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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
     
(Mark One)    
X
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 28, 2007
OR
     
  
  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)
 
(212) 449-1000
Registrant’s telephone number, including area code:
 
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.
 
X     YES          NO
 
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  X Accelerated Filer     Non-Accelerated Filer    
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
      YES      X    NO
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
853,434,567 shares of Common Stock and 2,596,282 Exchangeable Shares as of the close of business on October 31, 2007. 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.


 

 
MERRILL LYNCH & CO., INC. QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 28, 2007
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 EX-12: STATEMENT RE: COMPUTATION OF RATIOS
 EX-15: LETTER OF AWARENESS
 EX-31.1: CERTIFICATION
 EX-31.2: CERTIFICATION
 EX-32.1: CERTIFICATION
 EX-32.2: CERTIFICATION
 EX-99.1: RECONCILIATION OF NON-GAAP MEASURES


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Available Information
 
We file 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 we file electronically with the SEC. The SEC’s internet site is www.sec.gov.
 
Our internet address is www.ml.com, and the investor relations section of our website can be accessed directly at www.ir.ml.com. We make 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. We have also posted on our website corporate governance materials including our Guidelines for Business Conduct, Code of Ethics for Financial Professionals, Director Independence Standards, Corporate Governance Guidelines, Related Party Transactions Policy 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 for Financial Professionals and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange. You can 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. The information on websites referenced herein is not incorporated by reference into this Report.


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PART I. FINANCIAL INFORMATION
 
ITEM 1. Financial Statements
 
Merrill Lynch & Co., Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings (Unaudited)
 
                 
    For the Three Months Ended
    Sept. 28,
  Sept. 29,
(in millions, except per share amounts)   2007   2006
 
Net revenues
               
Principal transactions
  $ (5,930 )   $ 1,673  
Commissions
    1,860       1,345  
Investment banking
    1,281       922  
Managed accounts and other fee-based revenues
    1,397       1,714  
Revenues from consolidated investments
    508       210  
Other
    (918 )     773  
                 
Subtotal
    (1,802 )     6,637  
                 
Interest and dividend revenues
    15,787       10,651  
Less interest expense
    13,408       9,424  
                 
Net interest profit
    2,379       1,227  
                 
Gain on merger
    -       1,969  
Total net revenues
    577       9,833  
                 
Non-interest expenses
               
Compensation and benefits
    1,992       3,942  
Communications and technology
    499       484  
Brokerage, clearing, and exchange fees
    365       278  
Occupancy and related depreciation
    297       259  
Professional fees
    243       223  
Advertising and market development
    182       163  
Expenses of consolidated investments
    68       142  
Office supplies and postage
    55       53  
Other
    341       199  
                 
Total Non-Interest Expenses
    4,042       5,743  
                 
(Loss)/earnings from continuing operations before income taxes
    (3,465 )     4,090  
Income tax (benefit)/expense
    (1,199 )     1,071  
                 
Net (loss)/earnings from continuing operations
    (2,266 )     3,019  
                 
Discontinued operations:
               
Earnings from discontinued operations
    38       38  
Income tax expense
    13       12  
                 
Net earnings from discontinued operations
    25       26  
                 
Net (loss)/earnings
  $ (2,241 )   $ 3,045  
Preferred stock dividends
    73       50  
                 
Net (loss)/earnings applicable to common stockholders
  $ (2,314 )   $ 2,995  
                 
Basic (loss)/earnings per common share from continuing operations
  $ (2.85 )   $ 3.47  
Basic earnings per common share from discontinued operations
    0.03       0.03  
                 
Basic (loss)/earnings per common share
  $ (2.82 )   $ 3.50  
                 
Diluted (loss)/earnings per common share from continuing operations
  $ (2.85 )   $ 3.14  
Diluted earnings per common share from discontinued operations
    0.03       0.03  
                 
Diluted (loss)/earnings per common share
  $ (2.82 )   $ 3.17  
                 
Dividend paid per common share
  $ 0.35     $ 0.25  
                 
Average shares used in computing earnings per common share
               
Basic
    821.6       855.8  
                 
Diluted
    821.6       945.3  
                 
 
 See Notes to Condensed Consolidated Financial Statements.


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Merrill Lynch & Co., Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings (Unaudited)
 
                 
    For the Nine Months
    Ended
    Sept. 28,
  Sept. 29,
(In millions, except per share amounts)   2007   2006
 
Net revenues
               
Principal transactions
  $ 351     $ 4,841  
Commissions
    5,360       4,462  
Investment banking
    4,333       3,166  
Managed accounts and other fee-based revenues
    4,038       5,047  
Revenues from consolidated investments
    772       500  
Other
    880       2,436  
                 
Subtotal
    15,734       20,452  
                 
Interest and dividend revenues
    43,346       28,928  
Less interest expense
    39,055       25,500  
                 
Net interest profit
    4,291       3,428  
                 
Gain on merger
    -       1,969  
                 
Total Net Revenues
    20,025       25,849  
                 
Non-Interest Expenses
               
Compensation and benefits
    11,640       13,662  
Communications and technology
    1,462       1,365  
Brokerage, clearing, and exchange fees
    1,021       803  
Occupancy and related depreciation
    838       749  
Professional fees
    711       617  
Advertising and market development
    540       498  
Expenses of consolidated investments
    170       334  
Office supplies and postage
    170       167  
Other
    910       687  
                 
Total Non-Interest Expenses
    17,462       18,882  
                 
Earnings from continuing operations before income taxes
    2,563       6,967  
Income tax expense
    592       1,883  
                 
Net earnings from continuing operations
    1,971       5,084  
                 
Discontinued operations:
               
Earnings from discontinued operations
    128       103  
Income tax expense
    43       34  
                 
Net earnings from discontinued operations
    85       69  
                 
Net Earnings
  $ 2,056     $ 5,153  
Preferred Stock Dividends
    197       138  
                 
Net Earnings Applicable to Common Stockholders
  $ 1,859     $ 5,015  
                 
Basic earnings per common share from continuing operations
  $ 2.13     $ 5.65  
Basic earnings per common share from discontinued operations
    0.10       0.08  
                 
Basic earnings per common share
  $ 2.23     $ 5.73  
                 
Diluted earnings per common share from continuing operations
  $ 1.94     $ 5.12  
Diluted earnings per common share from discontinued operations
    0.09       0.07  
                 
Diluted earnings per common share
  $ 2.03     $ 5.19  
                 
Dividend paid per common share
  $ 1.05     $ 0.75  
                 
Average Shares Used in Computing Earnings Per Common Share
               
Basic
    832.2       875.0  
                 
Diluted
    916.3       966.6  
                 
 
 See Notes to Condensed Consolidated Financial Statements.


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Merrill Lynch & Co., Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)
 
                 
    Sept. 28,
  Dec. 29,
(dollars in millions)   2007   2006
 
ASSETS
               
                 
Cash and cash equivalents
  $ 46,850     $ 32,109  
                 
Cash and securities segregated for regulatory purposes or deposited with clearing organizations
    20,032       13,449  
                 
Securities financing transactions
               
Receivables under resale agreements (includes $110,472 measured at fair value in 2007 in accordance with SFAS No. 159)
    219,849       178,368  
Receivables under securities borrowed transactions
    172,479       118,610  
                 
      392,328       296,978  
                 
Trading assets, at fair value (includes securities pledged as collateral that can be sold or repledged of $73,788 in 2007 and $58,966 in 2006)
               
Equities and convertible debentures
    66,290       48,527  
Mortgages, mortgage-backed, and asset-backed
    56,342       44,401  
Contractual agreements
    53,307       32,100  
Corporate debt and preferred stock
    40,499       32,854  
Non-U.S. governments and agencies
    18,033       21,075  
U.S. Government and agencies
    13,647       13,086  
Municipals and money markets
    6,443       7,243  
Commodities and related contracts
    4,552       4,562  
                 
      259,113       203,848  
                 
Investment securities (includes $3,534 measured at fair value in 2007 in accordance with SFAS No. 159)
    92,790       83,410  
                 
Securities received as collateral
    45,785       24,929  
                 
Other receivables
               
Customers (net of allowance for doubtful accounts of $40 in 2007 and $41 in 2006)
    61,400       49,427  
Brokers and dealers
    26,473       18,900  
Interest and other
    29,914       21,054  
                 
      117,787       89,381  
                 
Loans, notes, and mortgages (net of allowances for loan losses of $588 in 2007 and $478 in 2006) (includes $987 measured at fair value in 2007 in accordance with SFAS No. 159)
    94,185       73,029  
                 
Separate accounts assets
    12,590       12,314  
                 
Equipment and facilities (net of accumulated depreciation and amortization of $5,380 in 2007 and $5,213 in 2006)
    2,956       2,924  
                 
Goodwill and other intangible assets
    4,891       2,457  
                 
Other assets
    7,881       6,471  
                 
                 
Total Assets
  $ 1,097,188     $ 841,299  
                 


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Merrill Lynch & Co., Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)
 
                 
    Sept. 28,
  Dec. 29,
(dollars in millions, except per share amount)   2007   2006
 
LIABILITIES
               
                 
Securities financing transactions
               
Payables under repurchase agreements (includes $117,536 measured at fair value in 2007 in accordance with SFAS No. 159)
  $ 298,585     $ 222,624  
Payables under securities loaned transactions
    46,961       43,492  
                 
      345,546       266,116  
                 
Short-term borrowings
    27,078       18,110  
                 
Deposits
    94,977       84,124  
                 
Trading liabilities, at fair value
               
Contractual agreements
    61,674       38,434  
Equities and convertible debentures
    31,505       23,268  
Non-U.S. governments and agencies
    13,677       13,385  
U.S. Government and agencies
    9,815       12,510  
Corporate debt and preferred stock
    6,973       6,323  
Commodities and related contracts
    2,447       3,606  
Municipals, money markets and other
    716       1,336  
                 
