due in one year or less
  $ 4,013     $ 4,007     $     $  
Due after one year through five years
    3,361       3,309              
Due after five years through ten years
    825       825       254       254  
Due after ten years
    195       202              
     
 
    8,394       8,343       254       254  
Mortgage- and asset-backed securities
    44,726       44,406       17       17  
     
Total(1)
  $  53,120     $  52,749     $  271     $  271  
 
(1)  
Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
The proceeds and gross realized gains (losses) from the sale of available-for-sale investments are as follows:
                         
(dollars in millions)   2005     2004     2003  
 
Proceeds
  $ 36,574     $ 27,983     $ 56,448  
Gross realized gains
    411       389       709  
Gross realized losses
    (71 )     (54 )     (138 )
 
Net unrealized losses from investment securities classified as trading included in the 2005, 2004, and 2003 Consolidated Statements of Earnings were $(13) million, $(275) million, and $(93) million, respectively.
NOTE 6  
Trading Assets and Liabilities
As part of its trading activities, Merrill Lynch provides its clients with brokerage, dealing, financing, and underwriting services for a broad range of products. While trading activities are primarily generated by client order flow, Merrill Lynch also takes proprietary positions based on expectations of future market movements and conditions. Merrill Lynch’s trading strategies rely on the integrated management of its client-driven and proprietary positions, along with related hedging and financing.
Interest revenue and expense are integral components of trading activities. In assessing the profitability of trading activities, Merrill Lynch views net interest and principal transactions revenues in the aggregate.
Trading activities expose Merrill Lynch to market and credit risks. These risks are managed in accordance with established risk management policies and procedures. Specifically, the Global Liquidity and Risk Management Group (“GLRM”), along with other control units, ensures that these risks are properly identified, monitored, and managed throughout Merrill Lynch. To accomplish this, GLRM has established a risk management process that includes:
 
A formal risk governance organization that defines the oversight process and its components;
 
 
A regular review of the risk management process by the Audit Committee of the Board of Directors as part of their oversight role;
 
 
Clearly defined risk management policies and procedures supported by a rigorous analytic framework;
 
 
Close communication and coordination between the business, executive, and risk functions while maintaining strict segregation of responsibilities, controls, and oversight;
 