      126,807       98,862  
                 
Obligation to return securities received as collateral
    45,785       24,929  
                 
Other payables
               
Customers
    62,942       49,414  
Brokers and dealers
    25,130       24,282  
Interest and other
    45,018       36,096  
                 
      133,090       109,792  
                 
Liabilities of insurance subsidiaries
    2,655       2,801  
                 
Separate accounts liabilities
    12,590       12,314  
                 
Long-term borrowings (includes $70,129 measured at fair value in 2007 in accordance with SFAS No. 159)
    264,880       181,400  
                 
Junior subordinated notes (related to trust preferred securities)
    5,154       3,813  
                 
                 
Total Liabilities
    1,058,562       802,261  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
STOCKHOLDERS’ EQUITY
               
                 
Preferred Stockholders’ Equity (liquidation preference of $30,000 per share; issued:
               
2007 - 155,000 shares; 2006 — 105,000 shares; liquidation preference of $1,000 per share; issued: 2007 - 115,000 shares)
    4,754       3,145  
Common Stockholders’ Equity
               
Shares exchangeable into common stock
    39       39  
Common stock (par value $1.331/3 per share; authorized: 3,000,000,000 shares; issued: 2007 - 1,269,200,520 shares; 2006 - 1,215,381,006 shares)
    1,691       1,620  
Paid-in capital
    22,809       18,919  
Accumulated other comprehensive loss (net of tax)
    (1,330 )     (784 )
Retained earnings
    33,949       33,217  
                 
      57,158       53,011  
Less: Treasury stock, at cost (2007 - 416,941,969 shares; 2006 - 350,697,271 shares)
    23,286       17,118  
                 
Total Common Stockholders’ Equity
    33,872       35,893  
                 
                 
Total Stockholders’ Equity
    38,626       39,038  
                 
                 
Total Liabilities and Stockholders’ Equity
  $ 1,097,188     $ 841,299  
                 
 
 See Notes to Condensed Consolidated Financial Statements.


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Merrill Lynch & Co., Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
 
                 
    For the Nine Months Ended
    Sept. 28,
  Sept. 29,
(dollars in millions)   2007   2006
 
Cash flows from operating activities:
               
Net earnings
  $ 2,056     $ 5,153  
Non-cash items included in earnings:
               
Gain on merger
    -       (1,969 )
Valuation adjustments for U.S. sub-prime residential mortgage-related and ABS CDO activities
    7,882       -  
Depreciation and amortization
    633       378  
Share-based compensation expense
    1,220       2,828  
Deferred taxes
    (1,380 )     (569 )
Policyholder reserves
    8       92  
Undistributed earnings from equity investments
    (814 )     (304 )
Other
    374       612  
Changes in operating assets and liabilities:
               
Trading assets
    (62,331 )     (35,461 )
Cash and securities segregated for regulatory purposes
               
or deposited with clearing organizations
    (6,500 )     (1,952 )
Receivables under resale agreements
    (41,479 )     (26,871 )
Receivables under securities borrowed transactions
    (53,869 )     (12,979 )
Customer receivables
    (11,977 )     (3,795 )
Brokers and dealers receivables
    (7,574 )     (1,210 )
Proceeds from loans, notes, and mortgages held for sale
    57,797       28,152  
Other changes in loans, notes, and mortgages held for sale
    (71,534 )     (33,882 )
Trading liabilities
    5,096       2,954  
Payables under repurchase agreements
    75,961       37,915  
Payables under securities loaned transactions
    3,469       (1,255 )
Customer payables
    13,495       8,846  
Brokers and dealers payables
    744       13,577  
Other, net
    8,838       4,593  
                 
Cash used for operating activities
    (79,885 )     (15,147 )
                 
Cash flows from investing activities:
               
Proceeds from (payments for):
               
Maturities of available-for-sale securities
    10,511       9,908  
Sales of available-for-sale securities
    25,830       13,413  
Purchases of available-for-sale securities
    (43,633 )     (22,381 )
Maturities of held-to-maturity securities
    2       2  
Purchases of held-to-maturity securities
    (2 )     (3 )
Loans, notes, and mortgages held for investment
    4,830       682  
Acquisitions, net of cash
    (1,826 )     (604 )
Other investments
    (6,711 )     (1,196 )
Transfer of cash balances related to merger
    -       (651 )
Equipment and facilities, net
    (364 )     (734 )
                 
Cash used for investing activities
    (11,363 )     (1,564 )
                 
Cash flows from financing activities:
               
Proceeds from (payments for):
               
Commercial paper and short-term borrowings
    8,480       5,356  
Issuance and resale of long-term borrowings
    137,235       53,265  
Settlement and repurchases of long-term borrowings
    (60,620 )     (27,556 )
Deposits
    874       (2,114 )
Derivative financing transactions
    22,849       8,219  
Issuance of common stock
    760       1,148  
Issuance of preferred stock, net
    1,494       360  
Common stock repurchases
    (5,272 )     (6,321 )
Other common stock transactions
    670       585  
Excess tax benefits related to share-based compensation
    643       386  
Dividends
    (1,124 )     (835 )
                 
Cash provided by financing activities
    105,989       32,493  
                 
Increase in cash and cash equivalents
    14,741       15,782  
Cash and cash equivalents, beginning of period
    32,109       14,586  
                 
Cash and cash equivalents, end of period
  $ 46,850     $ 30,368  
                 
Supplemental Disclosure of Cash Flow Information:
               
Cash paid for:
               
Income taxes
  $ 1,391     $ 2,134  
Interest
    38,078       24,976  
Non-cash investing and financing activities:
The investment recorded in connection with the merger of the MLIM business with BlackRock in September 2006 totaled $7.7 billion.
The book value of net asset transfers, derecognition of goodwill and other adjustments totaled $4.9 billion.
Issuances of Common Stock and Preferred Stock of approximately $865 million and $115 million, respectively, related to the First Republic Bank acquisition in September 2007.


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Merrill Lynch & Co., Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
September 28, 2007
 
Note 1.  Summary of Significant Accounting Policies
 
For a complete discussion of Merrill Lynch’s accounting policies, refer to the Annual Report on Form 10-K for the year ended December 29, 2006 (“2006 Annual Report”).
 
Basis of Presentation
 
The Condensed Consolidated Financial Statements include the accounts of Merrill Lynch & Co., Inc. (“ML & Co.”) and subsidiaries (collectively, “Merrill Lynch”). The Condensed Consolidated Financial Statements are presented in accordance with U.S. Generally Accepted Accounting Principles, which include industry practices. Intercompany transactions and balances have been eliminated. The interim Condensed Consolidated Financial Statements for the three- and nine-month periods are unaudited; however, in the opinion of Merrill Lynch management, all adjustments (consisting of normal recurring accruals) necessary for a fair statement of the Condensed Consolidated Financial Statements have been included.
 
These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements included in the 2006 Annual Report. The nature of Merrill Lynch’s business is such that the results of any interim period are not necessarily indicative of results for a full year. In presenting the Condensed Consolidated Financial Statements, management makes estimates that affect the reported amounts and disclosures 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 Condensed Consolidated Financial Statements, and it is possible that such changes could occur in the near term. Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation.
 
Merrill Lynch offers a broad array of products and services to its diverse client base of individuals, small to mid-size businesses, employee benefit plans, corporations, financial institutions, and governments around the world. These products and services are offered from a number of locations globally. In some cases, the same or similar products and services may be offered to both individual and institutional clients, utilizing the same infrastructure. In other cases, a single infrastructure may be used to support multiple products and services offered to clients. When Merrill Lynch analyzes its profitability, it does not focus on the profitability of a single product or service. Instead, Merrill Lynch looks at the profitability of businesses offering an array of products and services to various types of clients. The profitability of the products and services offered to individuals, small to mid-size businesses, and employee benefit plans is analyzed separately from the profitability of products and services offered to corporations, financial institutions, and governments, regardless of whether there is commonality in products and services infrastructure. As such, Merrill Lynch does not separately disclose the costs associated with the products and services sold or general and administrative costs either in total or by product.
 
When determining the prices for products and services, Merrill Lynch considers multiple factors, including prices being offered in the market for similar products and services, the competitiveness of its pricing compared to competitors, the profitability of its businesses and its overall profitability, as well as the profitability, creditworthiness, and importance of the overall client relationships.


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Shared expenses that are incurred to support products and services and infrastructures are allocated to the businesses based on various methodologies, which may include headcount, square footage, and certain other criteria. Similarly, certain revenues may be shared based upon agreed methodologies. When looking at the profitability of various businesses, Merrill Lynch considers all expenses incurred, including overhead and the costs of shared services, as all are considered integral to the operation of the businesses.
 
Discontinued Operations
 
On August 13, 2007, Merrill Lynch announced that it had agreed to sell Merrill Lynch Life Insurance Company and ML Life Insurance Company of New York (together “Merrill Lynch Insurance Group” or “MLIG”). Consequently, the financial results of MLIG are reported as discontinued operations for all periods presented. The results of MLIG were formerly reported in the Global Wealth Management business segment. Refer to Note 17 to the Condensed Consolidated Financial Statements for additional information.
 
Consolidation Accounting Policies
 
The Condensed Consolidated Financial Statements include the accounts of Merrill Lynch, whose subsidiaries are generally controlled through a majority voting interest. In certain cases, Merrill Lynch subsidiaries may also be consolidated based on a risks and rewards approach. Merrill Lynch does not consolidate those special purpose entities that meet the criteria of a qualified special purpose entity (“QSPE”).
 