 
Clearly articulated risk tolerance levels as defined by a group composed of executive management that are regularly reviewed to ensure that Merrill Lynch’s risk-taking is consistent with its business strategy, capital structure, and current and anticipated market conditions.
The risk management process, combined with GLRM’s personnel and analytic infrastructure, works to ensure that Merrill Lynch’s risk tolerance is well-defined and understood by the firm’s risk-takers as well as by its executive management. Other groups, including Corporate Audit, Finance, and the Office of the General Counsel, partner with GLRM to establish this overall risk management control process. While no risk management system can ever be absolutely complete, the goal of GLRM is to make certain that risk-related losses occur within acceptable, predefined levels.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Merrill Lynch documents its risk management objectives and strategies for undertaking various hedge transactions. The risk management objectives and strategies are monitored and managed by GLRM in accordance with established risk management policies and procedures that include risk tolerance levels.
Market Risk
Market risk is the potential change in an instrument’s value caused by fluctuations in interest and currency exchange rates, equity and commodity prices, credit spreads, or other risks. The level of market risk is influenced by the volatility and the liquidity in the markets in which financial instruments are traded.
Merrill Lynch seeks to mitigate market risk associated with trading inventories by employing hedging strategies that correlate rate, price, and spread movements of trading inventories and related financing and hedging activities. Merrill Lynch uses a combination of cash instruments and derivatives to hedge its market exposures. The following discussion describes the types of market risk faced by Merrill Lynch.
Interest Rate Risk
Interest rate risk arises from the possibility that changes in interest rates will affect the value of financial instruments. Interest rate swap agreements, Eurodollar futures, and U.S. Treasury securities and futures are common interest rate risk management tools. The decision to manage interest rate risk using futures or swap contracts, as opposed to buying or selling short U.S. Treasury or other securities, depends on current market conditions and funding considerations.
Interest rate agreements used by Merrill Lynch include caps, collars, floors, basis swaps, leveraged swaps, and options. Interest rate caps and floors provide the purchaser with protection against rising and falling interest rates, respectively. Interest rate collars combine a cap and a floor, providing the purchaser with a predetermined interest rate range. Basis swaps are a type of interest rate swap agreement where variable rates are received and paid, but are based on different index rates. Leveraged swaps are another type of interest rate swap where changes in the variable rate are multiplied by a contractual leverage factor, such as four times three-month London Interbank Offered Rate (“LIBOR”). Merrill Lynch’s exposure to interest rate risk resulting from these leverage factors is typically hedged with other financial instruments.
Currency Risk
Currency risk arises from the possibility that fluctuations in foreign exchange rates will impact the value of financial instruments. Merrill Lynch’s trading assets and liabilities include both cash instruments denominated in and derivatives linked to more than 50 currencies, including the euro, Japanese yen, British pound, and Swiss franc. Currency forwards and options are commonly used to manage currency risk associated with these instruments. Currency swaps may also be used in situations where a long-dated forward market is not available or where the client needs a customized instrument to hedge a foreign currency cash flow stream. Typically, parties to a currency swap initially exchange principal amounts in two currencies, agreeing to exchange interest payments and to re-exchange the currencies at a future date and exchange rate.
Equity Price Risk
Equity price risk arises from the possibility that equity security prices will fluctuate, affecting the value of equity securities and other instruments that derive their value from a particular stock, a defined basket of stocks, or a stock index. Instruments typically used by Merrill Lynch to manage equity price risk include equity options, warrants, and baskets of equity securities. Equity options, for example, can require the writer to purchase or sell a specified stock or to make a cash payment based on changes in the market price of that stock, basket of stocks, or stock index.
Credit Spread Risk
Credit spread risk arises from the possibility that changes in credit spreads will affect the value of financial instruments. Credit spreads represent the credit risk premiums required by market participants for a given credit quality (i.e., the additional yield that a debt instrument issued by a AA-rated entity must produce over a risk-free alternative (e.g., U.S. Treasury instrument)). Certain instruments are used by Merrill Lynch to manage this type of risk. Swaps and options, for example, can be designed to mitigate losses due to changes in credit spreads, as well as the credit downgrade or default of the issuer. Credit risk resulting from default on counterparty obligations is discussed in the Credit Risk section.
Commodity Price and Other Risks
Through its commodities business, Merrill Lynch enters into exchange-traded contracts, financially settled OTC derivatives, contracts for physical delivery and contracts providing for the transportation and/or storage rights on pipelines, power lines or storage facilities. Commodity contracts expose Merrill Lynch to the possibility that the price of the underlying commodity may rise or fall. In addition, contracts resulting in physical delivery can expose Merrill Lynch to numerous other risks, including performance risk and other delivery risks.
92
Merrill Lynch 2005 Annual Report
 