Merrill Lynch determines whether it is required to consolidate an entity by first evaluating whether the entity qualifies as a voting rights entity (“VRE”), a variable interest entity (“VIE”), or a QSPE.
 
VREs — In accordance with the guidance in Financial Accounting Standards Board (“FASB”) Interpretation No. 46, Consolidation of Variable Interest Entities — an interpretation of ARB No. 51 (“FIN 46R”), VREs are defined to include entities that have both equity at risk that is sufficient to fund future operations and have equity investors with decision making ability that absorb the majority of the expected losses and expected returns of the entity. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 94, Consolidation of All Majority-Owned Subsidiaries (“SFAS No. 94”), Merrill Lynch generally consolidates those VREs where it holds a controlling financial interest. For investments in limited partnerships and certain limited liability corporations that Merrill Lynch does not control, Merrill Lynch applies Emerging Issues Task Force (“EITF”) Topic D-46, Accounting for Limited Partnership Investments, which requires use of the equity method of accounting for investors that have more than a minor influence, which is typically defined as an investment of greater than 3% of the outstanding equity in the entity. For more traditional corporate structures, in accordance with Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, Merrill Lynch applies the equity method of accounting where it has significant influence over the investee. Significant influence can be evidenced by a significant ownership interest (which is generally defined as voting interest of 20% to 50%), significant board of director representation, or other contracts and arrangements.
 
VIEs — Those entities that do not meet the VRE criteria as defined in FIN 46R are generally analyzed for consolidation as either VIEs or QSPEs. Merrill Lynch consolidates those VIEs in which it absorbs the majority of the variability in expected losses and/or the variability in expected returns of the entity as required by FIN 46R. Merrill Lynch relies on a quantitative and/or qualitative analysis, including an analysis of the design of the entity, to determine if it is the primary beneficiary of the VIE and


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therefore must consolidate the entity. Merrill Lynch reassesses whether it is the primary beneficiary of a VIE upon the occurrence of a reconsideration event.
 
QSPEs — QSPEs are passive entities with significantly limited permitted activities. QSPEs are generally used as securitization vehicles and are limited in the type of assets they may hold, the derivatives that they can enter into and the level of discretion they may exercise through servicing activities. In accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (“SFAS No. 140”), and FIN 46R, Merrill Lynch does not consolidate QSPEs.
 
Revenue Recognition
 
Principal transactions revenues include both realized and unrealized gains and losses on trading assets, trading liabilities and investment securities classified as trading investments. Gains and losses are recognized on a trade date basis.
 
Commissions revenues include commissions, mutual fund distribution fees and contingent deferred sales charge revenue, which are all accrued as earned. Commissions revenues also include 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.
 
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. Underwriting revenues are presented net of transaction-related expenses. Transaction-related expenses are deferred to match revenue recognition.
 
Managed accounts and other fee-based revenues primarily consist of asset-priced portfolio service fees earned from the administration of separately managed accounts and other investment accounts for retail investors, annual account fees, and certain other account-related fees. In addition, until the merger of our Merrill Lynch Investment Management (“MLIM”) business with BlackRock, Inc. (“BlackRock”) at the end of the third quarter of 2006 (“BlackRock merger”), managed accounts and other fee-based revenues also included fees earned from the management and administration of retail mutual funds and institutional funds such as pension assets, and performance fees earned on certain separately managed accounts and institutional money management arrangements. For additional information regarding the BlackRock merger, refer to Note 2 of the 2006 Annual Report.
 
Revenues from consolidated investments and expenses of consolidated investments are related to special purpose entities that are consolidated under SFAS No. 94 and FIN 46R.
 
Other revenues include gains/(losses) on investment securities, including unrealized losses on certain available-for-sale securities, dividends on cost method investments, income from equity method investments, gains/(losses) on private equity investments that are held for capital appreciation and/or current income, gains/(losses) on loans and other miscellaneous items.
 
Contractual interest and dividends received and paid on trading assets and trading liabilities, excluding derivatives, are recognized on an accrual basis as a component of interest and dividend revenues and interest expense. Interest and dividends on investment securities are recognized on an accrual basis as a component of interest and dividend revenues. Interest related to loans, notes, and mortgages, securities financing activities and certain short- and long-term borrowings are recorded on an accrual basis with related interest recorded as interest revenue or interest expense, as applicable. Contractual interest expense on structured notes is recorded as a component of interest expense.


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Financial Instruments
 
Merrill Lynch accounts for a significant portion of its financial instruments at fair value or considers fair value in their measurement. Merrill Lynch accounts for certain financial assets and liabilities at fair value under various accounting literature, including SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS No. 115”), SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), and SFAS No. 159, Fair Value Option for Certain Financial Assets and Liabilities (“SFAS No. 159”). Merrill Lynch also accounts for certain assets at fair value under applicable industry guidance, namely broker-dealer and investment company accounting guidance.
 
Merrill Lynch early adopted the provisions of SFAS No. 157, Fair Value Measurements (“SFAS No. 157”) in the first quarter of 2007. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements. SFAS No. 157 nullifies the guidance provided by EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF 02-3”), which prohibited recognition of day one gains or losses on derivative transactions where model inputs that significantly impact valuation are not observable.
 
Merrill Lynch also early adopted SFAS No. 159 in the first quarter of 2007 for certain financial instruments. Such instruments include certain structured debt, repurchase and resale agreements, loans, available-for-sale securities and non-qualifying investments. The changes in fair value of these instruments are recorded in either principal transactions revenues or other revenues in the Condensed Consolidated Statement of Earnings. See Note 3 to the Condensed Consolidated Financial Statements for further information.
 
In presenting the Condensed Consolidated Financial Statements, management makes estimates regarding valuations of assets and liabilities requiring fair value measurements. These assets and liabilities include:
 
  •  Trading inventory and investment securities;
  •  Private equity and principal investments;
  •  Certain receivables under resale agreements and payables under repurchase agreements;
  •  Loans and allowance for loan losses and liabilities recorded for unrealized losses on unfunded commitments; and
  •  Certain long-term borrowings, primarily structured debt.
 
A discussion of certain areas in which estimates are a significant component of the amounts reported in the Condensed Consolidated Financial Statements follows:
 
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 a variety of inputs including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of such inputs), or management’s estimates of amounts to be realized on settlement. 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 the assets are sold. Trading security liabilities are valued at the institutional offer price and bid-offer revenues are recognized when the positions are closed.


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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 marketplace participant in settlement of these instruments (i.e., the amount Merrill Lynch would expect to receive in a derivative asset assignment or would expect to pay to have a derivative liability assumed). 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. Determining the fair value for OTC derivative contracts can require a significant level of estimation and management judgment.
 
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 that market participants would use in pricing the instrument, which may impact the results of operations reported in the Condensed 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 fair value 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 to correlate more closely to the market risk of these instruments.
 
Prior to adoption of SFAS No. 157, Merrill Lynch followed the provisions of EITF 02-3. Under EITF 02-3, recognition of day one gains and losses on derivative transactions where model inputs that significantly impact valuation are not observable were prohibited. Day one gains and losses deferred at inception under EITF 02-3 were recognized at the earlier of when the valuation of such derivative became observable or at the termination of the contract. SFAS No. 157 nullifies this guidance in EITF 02-3. Although this guidance in EITF 02-3 has been nullified, the recognition of significant inception gains and losses that incorporate unobservable inputs are reviewed by management to ensure such gains and losses are derived from observable inputs and/or incorporate reasonable assumptions about the unobservable component, such as implied bid-offer adjustments.
 
Certain financial instruments recorded at fair value are initially measured using mid-market prices which results in gross long and short positions marked-to-market at the same pricing level prior to the application of position netting. The resulting net positions are then adjusted to fair value representing the exit price as defined in SFAS No. 157. The significant adjustments include:
 
Liquidity
 
Merrill Lynch makes adjustments to bring a position from a mid-market to a bid or offer price, depending upon the net open position. Merrill Lynch values net long positions at bid prices and net short positions at offer prices. These adjustments are based upon either observable or implied bid-offer prices.
 
Credit Risk
 
In determining fair value Merrill Lynch considers both the credit risk of its counterparties, as well its own creditworthiness. Credit risk to third parties is generally mitigated by entering into netting and collateral arrangements. Net exposure is then measured with consideration of market observable pricing of a counterparty’s credit risk and is incorporated into the fair value of the respective instruments. The calculation of the credit adjustment for derivatives is generally based upon observable credit derivative spreads. Alternatively, the calculation for cash products generally considers observable bond spreads.


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SFAS No. 157 requires that Merrill Lynch’s own creditworthiness be considered when determining the fair value of an instrument. The approach to measuring the impact of Merrill Lynch’s own credit on an instrument is the same approach as that used to measure third party credit risk.
 
Investment Securities
 
Marketable Investments
 
ML & Co. and certain of its non-broker-dealer subsidiaries follow the guidance prescribed by SFAS No. 115 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. Held-to-maturity securities are carried at cost unless a decline in value is deemed other-than-temporary, in which case the carrying value is reduced. For Merrill Lynch, the trading classification under SFAS No. 115 generally includes those securities that are bought and held principally for the purpose of selling them in the near term, securities that are economically hedged, or securities that contain an embedded derivative as defined in SFAS No. 133. Securities classified as trading are 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 requires judgment and will depend on several factors, including but not limited to the severity and duration of the decline in value of the investment securities and the financial condition of the issuer. 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.
 
Private Equity Investments
 
Private equity investments that are not strategic, 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 (“the Guide”) and carried at fair value. Additionally, certain private equity investments that are not accounted for under the Guide may be carried at fair value under the fair value option election in SFAS No. 159. Investments are adjusted to fair value when changes in the underlying fair values are readily ascertainable, generally based on specific events (for example recapitalizations and initial public offerings), or by using other valuation methodologies including expected cash flows and market comparables of similar companies.
 
Securities Financing Transactions
 
Merrill Lynch enters into repurchase and resale agreements and securities borrowed and loaned transactions to accommodate customers and earn residual interest rate spreads (also referred to as “matched-book transactions”), obtain securities for settlement and finance inventory positions.
 
Resale and repurchase agreements are accounted for as collateralized financing transactions and may be recorded at their contractual amounts plus accrued interest or at fair value under the fair value option election in SFAS No. 159. Resale and repurchase agreements recorded at fair value are generally valued based on pricing models that use inputs with observable levels of price transparency. Changes in the fair value of resale and repurchase agreements are reflected in principal transactions


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revenues and the stated interest coupon is recorded as interest revenue or interest expense, respectively. For further information refer to Note 3 to the Condensed Consolidated Financial Statements.
 
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 may 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 Condensed 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 may return collateral pledged, when appropriate.
 
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 or, if applicable, in investment securities on the Condensed Consolidated Balance Sheets.
 
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 Condensed 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 Condensed Consolidated Balance Sheets result from non-cash transactions.
 
Loans and Allowance for Loan Losses
 
Certain loans held by Merrill Lynch are carried at fair value or lower of cost or fair value, 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, automobile loans, and home equity loans, fair value is estimated using market price quotations, previously executed transactions for securities backed by similar loans, adjusted for credit risk and other individual loan characteristics, the value of underlying collateral, as well as valuation techniques including discounted cash flow models.
 
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


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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, quoted market prices for securities, or other types of estimates for other assets. Management’s estimate of loan losses includes judgment about collectibility based on available information at the balance sheet date, and the uncertainties inherent in those underlying assumptions. While management has based its estimates on the best information available, future adjustments to the allowance may be necessary as a result of changes in the economic environment or variances between actual results and the original assumptions.
 
Derivatives
 
A derivative is an instrument whose value is derived from an underlying instrument or index, such as interest rates, equity securities, currencies, or credit spreads. Derivatives include futures, forwards, swaps, or option contracts, or other financial instruments 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.
 
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 Condensed 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 Condensed 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 risk exposures arising from trading assets and liabilities. Derivatives entered into for these purposes are recognized at fair value on the Condensed Consolidated Balance Sheets as trading assets and liabilities in contractual agreements, and changes in fair value are reported in current period earnings as principal transactions revenues.
 
Merrill Lynch also enters into derivatives in order to manage 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; and
  •  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.


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3.  Merrill Lynch has fair value hedges of long-term fixed rate resale and repurchase agreements to manage the interest rate risk of these assets and liabilities. Subsequent to the adoption of SFAS No. 159, Merrill Lynch elects to account for these instruments on a fair value basis rather than apply hedge accounting.
 
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, swaps, options and forward contracts 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 on the Condensed Consolidated Balance Sheets. Derivatives used to hedge commodity inventory are included in trading assets and trading liabilities on the Condensed Consolidated Balance Sheets.
 
Derivatives that qualify as accounting hedges under the guidance in SFAS No. 133 are designated on the date they are entered into as one of the following:
 
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


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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. 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 revenues. Ineffectiveness associated with these hedges was immaterial for all periods presented.
 
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 expense, depending on the nature of the transaction.
 
Hybrid Financial Instruments
 
Merrill Lynch issues structured debt instruments that have coupons or repayment terms linked to the performance of debt or equity securities, indices, currencies, or commodities, generally referred to as hybrid debt instruments or structured notes. The contingent payment components of these obligations may meet the definition in SFAS No. 133 of an “embedded derivative.” Historically, these hybrid debt instruments were assessed to determine if the embedded derivative required separate reporting and accounting, and if so, the embedded derivative was accounted for at fair value and reported in long-term borrowings on the Condensed Consolidated Balance Sheets along with the debt obligation. Changes in the fair value of the embedded derivative and related economic hedges were reported in principal transactions revenues. Separating an embedded derivative from its host contract required careful analysis, judgment, and an understanding of the terms and conditions of the instrument. Beginning in the first quarter of 2007, Merrill Lynch elected the fair value option in SFAS No. 159 for all hybrid debt instruments issued subsequent to December 29, 2006. Changes in fair value of the entire hybrid debt instrument are reflected in principal transactions revenues and the stated interest coupon is recorded as interest expense. For further information refer to Note 3 to the Condensed Consolidated Financial Statements.
 
Merrill Lynch may also purchase financial instruments that contain embedded derivatives. These instruments may be part of either trading assets 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.
 
Securitization Activities
 
In the normal course of business, Merrill Lynch securitizes: commercial and residential mortgage loans and home equity loans; municipal, government, and corporate bonds; and other types of financial assets. Merrill Lynch may retain interests in the securitized financial assets through holding tranches of the securitization. In accordance with SFAS No. 140, Merrill Lynch recognizes transfers of financial assets that relinquish control as sales to the extent of cash and other proceeds received. Control is considered to be relinquished when all of the following conditions have been met:
 
  a.  The transferred assets have been legally isolated from the transferor even in bankruptcy or other receivership;


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  b.  The transferee has the right to pledge or exchange the assets it received or, if the entity is a QSPE, the beneficial interest holders have that right; and
 
  c.  The transferor does not maintain effective control over the transferred assets (e.g. the ability to unilaterally cause the holder to return specific transferred assets).
 
Stock Based Compensation
 
Merrill Lynch adopted the provisions of Statement No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123R”) beginning in the first quarter of 2006. Under SFAS No. 123R, compensation expenses for share-based awards that do not require future service are recorded immediately, and share-based awards that require future service continue to be amortized into expense over the relevant service period. Merrill Lynch adopted SFAS No. 123R under the modified prospective method whereby the provisions of SFAS No. 123R are generally applied only to share-based awards granted or modified subsequent to adoption. Thus, for Merrill Lynch, SFAS No. 123R required the immediate expensing of share-based awards granted or modified in 2006 to retirement-eligible employees, including awards that are subject to non-compete provisions.
 
Prior to the adoption of SFAS No. 123R, Merrill Lynch had recognized expense for share-based compensation over the vesting period stipulated in the grant for all employees. This included those who had satisfied retirement eligibility criteria but were subject to a non-compete agreement that applied from the date of retirement through each applicable vesting period. Previously, Merrill Lynch had accelerated any unrecognized compensation cost for such awards if a retirement-eligible employee left Merrill Lynch. However, because SFAS No. 123R applies only to awards granted or modified in 2006, expenses for share-based awards granted prior to 2006 to employees who were retirement-eligible with respect to those awards must continue to be amortized over the stated vesting period.
 
New Accounting Pronouncements
 
In June 2007, the Accounting Standards Executive Committee of the AICPA issued Statement of Position 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). The intent of SOP 07-1 is to clarify which entities are within the scope of the AICPA Audit and Accounting Guide, Investment Companies (the “Guide”). For those entities that are investment companies under SOP 07-1, the SOP also addresses whether the specialized industry accounting principles of the Guide (referred to as “investment company accounting”) should be retained by the parent company in consolidation or by an investor that has the ability to exercise significant influence over the investment company and applies the equity method of accounting to its investment in the entity. Under SOP 07-1, an investment company is generally defined as a separate legal entity whose business purpose and activity are investing in multiple substantive investments for current income, capital appreciation, or both, with investment plans that include exit strategies. The provisions of SOP 07-1 as currently drafted are effective for fiscal years beginning on or after December 15, 2007, with earlier application permitted. Entities that previously applied the provisions of the Guide, but that do not meet the provisions of SOP 07-1 to be an investment company within the scope of the Guide, must report the effects of adopting SOP 07-1 prospectively by accounting for their investments in conformity with applicable generally accepted accounting principles, other than investment company accounting, as of the date of adoption. Entities that are investment companies within the scope of the Guide, but that previously had not followed the provisions of the Guide, should report the cumulative effect of adopting SOP 07-1 as an adjustment to beginning retained earnings as of the beginning of the year in which SOP 07-1 is adopted. Merrill Lynch is currently evaluating the


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provisions of SOP 07-1 and is assessing its potential impact on the Condensed Consolidated Financial Statements. On October 17, 2007, the FASB proposed an indefinite delay of the effective dates of SOP 07-1 to allow the Board to address certain implementation issues that have arisen and possibly revise SOP 07-1.
 
In February 2007, the FASB issued SFAS No. 159, which provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities. Changes in fair value for assets and liabilities for which the election is made will be recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided that the entity makes that choice in the first 120 days of that fiscal year, has not yet issued financial statements for any interim period of the fiscal year of adoption, and also elects to apply the provisions of SFAS No. 157 (described below). We early adopted SFAS No. 159 in the first quarter of 2007. In connection with this adoption management reviewed its treasury liquidity portfolio and determined that we should decrease our economic exposure to interest rate risk by eliminating long-term fixed rate assets from the portfolio and replacing them with floating rate assets. The fixed rate assets had been classified as available-for-sale and the unrealized losses related to such assets had been recorded in accumulated other comprehensive loss. As a result of the adoption of SFAS No. 159, the loss related to these assets was removed from accumulated other comprehensive loss and a loss of approximately $185 million, net of tax, primarily related to these assets, was recorded as a cumulative-effect adjustment to beginning retained earnings, with no material impact to total stockholders’ equity. Refer to Note 3 to the Condensed Consolidated Financial Statements for additional information.
 