Table of Contents

Credit Risk
Merrill Lynch is exposed to risk of loss if an individual, counterparty or issuer fails to perform its obligations under contractual terms (“default risk”). Both cash instruments and derivatives expose Merrill Lynch to default risk. Credit risk arising from changes in credit spreads was previously discussed in the Market Risk section.
Merrill Lynch has established policies and procedures for mitigating credit risk on principal transactions, including reviewing and establishing limits for credit exposure, maintaining collateral, and continually assessing the creditworthiness of counterparties.
In the normal course of business, Merrill Lynch executes, settles, and finances various customer securities transactions. Execution of these transactions includes the purchase and sale of securities by Merrill Lynch. These activities may expose Merrill Lynch to default risk arising from the potential that customers or counterparties may fail to satisfy their obligations. In these situations, Merrill Lynch may be required to purchase or sell financial instruments at unfavorable market prices to satisfy obligations to other customers or counterparties. Additional information about these obligations is provided in Note 12 to the Consolidated Financial Statements. In addition, Merrill Lynch seeks to control the risks associated with its customer margin activities by requiring customers to maintain collateral in compliance with regulatory and internal guidelines.
Liabilities to other brokers and dealers related to unsettled transactions (i.e., securities failed-to-receive) are recorded at the amount for which the securities were purchased, and are paid upon receipt of the securities from other brokers or dealers. In the case of aged securities failed-to-receive, Merrill Lynch may purchase the underlying security in the market and seek reimbursement for losses from the counterparty.
Concentrations of Credit Risk
Merrill Lynch’s exposure to credit risk (both default and credit spread) associated with its trading and other activities is measured on an individual counterparty basis, as well as by groups of counterparties that share similar attributes. Concentrations of credit risk can be affected by changes in political, industry, or economic factors. To reduce the potential for risk concentration, credit limits are established and monitored in light of changing counterparty and market conditions.
At December 30, 2005, Merrill Lynch’s most significant concentration of credit risk was with the U.S. Government and its agencies. This concentration consists of both direct and indirect exposures. Direct exposure, which primarily results from trading asset and investment security positions in instruments issued by the U.S. Government and its agencies, excluding mortgage-backed securities, amounted to $11.9 billion and $18.3 billion at December 30, 2005 and December 31, 2004, respectively. Merrill Lynch’s indirect exposure results from maintaining U.S. Government and agencies securities as collateral for resale agreements and securities borrowed transactions. Merrill Lynch’s direct credit exposure on these transactions is with the counterparty; thus Merrill Lynch has credit exposure to the U.S. Government and its agencies only in the event of the counterparty’s default. Securities issued by the U.S. Government or its agencies held as collateral for resale agreements and securities borrowed transactions at December 30, 2005 and December 31, 2004 totaled $140.7 billion and $79.3 billion, respectively.
At December 30, 2005, Merrill Lynch had other concentrations of credit risk, the largest of which was related to a U.S.-based investment company carrying a credit rating equivalent internal rating of AAA, which reflects structural seniority and other credit enhancements. Total unsecured exposure to this counterparty was approximately $2.4 billion, or 0.4% of total assets.
Merrill Lynch’s most significant industry credit concentration is with financial institutions. Financial institutions include banks, insurance companies, finance companies, investment managers, and other diversified financial institutions. This concentration arises in the normal course of Merrill Lynch’s brokerage, trading, hedging, financing, and underwriting activities. Merrill Lynch also monitors credit exposures worldwide by region. Outside the United States, financial institutions and sovereign governments represent the most significant concentrations of credit risk.
In the normal course of business, Merrill Lynch purchases, sells, underwrites, and makes markets in non-investment grade instruments. Merrill Lynch also provides extensions of credit and makes equity investments to facilitate leveraged transactions. These activities expose Merrill Lynch to a higher degree of credit risk than is associated with trading, investing in, and underwriting investment grade instruments and extending credit to investment grade counterparties.
Derivatives
Merrill Lynch’s trading derivatives consist of derivatives provided to customers and derivatives entered into for proprietary trading strategies or risk management purposes.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Default risk on derivatives can also occur for the full notional amount of the trade where a final exchange of principal takes place, as may be the case for currency swaps. Default risk exposure varies by type of derivative. Swap agreements and forward contracts are generally OTC-transacted and thus are exposed to default risk to the extent of their replacement cost. Since futures contracts are exchange-traded and usually require daily cash settlement, the related risk of loss is generally limited to a one-day net positive change in market value. Generally such receivables and payables are recorded in customers receivables and payables on the Consolidated Balance Sheets. Option contracts can be exchange-traded or OTC-transacted. Purchased options have default risk to the extent of their replacement cost. Written options represent a potential obligation to counterparties and typically do not subject Merrill Lynch to default risk except under circumstances such as where the option premium is being financed or in cases where Merrill Lynch is required to post collateral. Additional information about derivatives that meet the definition of a guarantee for accounting purposes is included in Note 12 to the Consolidated Financial Statements.
Merrill Lynch generally enters into International Swaps and Derivatives Association, Inc. master agreements or their equivalent (“master netting agreements”) with each of its counterparties, as soon as possible. Master netting agreements provide protection in bankruptcy in certain circumstances and, in some cases, enable receivables and payables with the same counterparty to be offset on the Consolidated Balance Sheets, providing for a more meaningful balance sheet presentation of credit exposure. However, the enforceability of master netting agreements under bankruptcy laws in certain countries, or in certain industries, is not free from doubt and receivables and payables with counterparties in these countries or industries are accordingly recorded on a gross basis.
To reduce the risk of loss, Merrill Lynch requires collateral, principally cash and U.S. Government and agencies securities, on certain derivative transactions. In the second quarter of 2005, Merrill Lynch elected to net cash collateral paid or received under credit support annexes associated with legally enforceable master netting agreements against derivative inventory. Refer to Basis of Presentation in Note 1 to the Consolidated Financial Statements for additional information. From an economic standpoint, Merrill Lynch evaluates default risk exposures net of related collateral. In addition to obtaining collateral, Merrill Lynch attempts to mitigate default risk on derivatives by entering into transactions with provisions that enable Merrill Lynch to terminate or reset the terms of the derivative contract.
Many of Merrill Lynch’s derivative contracts contain provisions that could, upon an adverse change in ML & Co.’s credit rating, trigger a requirement for an early payment or additional collateral support.
NOTE 7  
Securitization Transactions and Transactions with Special Purpose Entities (“SPEs”)
Securitizations
In the normal course of business, Merrill Lynch securitizes: commercial and residential mortgage and home equity loans; municipal, government, and corporate bonds; and other types of financial assets. SPEs, often referred to as Variable Interest Entities, or VIEs, are often used when entering into or facilitating securitization transactions. Merrill Lynch’s involvement with SPEs used to securitize financial assets includes: structuring and/or establishing SPEs; selling assets to SPEs; managing or servicing assets held by SPEs; underwriting, distributing, and making loans to SPEs; making markets in securities issued by SPEs; engaging in derivative transactions with SPEs; owning notes or certificates issued by SPEs; and/or providing liquidity facilities and other guarantees to SPEs.
Merrill Lynch securitized assets of approximately $90.3 billion and $65.1 billion for the years ended December 30, 2005 and December 31, 2004, respectively. For the years ended December 30, 2005 and December 31, 2004, Merrill Lynch received $91.1 billion and $65.9 billion, respectively, of proceeds, and other cash inflows, from securitization transactions, and recognized net securitization gains of $425.4 million and $456.5 million, respectively, in Merrill Lynch’s Consolidated Statements of Earnings.
In 2005 and 2004, cash inflows from securitizations related to the following asset types:
                 
(dollars in millions)   2005     2004  
 
Asset category
               
Residential mortgage loans
  $ 57,958     $ 45,944  
Municipal bonds
    17,085       9,982  
Corporate and government bonds
    2,468       1,486  
Commercial loans and other
    13,569       8,462  
     
 
  $ 91,080     $ 65,874  
 
In certain instances, Merrill Lynch retains interests in the senior tranche, subordinated tranche, and/or residual tranche of securities issued by certain SPEs created to securitize assets. The gain or loss on the sale of the assets is determined with reference to the previous carrying amount of the financial assets transferred, which is allocated between the assets sold and the retained interests, if any, based on their relative fair value at the date of transfer.
94
Merrill Lynch 2005 Annual Report
 


Table of Contents

Retained interests are recorded in the Consolidated Balance Sheets at fair value. To obtain fair values, observable market prices are used if available. Where observable market prices are unavailable, Merrill Lynch generally estimates fair value initially and on an ongoing basis based on the present value of expected future cash flows using management’s best estimates of credit losses, prepayment rates, forward yield curves, and discount rates, commensurate with the risks involved. Retained interests are either held as trading assets, with changes in fair value recorded in the Consolidated Statements of Earnings, or as securities available-for-sale, with changes in fair value included in accumulated other comprehensive loss. Retained interests held as available-for-sale are reviewed periodically for impairment.
Retained interests in securitized assets were approximately $4.0 billion and $2.0 billion at December 30, 2005 and December 31, 2004, respectively, which related primarily to residential mortgage loan and municipal bond securitization transactions. The majority of the retained interest balance consists of mortgage-backed securities that have observable market prices. These retained interests include mortgage-backed securities that Merrill Lynch has committed to purchase and expects to sell to investors in the normal course of its underwriting activity.
The following table presents information on retained interests, excluding the offsetting benefit of financial instruments used to hedge risks, held by Merrill Lynch as of December 30, 2005, arising from Merrill Lynch’s residential mortgage loan, municipal bond and other securitization transactions. The sensitivities of the current fair value of the retained interests to immediate 10% and 20% adverse changes in assumptions and parameters are also shown.
                         