In September 2006, the FASB issued SFAS No. 157. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure about fair value measurements. SFAS No. 157 nullifies the guidance provided by EITF 02-3 that prohibits recognition of day one gains or losses on derivative transactions where model inputs that significantly impact valuation are not observable. In addition, SFAS No. 157 prohibits the use of block discounts for large positions of unrestricted financial instruments that trade in an active market and requires an issuer to incorporate changes in its own credit spreads when determining the fair value of its liabilities. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 with early adoption permitted provided that the entity has not yet issued financial statements for that fiscal year, including any interim periods. The provisions of SFAS No. 157 are to be applied prospectively, except that the provisions related to block discounts and existing derivative financial instruments measured under EITF 02-3 are to be applied as a one-time cumulative effect adjustment to opening retained earnings in the year of adoption. We early adopted SFAS No. 157 in the first quarter of 2007. The cumulative-effect adjustment to beginning retained earnings was an increase of approximately $53 million, net of tax, primarily representing the difference between the carrying amounts and fair value of derivative contracts valued using the guidance in EITF 02-3. The impact of adopting SFAS No. 157 was not material to our Condensed Consolidated Statement of Earnings. Refer to Note 3 to the Condensed Consolidated Financial Statements for additional information.
 
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132R (“SFAS No. 158”). SFAS No. 158 requires an employer to recognize the overfunded or underfunded status of its defined benefit pension and other postretirement plans, measured as the difference between the fair value of plan assets and the benefit obligation as an asset or liability in its statement of financial condition. Upon adoption, SFAS No. 158 requires an entity to recognize previously unrecognized actuarial gains and losses and prior service costs within accumulated other


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comprehensive income (loss), net of tax. In accordance with the guidance in SFAS No. 158, we adopted this provision of the standard for year-end 2006. The adoption of SFAS No. 158 resulted in a net credit of $65 million to accumulated other comprehensive loss recorded on the Consolidated Financial Statements at December 29, 2006. SFAS No. 158 also requires defined benefit plan assets and benefit obligations to be measured as of the date of the company’s fiscal year-end. We have historically used a September 30 measurement date. Under the provisions of SFAS No. 158, we will be required to change our measurement date to coincide with our fiscal year-end. This provision of SFAS No. 158 will be effective for us in fiscal 2008. We are currently assessing the impact of adoption of this provision of SFAS No. 158 on the Condensed Consolidated Financial Statements.
 
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted FIN 48 in the first quarter of 2007. The impact of the adoption of FIN 48 resulted in a decrease to beginning retained earnings and an increase to the liability for unrecognized tax benefits of approximately $66 million. See Note 14 to the Condensed Consolidated Financial Statements for further information.
 
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets (“SFAS No. 156”). SFAS No. 156 amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to require all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. SFAS No. 156 also permits servicers to subsequently measure each separate class of servicing assets and liabilities at fair value rather than at the lower of amortized cost or market. For those companies that elect to measure their servicing assets and liabilities at fair value, SFAS No. 156 requires the difference between the carrying value and fair value at the date of adoption to be recognized as a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year in which the election is made. Prior to adoption of SFAS No. 156 we accounted for servicing assets and servicing liabilities at the lower of amortized cost or market. We adopted SFAS No. 156 on December 30, 2006. We have not elected to subsequently fair value those mortgage servicing rights (“MSR”) held as of the date of adoption or those MSRs acquired or retained after December 30, 2006. The adoption of SFAS No. 156 did not have a material impact on the Condensed Consolidated Financial Statements.
 
In February 2006, the FASB issued Statement No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140 (“SFAS No. 155”). SFAS No. 155 clarifies the bifurcation requirements for certain financial instruments and permits hybrid financial instruments that contain a bifurcatable embedded derivative 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. At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instruments and the fair value of the combined hybrid financial instruments is recognized as a cumulative-effect adjustment to beginning retained earnings. We adopted SFAS No. 155 on a prospective basis beginning in the first quarter of 2007. Since SFAS No. 159 incorporates accounting and disclosure requirements that are similar to SFAS No. 155, we apply SFAS No. 159, rather than SFAS No. 155, to our fair value elections for hybrid financial instruments.
 
Merrill Lynch adopted the provisions of Statement No. 123 (revised 2004), Share-Based Payment, a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123R”) as of the beginning of the first quarter of 2006. Under SFAS No. 123R, compensation expenses for share-based


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awards that do not require future service are recorded immediately, and share-based awards that require future service continue to be amortized into expense over the relevant service period. We adopted SFAS No. 123R under the modified prospective method whereby the provisions of SFAS No. 123R are generally applied only to share-based awards granted or modified subsequent to adoption. Thus, for Merrill Lynch, SFAS No. 123R required the immediate expensing of share-based awards granted or modified in 2006 to retirement-eligible employees, including awards that are subject to non-compete provisions.
 
Prior to the adoption of SFAS No. 123R, we had recognized expense for share-based compensation over the vesting period stipulated in the grant for all employees. This included those who had satisfied retirement eligibility criteria but were subject to a non-compete agreement that applied from the date of retirement through each applicable vesting period. Previously, we had accelerated any unrecognized compensation cost for such awards if a retirement-eligible employee left Merrill Lynch. However, because SFAS No. 123R applies only to awards granted or modified in 2006, expenses for share-based awards granted prior to 2006 to employees who were retirement-eligible with respect to those awards must continue to be amortized over the stated vesting period.
 
In addition, beginning with performance year 2006, for which we granted stock awards in January 2007, we accrued the expense for future awards granted to retirement-eligible employees over the award performance year instead of recognizing the entire expense related to the award on the grant date. Compensation expense for 2006 performance year and all future stock awards granted to employees not eligible for retirement with respect to those awards will be recognized over the applicable vesting period.
 
SFAS No. 123R also requires expected forfeitures of share-based compensation awards for non-retirement-eligible employees to be included in determining compensation expense. Prior to the adoption of SFAS No. 123R, any benefits of employee forfeitures of such awards were recorded as a reduction of compensation expense when the employee left Merrill Lynch and forfeited the award. In the first quarter of 2006, we recorded a benefit based on expected forfeitures which was not material to the results of operations for the quarter.
 
The adoption of SFAS No. 123R resulted in a charge to compensation expense of approximately $550 million on a pre-tax basis and $370 million on an after-tax basis in the first quarter of 2006.
 
The adoption of SFAS No. 123R, combined with other business and competitive considerations, prompted us to undertake a comprehensive review of our stock-based incentive compensation awards, including vesting schedules and retirement eligibility requirements, examining their impact to both Merrill Lynch and its employees. Upon the completion of this review, the Management Development and Compensation Committee of Merrill Lynch’s Board of Directors determined that to fulfill the objective of retaining high quality personnel, future stock grants should contain more stringent retirement provisions. These provisions include a combination of increased age and length of service requirements. While the stock awards of employees who retire continue to vest, retired employees are subject to continued compliance with the strict non-compete provisions of those awards. To facilitate transition to the more stringent future requirements, the terms of most outstanding stock awards previously granted to employees, including certain executive officers, were modified, effective March 31, 2006, to permit employees to be immediately eligible for retirement with respect to those earlier awards. While we modified the retirement-related provisions of the previous stock awards, the vesting and non-compete provisions for those awards remain in force.
 
Since the provisions of SFAS No. 123R apply to awards modified in 2006, these modifications required us to record additional one-time compensation expense in the first quarter of 2006 for the remaining unamortized amount of all awards to employees who had not previously been retirement-eligible under the original provisions of those awards.


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The one-time, non-cash charge associated with the adoption of SFAS No. 123R, and the policy modifications to previous awards resulted in a net charge to compensation expense in the first quarter of 2006 of approximately $1.8 billion pre-tax, and $1.2 billion after-tax, or a net impact of $1.34 and $1.21 on basic and diluted earnings per share, respectively. Policy modifications to previously granted awards amounted to $1.2 billion of the pre-tax charge and impacted approximately 6,300 employees.
 
Prior to the adoption of SFAS No. 123R, we presented the cash flows related to income tax deductions in excess of the compensation expense recognized on share-based compensation as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123R requires cash flows resulting from tax deductions in excess of the grant-date fair value of share-based awards to be included in cash flows from financing activities. The excess tax benefits of $283 million related to total share-based compensation included in cash flows from financing activities in the first quarter of 2006 would have been included in cash flows from operating activities if we had not adopted SFAS No. 123R.
 
As a result of adopting SFAS No. 123R, approximately $600 million of liabilities associated with the Financial Advisor Capital Accumulation Award Plan (“FACAAP”) were reclassified to stockholders’ equity. In addition, as a result of adopting SFAS No. 123R, the unamortized portion of employee stock grants, which was previously reported as a separate component of stockholders’ equity on the Consolidated Balance Sheets, has been reclassified to Paid-in capital.
 
In June 2005, the FASB ratified the consensus reached by the Emerging Issues Task Force 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 beginning in the third quarter of 2005 for all new limited partnership agreements and any limited partnership agreements that were modified. For those partnership agreements that existed at the date EITF 04-5 was issued, the guidance became effective in the first quarter of 2006. The adoption of this guidance did not have a material impact on the Condensed Consolidated Financial Statements.
 
Note 2.  Segment and Geographic Information
 
Segment Information
 
Merrill Lynch’s operations are organized into two business segments: Global Markets and Investment Banking (“GMI”) and Global Wealth Management (“GWM”). GMI provides full service global markets and origination products and services to corporate, institutional, and government clients around the world. GWM creates and distributes investment products and services for individuals, small- to mid-size businesses, and employee benefit plans. Prior to the fourth quarter of 2006, Merrill Lynch reported its business activities in three business segments: GMI, Global Private Client (“GPC”) and MLIM. Effective with the merger of the MLIM business with BlackRock in September 2006, MLIM ceased to exist as a separate business segment. For information regarding the BlackRock merger refer to Note 2 of the 2006 Annual Report.
 