    Residential              
    Mortgage     Municipal        
(dollars in millions)   Loans     Bonds     Other  
 
Retained interest amount
  $ 2,933     $ 800     $ 270  
Weighted average credit losses (rate per annum)
    0.7 %     0.0 %     0.0 %
Range
    0.0–8.0 %     0.0 %     0.0–8.0 %
Impact on fair value of 10% adverse change
  $ (27 )   $     $  
Impact on fair value of 20% adverse change
  $ (52 )   $     $  
Weighted average discount rate
    6.7 %     4.2 %     5.2 %
Range
    0.0–50.0 %     0.1–8.0 %     3.6–23.2 %
Impact on fair value of 10% adverse change
  $ (44 )   $ (67 )   $ (7 )
Impact on fair value of 20% adverse change
  $ (82 )   $ (122 )   $ (13 )
Weighted average life (in years)
    4.3       1.8       4.2  
Range
    0.2–19.3       0.1–3.9       0.0–7.8  
Weighted average prepayment speed (CPR)
    21.9 %     11.3% (1)     8.4 %
Range
    0.0–61.4 %     2.0–23.9% (1)     0.0–15.0 %
Impact on fair value of 10% adverse change
  $ (52 )   $     $ (1 )
Impact on fair value of 20% adverse change
  $ (85 )   $     $ (1 )
 
CPR=Constant Prepayment Rate
(1)  
Relates to select securitization transactions where assets are prepayable.
The preceding sensitivity analysis is hypothetical and should be used with caution. In particular, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Further, changes in fair value based on a 10% or 20% variation in an assumption or parameter generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the sensitivity analysis does not include the offsetting benefit of financial instruments that Merrill Lynch utilizes to hedge risks, including credit, interest rate, and prepayment risk, that are inherent in the retained interests. These hedging strategies are structured to take into consideration the hypothetical stress scenarios above such that they would be effective in principally offsetting Merrill Lynch’s exposure to loss in the event these scenarios occur.
 (MERRILL LYNCH LOGO)
 


Table of Contents

The weighted average assumptions and parameters used initially to value retained interests relating to securitizations that were still held by Merrill Lynch as of December 30, 2005 are as follows:
                         
    Residential              
    Mortgage     Municipal        
    Loans     Bonds     Other  
 
Credit losses (rate per annum)
    0.7 %     0.0 %     0.0 %
Weighted average discount rate
    6.3 %     3.8 %     5.5 %
Weighted average life (in years)
    4.5       2.7       5.3  
Prepayment speed assumption (CPR)
    19.6 %     9.0 %     8.4 %
 
CPR=Constant Prepayment Rate
For residential mortgage loan and other securitizations, the investors and the securitization trust have no recourse to Merrill Lynch’s other assets for failure of mortgage holders to pay when due.
For municipal bond securitization SPEs, in the normal course of dealer market-making activities, Merrill Lynch acts as liquidity provider. Specifically, the holders of beneficial interests issued by municipal bond securitization SPEs have the right to tender their interests for purchase by Merrill Lynch on specified dates at a specified price. Beneficial interests that are tendered are then sold by Merrill Lynch to investors through a best efforts remarketing where Merrill Lynch is the remarketing agent. If the beneficial interests are not successfully remarketed, the holders of beneficial interests are paid from funds drawn under a standby liquidity letter of credit issued by Merrill Lynch.
In addition to standby letters of credit, in certain municipal bond securitizations, Merrill Lynch also provides default protection or credit enhancement to investors in securities issued by certain municipal bond securitization SPEs. Interest and principal payments on beneficial interests issued by these SPEs are secured by a guarantee issued by Merrill Lynch. In the event that the issuer of the underlying municipal bond defaults on any payment of principal and/or interest when due, the payments on the bonds will be made to beneficial interest holders from an irrevocable guarantee by Merrill Lynch.
The maximum payout under these liquidity and default guarantees totaled $29.9 billion and $21.3 billion at December 30, 2005 and December 31, 2004, respectively. The fair value of the guarantee approximated $14 million and $74 million at December 30, 2005 and December 31, 2004, respectively, which is reflected in the Consolidated Balance Sheets. Of these arrangements, $6.9 billion and $4.7 billion at December 30, 2005 and December 31, 2004, respectively, represent agreements where the guarantee is provided to the SPE by a third-party financial intermediary and Merrill Lynch enters into a reimbursement agreement with the financial intermediary. In these arrangements, if the financial intermediary incurs losses, Merrill Lynch has up to one year to fund those losses. Additional information regarding these commitments is provided in Note 12 to the Consolidated Financial Statements.
The following table summarizes principal amounts outstanding and delinquencies of securitized financial assets as of December 30, 2005 and December 31, 2004, and net credit losses for the years then ended:
                         
  Residential              
  Mortgage   Municipal      
(dollars in millions) Loans   Bonds   Other  
 
December 30, 2005
                       
Principal Amount Outstanding
  $  82,468     $  19,745     $  10,416  
Delinquencies
    39              
Net Credit Losses
    4             6  
 
                       
December 31, 2004
                       
Principal Amount Outstanding
  $ 31,541     $ 14,510     $ 3,866  
Delinquencies
    40              
Net Credit Losses
    2             9  
 
96
Merrill Lynch 2005 Annual Report
 


Table of Contents

Variable Interest Entities
In January 2003, the FASB issued FIN 46, which provides additional guidance on the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, for enterprises that have interests in entities that meet the definition of a VIE, and on December 24, 2003, the FASB issued FIN 46R. FIN 46R requires that an entity shall consolidate a VIE if that enterprise has a variable interest that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both.
QSPEs are a type of VIE that holds financial instruments and distributes cash flows to investors based on preset terms. QSPEs are commonly used in mortgage and other securitization transactions. In accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and FIN 46R, Consolidation of Variable Interest Entities, Merrill Lynch does not consolidate QSPEs. Information regarding QSPEs can be found in the Securitization section of this Note and the Guarantees section of Note 12 to the Consolidated Financial Statements.
For the purpose of determining whether Merrill Lynch has a variable interest in a VIE, Merrill Lynch generally employs a cash flow approach. Under a cash flow approach, the determination as to whether an interest is a variable interest is based on whether the interest absorbs variability in the cash flows of the VIE.
Merrill Lynch has entered into transactions with a number of VIEs in which it is the primary beneficiary and therefore must consolidate the VIE; or is a significant variable interest holder in the VIE. These VIEs are as follows:
 
Merrill Lynch has made loans to, and/or investments in, VIEs that hold loan receivable assets and real estate, and as a result of these loans and investments, Merrill Lynch may be either the primary beneficiary of and consolidate the VIE, or may be a significant variable interest holder. These VIEs are primarily designed to provide on- or off-balance sheet financing to clients and/or to invest in real estate. Assets held by VIEs where Merrill Lynch has provided financing and is the primary beneficiary are recorded in other assets and/or loans, notes, and mortgages in the Consolidated Balance Sheets. Assets held by VIEs where Merrill Lynch has invested in real estate partnerships and is the primary beneficiary are included in other assets. The beneficial interest holders in these VIEs have no recourse to the general credit of Merrill Lynch; their investments are paid exclusively from the assets in the VIE.
 
 
Merrill Lynch has entered into transactions with VIEs that are used, in part, to provide tax planning strategies to investors and/or Merrill Lynch through an enhanced yield investment security. These structures typically provide financing to Merrill Lynch and/or the investor at enhanced rates. Merrill Lynch may be either the primary beneficiary of and consolidate the VIE, or may be a significant variable interest holder in the VIE. Where Merrill Lynch is the primary beneficiary, the assets held by the VIEs are primarily included in either trading or investments.
 
   
     In 2004, Merrill Lynch entered into a transaction with an international financial institution involving VIEs that provided to Merrill Lynch a $6.25 billion secured credit facility and $500 million unsecured financing. These VIEs are also used as part of Merrill Lynch’s overall tax-planning strategies and enable Merrill Lynch to borrow at more favorable rates. Merrill Lynch consolidates the VIEs as it is deemed to be the primary beneficiary of these VIEs.
 
Merrill Lynch is the sponsor, guarantor, derivative counterparty, or liquidity and credit facility provider to certain mutual funds, investment entities, and conduits. Some of these funds provide a guaranteed return to investors at the maturity of the VIE. This guarantee may include a guarantee of the return of an initial investment or of the initial investment plus an agreed upon return depending on the terms of the VIE. Investors in certain of these VIEs have recourse to Merrill Lynch to the extent that the value of the assets held by the VIEs at maturity is less than the guaranteed amount. In some instances, Merrill Lynch is the primary beneficiary and must consolidate the fund. Assets held in these VIEs are primarily classified in trading. In instances where Merrill Lynch is not the primary beneficiary, the guarantees related to these funds are further discussed in Note 12 to the Consolidated Financial Statements.
 