Results for the nine months ended September 29, 2006 include one-time compensation expenses incurred in the first quarter of 2006, as follows: $1.4 billion in GMI, $281 million in GWM and $109 million in MLIM; refer to Note 1, New Accounting Pronouncements, to the Condensed Consolidated Financial Statements for further information on one-time compensation expenses.


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The following segment results represent the information that is used by management in its decision-making processes and are presented before discontinued operations. Prior period amounts have been restated to conform to the current period presentation:
 
                                         
(dollars in millions)        
 
    GMI   GWM   MLIM(1)   Corporate(2)   Total
     
 
Three Months Ended Sept. 28, 2007
                                       
Non-interest revenues
  $ (4,179 )   $ 2,965     $ -     $ (588 )   $ (1,802 )
Net interest profit(3)
    1,198       573       -       608       2,379  
                                         
Net revenues
    (2,981 )     3,538       -       20       577  
Non-interest expenses
    1,458       2,585       -       (1 )     4,042  
                                         
Pre-tax earnings (loss) from continuing
operations(4)
  $ (4,439 )   $ 953     $ -     $ 21     $ (3,465 )
                                         
Quarter-end total assets
  $ 986,002     $ 105,868     $ -     $ 5,318     $ 1,097,188  
                                         
 
 
Three Months Ended Sept. 29, 2006
                                       
Non-interest revenues
  $ 3,664     $ 2,251     $ 693     $ 1,998     $ 8,606  
Net interest profit(3)
    755       489       7       (24 )     1,227  
                                         
Net revenues
    4,419       2,740       700       1,974       9,833  
Non-interest expenses
    2,947       2,180       416       200       5,743  
                                         
Pre-tax earnings from continuing
operations(4)
  $ 1,472     $ 560     $ 284     $ 1,774     $ 4,090  
                                         
Quarter-end total assets
  $ 720,195     $ 73,690     $ 8,028     $ 2,811     $ 804,724  
                                         
 
 
Nine Months Ended Sept. 28, 2007
                                       
Non-interest revenues
  $ 7,706     $ 8,680     $ -     $ (652 )   $ 15,734  
Net interest profit(3)
    2,042       1,746       -       503       4,291  
                                         
Net revenues
    9,748       10,426       -       (149 )     20,025  
Non-interest expenses
    9,742       7,710       -       10       17,462  
                                         
Pre-tax earnings (loss) from continuing
operations(4)
  $ 6     $ 2,716     $ -     $ (159 )   $ 2,563  
                                         
 
 
Nine Months Ended Sept. 29, 2006
                                       
Non-interest revenues
  $ 11,445     $ 7,087     $ 1,867     $ 2,022     $ 22,421  
Net interest profit(3)
    2,107       1,532       33       (244 )     3,428  
                                         
Net revenues
    13,552       8,619       1,900       1,778       25,849  
Non-interest expenses
    10,399       7,034       1,263       186       18,882  
                                         
Pre-tax earnings from continuing
operations(4)
  $ 3,153     $ 1,585     $ 637     $ 1,592     $ 6,967  
                                         
 
 
(1) MLIM ceased to exist in connection with the BlackRock merger in September 2006.
(2) Includes the impact of junior subordinated notes (related to trust preferred securities) and other corporate items. In addition, results for the three and nine months ended September 28, 2007 include an allocation of non-interest revenues (principal transactions) and net interest profit among the business and corporate segments associated with certain hybrid financing instruments accounted for under SFAS No. 159. Results for the three and nine months ended September 29, 2006 include $2.0 billion of non-interest revenues and $202 million of non-interest expenses related to the closing of the BlackRock merger.
(3) Management views interest income net of interest expense in evaluating results.
(4) See Note 17 to the Condensed Consolidated Financial Statements for further information on discontinued operations.


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Geographic Information
 
Merrill Lynch conducts its business activities through offices in the following five regions:
 
  •   United States;
  •   Europe, Middle East, and Africa;
  •   Pacific Rim;
  •   Latin America; and
  •   Canada.
 
The principal methodologies used in preparing the geographic information below are as follows:
 
  •   Revenues and expenses are generally recorded based on the location of the employee generating the revenue or incurring the expense;
  •   Pre-tax earnings from continuing operations include the allocation of certain shared expenses among regions; and
  •   Intercompany transfers are based primarily on service agreements.
 
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)
 
    For the Three Months Ended   For the Nine Months Ended
     
    Sept. 28, 2007   Sept. 29, 2006(1)   Sept. 28, 2007   Sept. 29, 2006(2)
 
 
Net revenues
                               
Europe, Middle East, and Africa
  $ 1,243     $ 1,758     $ 5,464     $ 5,131  
Pacific Rim
    1,482       826       4,155       2,708  
Latin America
    374       223       1,124       766  
Canada
    75       88       367       273  
                                 
Total Non-U.S.
    3,174       2,895       11,110       8,878  
United States(3)(5)(6)
    (2,597 )     6,938       8,915       16,971  
                                 
Total net revenues
  $ 577     $ 9,833     $ 20,025     $ 25,849  
                                 
Pre-tax earnings from continuing operations(4)(7)
                               
Europe, Middle East, and Africa
  $ 148     $ 593     $ 1,624     $ 1,291  
Pacific Rim
    786       313       2,068       835  
Latin America
    180       74       542       313  
Canada
    35       44       209       128  
                                 
Total Non-U.S.
    1,149       1,024       4,443       2,567  
United States(3)(5)(6)
    (4,614 )     3,066       (1,880 )     4,400  
                                 
Total pre-tax (loss)/earnings from continuing
operations(7)
  $ (3,465 )   $ 4,090     $ 2,563     $ 6,967  
                                 
 
 
(1) The 2006 third quarter results include net revenues earned by MLIM of $700 million, which include non-U.S. net revenues of $378 million.
(2) The 2006 nine-month results include net revenues earned by MLIM of $1.9 billion, which include non-U.S. net revenues of $1.0 billion.
(3) Corporate revenues and adjustments are reflected in the U.S. region.
(4) For the nine months ended September 29, 2006, pre-tax earnings include the impact of the $1.8 billion of one-time compensation expenses incurred in the first quarter of 2006. These costs have been allocated to each of the regions, accordingly.
(5) The U.S. results for the three and nine months ended September 29, 2006 include $2.0 billion of revenues and $202 million of non-interest expenses related to the closing of the BlackRock merger.


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(6)  The U.S. results for the three and nine months ended September 28, 2007 include $7.9 billion of losses related to U.S. sub-prime residential mortgage-related and asset-backed securities (“ABS”) and collateralized debt obligations (“CDOs”) in the third quarter of 2007.
(7)  See Note 17 to the Condensed Consolidated Financial Statements for further information on discontinued operations.
 
Note 3. Fair Value of Financial Instruments
 
Merrill Lynch early adopted the provisions of SFAS No. 157 and SFAS No. 159 in the first quarter of 2007.
 
Fair Value Measurements
 
SFAS No. 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value, and enhances disclosure requirements for fair value measurements. Merrill Lynch accounts for a significant portion of its financial instruments at fair value or considers fair value in their measurement. Merrill Lynch accounts for certain financial assets and liabilities at fair value under various accounting literature, including SFAS No. 115, SFAS No. 133 and SFAS No. 159. Merrill Lynch also accounts for certain assets at fair value under applicable industry guidance, namely broker-dealer and investment company accounting guidance.
 
Fair Value Hierarchy
 
In accordance with SFAS No. 157, Merrill Lynch has categorized its financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.
 
Financial assets and liabilities recorded on the Condensed Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as follows:
 
Level 1.   Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that Merrill Lynch has the ability to access (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).
 
Level 2.   Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:
 
  a)  Quoted prices for similar assets or liabilities in active markets (for example, restricted stock);
 
  b)  Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently);


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  c)  Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and
 
  d)  Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).
 
Level 3.   Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).
 
As required by SFAS No. 157, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Levels 1 and 2) and unobservable (Level 3). Gains and losses for such assets and liabilities categorized within the Level 3 table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following tables do not take into consideration the effect of offsetting Level 1 and 2 financial instruments entered into by Merrill Lynch that economically hedge certain exposures to the Level 3 positions.
 
A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain financial assets or liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassifications occur. During the third quarter of 2007, a significant amount of assets and liabilities was reclassified from Level 2 to Level 3. This reclassification primarily relates to U.S. sub-prime residential mortgage-related assets and liabilities, including ABS CDOs, due to a significant decrease in the observability of market pricing for these assets and liabilities in the third quarter.


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The following table presents Merrill Lynch’s fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis as of September 28, 2007.
 
                                         
(dollars in millions)
    Fair Value Measurements on a Recurring Basis
    as of September 28, 2007
                Netting
   
    Level 1   Level 2   Level 3   Adj(1)   Total
 
 
Assets:
                                       
Securities segregated for regulatory purposes or deposited with clearing organizations
  $ 507     $ 5,303     $ -     $ -     $ 5,810  
Receivables under resale agreements
    -       110,472       -       -       110,472  
Trading assets, excluding contractual agreements
    89,351       102,653       9,733       -       201,737  
Contractual agreements(2)
    4,487       272,288       11,753       (231,152 )     57,376  
Investment securities
    5,342       60,327       5,653       -       71,322  
Loans, notes and mortgages
    -       980       7       -       987  
Other assets(3)
    8       923       -       (99 )     832  
Liabilities:
                                       
Payables under repurchase agreements
  $ -     $ 117,536     $ -     $ -     $ 117,536  
Trading liabilities, excluding contractual agreements
    58,900       3,755       -       -       62,655  
Contractual agreements(2)
    5,903       283,780       15,327       (240,858 )     64,152  
Long-term borrowings(4)
    -       71,541       612       -       72,153  
Other payables — interest and other(3)
    12       619       -       (4 )     627  
 
 
(1) Represents counterparty and cash collateral netting.
(2) Includes $4.1 billion and $2.4 billion of derivative assets and liabilities, respectively, that are included in commodities and related contracts on the Condensed Consolidated Balance Sheet.
(3) Primarily represents certain derivatives used for non-trading purposes.
(4) Includes bifurcated embedded derivatives carried at fair value.
 
Level 3 Assets and Liabilities
 
Level 3 trading assets primarily include U.S. sub-prime residential mortgage-related and ABS CDO positions of $2.5 billion and corporate bonds and loans of $5.9 billion.
 
Level 3 contractual agreements (assets) primarily include long-dated equity derivatives of $4.6 billion and derivatives on U.S. sub-prime residential mortgage-related and ABS CDO positions, primarily in the form of credit default swaps of $3.8 billion.
 
Level 3 investment securities primarily relate to U.S. sub-prime residential mortgage-related and ABS CDO positions of $1.8 billion that are accounted for as trading securities under SFAS No. 115 as well as certain private equity and principal investment positions of $3.6 billion.
 
Level 3 contractual agreements (liabilities) primarily relate to long-dated equity derivatives of $5.5 billion and derivatives on U.S. sub-prime residential mortgage-related and ABS CDO positions, primarily in the form of total return swaps and credit default swaps of $8.5 billion.
 
Level 3 long-term borrowings primarily relate to structured notes with embedded long-dated currency derivatives of $544 million.


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U.S. sub-prime residential mortgage-related and ABS CDO activities
 
During the third quarter of 2007, Merrill Lynch recorded a net loss of approximately $7.9 billion related to U.S. ABS CDO securities positions and warehouses, as well as U.S. sub-prime mortgage-related assets including whole loans, warehouse lending, residual positions and residential mortgage-backed securities. These losses primarily related to assets and liabilities recorded at fair value on a recurring basis and are included in principal transactions losses in the table below.
 
At September 28, 2007, the remaining net exposure for these positions was approximately $21.5 billion. This $21.5 billion net exposure includes:
 
•  Assets and liabilities, including derivative positions, that are recorded at fair value on a recurring basis of $5.0 billion (includes Level 2 and Level 3);
 
•  Assets that are recorded at fair value on a non-recurring basis of $2.3 billion (i.e., loans recorded at lower of cost or market);
 
•  Additional off-balance sheet exposures on derivative positions (i.e., notional amounts) of $13.6 billion; and
 
•  Additional off-balance sheet exposures on loan commitments of $0.6 billion.
 
In addition, Merrill Lynch through its U.S. bank subsidiaries has SFAS 115 investment securities and off-balance sheet arrangements that have exposure to U.S. sub-prime residential mortgage-related assets of $5.7 billion at September 28, 2007.
 
Valuation of these exposures will continue to be impacted by external market factors including default rates, rating agency actions, and the prices at which observable market transactions occur. Merrill Lynch’s ability to mitigate its risk by selling or hedging its exposures is limited by the market environment. Merrill Lynch’s future results may continue to be materially impacted by the valuation adjustments applied to these positions.
 
The following table provides a summary of changes in fair value of Merrill Lynch’s Level 3 financial assets and liabilities for the three months ended September 28, 2007.
 
                                                                 
(dollars in millions)
    Level 3 Financial Assets and Liabilities
    Three months ended September 28, 2007
        Total Realized and Unrealized
               
        Gains or (Losses)
  Total Realized and
  Purchases,
       
        included in Income   Unrealized Gains
  Issuances
       
    Beginning
  Principal
  Other
      or (Losses)
  and
  Transfers
  Ending
    Balance   Transactions   Revenue   Interest   included in Income   Settlements   in (out)   Balance
 
 
Assets:
                                                               
Trading assets
  $ 3,648     $ (1,938 )   $ -     $ 6     $ (1,932 )   $ 1,608     $ 6,409     $ 9,733  
Contractual agreements, net
    229       (4,032 )     (2 )     11       (4,023 )     139       81       (3,574 )
Investment securities
    5,784       (974 )     4       -       (970 )     938       (99 )     5,653  
Loans, notes and mortgages
    4       -       (4 )     -       (4 )     (2 )     9       7  
Liabilities:
                                                               
Long-term borrowings
  $ 282     $ 280     $ -     $ -     $ 280     $ 81     $ 529     $ 612  
 
 
 
Net losses in principal transactions were due primarily to $7.9 billion of write-downs taken on U.S. sub-prime residential mortgage-related and ABS CDO positions that are classified as Level 3, partially offset by approximately $0.9 billion of gains in other fixed income and equity related products.
 
The increases attributable to purchases, issuances, and settlements of Level 3 assets and liabilities were primarily due to the exercise of certain purchase obligations that required Merrill Lynch to buy


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underlying assets, primarily U.S. sub-prime residential mortgage-related and ABS CDO positions of $1.4 billion. These purchase obligations were previously included in contractual agreements and were primarily classified as Level 2 in prior periods.
 
The increases attributable to net transfers in of Level 3 assets and liabilities were due primarily to the decrease in observability of market pricing for instruments which had previously been classified as Level 2, primarily U.S. sub-prime residential mortgage-related and ABS CDO positions and related instruments of $1.2 billion and other notes and loans of $4.8 billion that are classified as trading assets.
 
The following table provides a summary of changes in fair value of Merrill Lynch’s Level 3 financial assets and liabilities for the nine months ended September 28, 2007.
 
                                                                 
(dollars in millions)
    Level 3 Financial Assets and Liabilities
    Nine months ended September 28, 2007
        Total Realized and Unrealized
               
        Gains or (Losses)
  Total Realized and
  Purchases,
       
        included in Income   Unrealized Gains
  Issuances
       
    Beginning
  Principal
  Other
      or (Losses)
  and
  Transfers
  Ending
    Balance   Transactions   Revenue   Interest   included in Income   Settlements   in (out)   Balance
 
 
Assets:
                                                               
Trading assets
  $ 2,021     $ (1,685 )   $ -     $ 34     $ (1,651 )   $ 2,111     $ 7,252     $ 9,733  
Contractual
                                                               
agreements, net
    (2,030 )     (3,461 )     3       17       (3,441 )     946       951       (3,574 )
Investment
                                                               
securities
    5,117       (1,404 )     484       5       (915 )     2,142       (691 )     5,653  
Loans, notes and mortgages
    7       -       (13 )     -       (13 )     (4 )     17       7  
Liabilities:
                                                               
Long-term borrowings
  $ -     $ 280     $ -     $ -     $ 280     $ 81     $ 811     $ 612  
 
 
 
The significant items affecting the rollforward for the nine months ended September 28, 2007 generally occurred in the three months ended September 28, 2007 and are described above.
 
The following table provides the portion of gains or losses included in income for the three and nine months ended September 28, 2007 attributable to unrealized gains or losses relating to those Level 3 assets and liabilities still held at September 28, 2007.
 
                                                                 
(dollars in millions)
    Unrealized Gains or (Losses) for Level 3 Assets and Liabilities
    Still Held at September 28, 2007
    Three Months Ended September 28, 2007   Nine Months Ended September 28, 2007
    Principal
  Other
          Principal
  Other
       
    Transactions   Revenue   Interest   Total   Transactions   Revenue   Interest   Total
     
 
Assets:
                                                               
Trading assets
  $ (1,956 )   $ -     $ 6     $ (1,950 )   $ (1,719 )   $ -     $ 34     $ (1,685 )
Contractual agreements, net
    (4,088 )     (2 )     11       (4,079 )     (3,589 )     (2 )     17       (3,574 )
Investment securities
    (974 )     (6 )     -       (980 )     (1,404 )     393       7       (1,004 )
Loans, notes and mortgages
    -       1       -       1       -       4       -       4  
Liabilities:
                                                               
Long-term borrowings
  $ 280     $ -     $ -     $ 280     $ 280     $ -     $ -     $ 280  
 
 
 
Total net unrealized losses were primarily due to $7.9 billion of write-downs of U.S. sub-prime residential mortgage-related and ABS CDO securities and related instruments that are classified as Level 3.
 
Certain assets and liabilities are measured at fair value on a non-recurring basis and, as such, are not included in the tables above. These assets and liabilities include loans and loan commitments classified


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as held for sale and reported at lower of cost or market and assets that are measured at cost that have been written down to fair value during the period as a result of an impairment. The following table shows the fair value hierarchy for those assets and liabilities measured at fair value on a non-recurring basis as of September 28, 2007.
 
                                                 
(dollars in millions)
                    Losses
                    Three Months
  Nine Months
    Non-Recurring Basis as of September 28, 2007   Ended
  Ended
    Level 1   Level 2   Level 3   Total   Sept. 28, 2007   Sept. 28, 2007
 
 
Assets:
                                               
Loans, notes, and
mortgages
  $ -     $ 15,784     $ 6,585     $ 22,369     $ (633 )   $ (626 )
Goodwill and other
intangible assets
    -       -       53       53       (107 )     (107 )
Other assets
    -       28       -       28       (1 )     (4 )
                                                 
Liabilities:
                                               
Other liabilities
  $ -     $ 471     $ -     $ 471     $ (310 )   $ (355 )
 
 
 
Loans, notes, and mortgages include held for sale loans that are carried at the lower of cost or market and for which the fair value was below the cost basis at September 28, 2007. It also includes certain impaired held for investment loans where an allowance for loan losses has been calculated based upon the fair value of the loans. Level 3 assets primarily relate to residential and commercial real estate loans in the United Kingdom that are classified as held for sale of $4.8 billion. The losses on the Level 3 loans were calculated primarily by models incorporating internally derived credit spreads and discounted cash flow valuations of the collateral. Losses related to Level 2 loans were calculated by models incorporating significant observable market data.
 