   
     In addition, in 2005 Merrill Lynch established an asset-backed commercial paper conduit (“Conduit”) and holds a significant variable interest in the Conduit in the form of 1) a liquidity facility that protects commercial paper holders against short term changes in the fair value of the assets held by the Conduit, and 2) a credit facility to the Conduit that protects commercial paper investors against credit losses for up to 2% of the portfolio of assets held by the Conduit. The liquidity facility and credit facility is further discussed in Note 12 to the Consolidated Financial Statements.
 
In 2004, Merrill Lynch entered into a transaction with a VIE whereby Merrill Lynch arranged for additional protection for directors and employees to indemnify them against certain losses they may incur as a result of claims against them. Merrill Lynch is the primary beneficiary and consolidates the VIE because its employees benefit from the indemnification arrangement. As of December 30, 2005 and December 31, 2004 the assets of the VIE totaled approximately $16 million, representing the fair value of a purchased credit default agreement, which is recorded in other assets on the Consolidated Balance Sheets. In the event of a Merrill Lynch insolvency, proceeds of $140 million will be received by the VIE to fund any claims. Neither Merrill Lynch nor its creditors have any recourse to the assets of the VIE.
 (MERRILL LYNCH LOGO)
 


Table of Contents

Other Involvement with VIEs
Merrill Lynch is involved with other VIEs in which it is neither the primary beneficiary or a significant variable interest holder; rather, its involvement relates to a significant program sponsored by Merrill Lynch. Significant programs sponsored by Merrill Lynch, which are disclosed in the table below, include the following:
 
Merrill Lynch has entered into transactions with VIEs where Merrill Lynch typically purchases credit protection from the VIE in the form of a derivative in order to synthetically expose investors to a specific credit risk. These are commonly known as credit-linked note VIEs.
 
 
Merrill Lynch has entered into transactions with VIEs in which Merrill Lynch transfers convertible bonds to the VIE and retains a call option on the underlying bonds. The purpose of these VIEs is to market convertible bonds to a broad investor base by separating the bonds into callable debt and a conversion call option.
The following tables summarize Merrill Lynch’s involvement with the VIEs listed above as of December 30, 2005 and December 31, 2004, respectively. The table below does not include information on QSPEs. For more information on these entities (e.g. municipal bond securitizations), see the Securitizations section of this note and the Guarantees section in Note 12 to the Consolidated Financial Statements.
Where an entity is a significant variable interest holder, FIN 46R requires that entity to disclose its maximum exposure to loss as a result of its interest in the VIE. It should be noted that this measure does not reflect Merrill Lynch’s estimate of the actual losses that could result from adverse changes because it does not reflect the economic hedges Merrill Lynch enters into to reduce its exposure.
                                                         
(dollars in millions)   Primary     Significant Variable     Other Involvement  
    Beneficiary     Interest Holder     with VIEs  
    Total     Net   Recourse     Total             Total        
    Asset     Asset   to Merrill     Asset   Maximum     Asset   Maximum  
Description   Size(4)     Size(5)   Lynch(6)     Size(4)   Exposure     Size(4)   Exposure  
 
December 30, 2005
                                                       
Loan and Real Estate VIEs
  $ 5,144     $ 5,140     $     $ 116     $ 63     $     $  
Tax Planning VIEs(1)(2)
    29,617       8,365        5,823       5,416        2,297              
Guaranteed and Other Funds
    1,802       1,349       464       2,981       2,973              
Credit-Linked Note and Other
VIEs(3)
    130       30                         8,835        780  
     
December 31, 2004
                                                       
Loan and Real Estate VIEs
  $ 3,550     $ 3,550     $     $ 330     $ 227     $     $  
Tax Planning VIEs(1)(2)
    25,037       7,847       5,105       7,061       2,328              
Guaranteed and Other Funds
    1,254       1,054       245                          
Credit-Linked Note and Other
VIEs(3)
    16       16                         9,061       536  
 
(1)  
Recourse to Merrill Lynch associated with Tax Planning VIEs primarily relates to transactions where the investors in the debt issued by the VIEs have recourse to both the assets of the VIEs and to Merrill Lynch, as well as certain indemnifications made by Merrill Lynch to the investors in the VIEs.
(2)  
The maximum exposure for Tax Planning VIEs reflects the fair value of investments