Goodwill and other intangible assets measured at fair value on a non-recurring basis relate to intangible assets (mortgage broker relationships) that were acquired in connection with the First Franklin acquisition. Losses of $107 million represent an impairment charge related to these intangible assets recorded in the third quarter of 2007. The fair value of these intangible assets was calculated based upon discounted cash flow projections.
 
Other liabilities include amounts recorded for loan commitments in which the funded loan will be held for sale, particularly leveraged loan commitments in the United States. The losses were calculated by models incorporating significant observable market data.
 
Fair Value Option
 
SFAS No. 159 provides a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities. Changes in fair value for assets and liabilities for which the election is made will be recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. As discussed above, certain of Merrill Lynch’s financial instruments are required to be accounted for at fair value under SFAS No. 115 and SFAS No. 133 as well as industry level guidance. For certain financial instruments that are not accounted for at fair value under other applicable accounting guidance, the fair value option has been elected.


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The following table presents a summary of eligible financial assets and financial liabilities for which the fair value option was elected on December 30, 2006 and the cumulative-effect adjustment to retained earnings recorded in connection with the initial adoption of SFAS No. 159.
 
                         
(dollars in millions)
        Transition Adjustments
   
    Carrying Value
  to Retained Earnings
  Carrying Value
    Prior to Adoption   Gain/(Loss)   After Adoption
 
 
Assets:
                       
Investment securities
  $ 8,723     $ (268 )   $ 8,732  
Loans, notes, and mortgages
    1,440       2       1,442  
                         
Liabilities:
                       
Long-term borrowings
  $ 10,308     $ (29 )   $ 10,337  
                         
Pre-tax cumulative-effect of adoption
          $ (295 )        
Deferred tax benefit
            110          
                         
Cumulative effect of adoption of the fair value option
          $ (185 )        
 
 
 
The following table provides information about where in the Condensed Consolidated Statement of Earnings changes in fair values, for which the fair value option has been elected, are included for the three and nine month periods ended September 28, 2007.
 
                                                 
(dollars in millions)
        Changes in Fair Value
    Changes in Fair Value for the Three
  for the Nine Months Ended
    Months Ended September 28, 2007,
  September 28, 2007,
    for Items Measured at Fair Value
  for Items Measured at Fair Value
    Pursuant to Fair Value Option   Pursuant to Fair Value Option
         
    Gains/
  Gains/
      Gains/
       
    (losses)
  (losses)
  Total
  (losses)
  Gains
  Total
    Principal
  Other
  Changes in
  Principal
  Other
  Changes in
    Transactions   Revenues   Fair Value   Transactions   Revenues   Fair Value
     
 
Assets:
                                               
Receivables under resale
agreements
  $ 62     $ -     $ 62     $ 67     $ -     $ 67  
Investment securities
    (68 )     (1 )     (69 )     142       20       162  
Loans, notes and mortgages
    (3 )     20       17       (1 )     60       59  
                                                 
Liabilities:
                                               
Payables under repurchase agreements
  $ (10 )   $ -     $ (10 )   $ 7     $ -     $ 7  
Long-term borrowings
    576       -       576       1,417       -       1,417  
 
 
 
The following describes the rationale for electing to account for certain financial assets and liabilities at fair value, as well as the impact of instrument-specific credit risk on the fair value.
 
Resale and repurchase agreements:
 
Merrill Lynch elected the fair value option on a prospective basis for certain resale and repurchase agreements. The fair value option election was made based on the tenor of the resale and repurchase agreements, which reflects the magnitude of the interest rate risk. Resale and repurchase agreements collateralized by U.S. and Japanese government securities were excluded from the fair value option election as these contracts are generally short-dated and therefore the interest rate risk is not considered significant. Resale and repurchase agreements require collateral to be maintained with a market value equal to or in excess of the principal amount loaned resulting in immaterial credit risk for such transactions.


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Investment securities:
 
Merrill Lynch elected the fair value option for certain fixed rate securities in its treasury liquidity portfolio previously classified as available-for-sale securities as management modified its investment strategy and economic exposure to interest rate risk by eliminating long-term fixed rate assets in its liquidity portfolio and replacing them with floating rate assets. These securities were carried at fair value in accordance with SFAS No. 115 prior to the adoption of SFAS No. 159. An unrealized loss of $172 million, net of tax, related to such securities was reclassified from accumulated other comprehensive loss to retained earnings.
 
Loans, notes, and mortgages:
 
Merrill Lynch elected the fair value option for automobile and certain corporate loans because the loans are risk managed on a fair value basis. The change in the fair value of loans, notes, and mortgages for which the fair value option was elected that was attributable to changes in borrower-specific credit risk was not material for all periods presented.
 
Long-term borrowings:
 
Merrill Lynch elected the fair value option for certain long-term borrowings that are risk managed on a fair value basis and for which hedge accounting under SFAS No. 133 had been difficult to obtain. The changes in the fair value of liabilities for which the fair value option was elected that was attributable to changes in Merrill Lynch credit spreads were $609 million and $656 million, respectively, for the three and nine months ended September 28, 2007. Changes in Merrill Lynch specific credit risk is derived by isolating fair value changes due to changes in Merrill Lynch’s credit spreads as observed in the secondary cash market.
 
The following table presents the difference between fair values and the aggregate contractual principal amounts of loans, notes, and mortgages and long-term borrowings for which the fair value option has been elected.
 
                         
(dollars in millions)
        Principal
   
        Amount
   
    Fair Value at
  Due Upon
   
    September 28, 2007   Maturity   Difference
 
 
Assets
                       
Loans, notes and mortgages(1)
  $ 987     $ 1,205     $ (218 )
                         
Liabilities
                       
Long-term borrowings(2)
  $ 70,129     $ 71,990     $ (1,861 )
 
 
(1) The majority of the difference relates to loans purchased at a substantial discount from the principal amount.
(2) The majority of the difference relates to zero coupon notes issued at a substantial discount from the principal amount and the impact of the widening of Merrill Lynch’s credit spreads.
 
At September 28, 2007, the difference between the fair value and the aggregate contractual principal amount of receivables under resale agreements and payables under repurchase agreements for which the fair value option has been elected was not material to the Condensed Consolidated Financial Statements.


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For those loans, notes and mortgages for which the fair value option has been elected, the aggregate fair value of loans that are 90 days or more past due and in non-accrual status is not material to the Condensed Consolidated Financial Statements.
 
Hybrid Financial Instruments
 
In February 2006, the FASB issued SFAS No. 155, which clarifies the bifurcation requirements for certain financial instruments and permits hybrid financial instruments that contain a bifurcatable embedded derivative 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. At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instruments and the fair value of the combined hybrid financial instruments is recognized as a cumulative-effect adjustment to beginning retained earnings. Merrill Lynch adopted SFAS No. 155 on a prospective basis beginning in the first quarter of 2007. Since SFAS No. 159 incorporates accounting and disclosure requirements that are similar to SFAS No. 155, Merrill Lynch applies SFAS No. 159, rather than SFAS No. 155, to its fair value elections for hybrid financial instruments.
 
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 September 28, 2007 and December 29, 2006, the fair value of securities received as collateral where Merrill Lynch is permitted to sell or repledge the securities was $827 billion and $633 billion, respectively, and the fair value of the portion that has been sold or repledged was $656 billion and $498 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 September 28, 2007 and December 29, 2006, the fair value of collateral used for this purpose was $11.7 billion, and $19.3 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 on the Condensed Consolidated Balance Sheets. The carrying value and classification of securities owned by Merrill Lynch that have been pledged to counterparties where


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those counterparties do not have the right to sell or repledge at September 28, 2007 and December 29, 2006 are as follows:
 
                 
(dollars in millions)
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
Trading asset category
               
Mortgages, mortgage-backed, and asset-backed securities
  $ 27,253     $ 34,475  
U.S. Government and agencies
    10,790       12,068  
Corporate debt and preferred stock
    16,326       11,454  
Non-U.S. governments and agencies
    8,994       4,810  
Equities and convertible debentures
    920       4,812  
Municipals and money markets
    600       975  
                 
Total
  $ 64,883     $ 68,594  
 
Note 5.  Investment Securities
 
Investment securities on the Condensed 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.
 
Investment securities at September 28, 2007 and December 29, 2006 are presented below:
 
                 
(dollars in millions)
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
Investment securities
               
Available-for-sale(1)
  $ 55,924     $ 56,292  
Trading
    9,481       6,512  
Held-to-maturity
    263       269  
Non-qualifying(2)
               
Equity investments(3)
    28,519       21,290  
Investments of insurance subsidiaries(4)
    1,228       1,360  
Deferred compensation hedges(5)
    1,800       1,752  
Investments in trust preferred securities and other investments
    438       715  
                 
Total
  $ 97,653     $ 88,190  
(1) At September 28, 2007 and December 29, 2006, includes $4.9 billion and $4.8 billion, respectively, of investment securities reported in cash and securities segregated for regulatory purposes or deposited with clearing organizations.
(2) Non-qualifying for SFAS 115 purposes.
(3) Includes Merrill Lynch’s investment in BlackRock.
(4) Primarily represents insurance policy loans held by MLIG. Refer to Note 17 to the Condensed Consolidated Financial Statements for further information on MLIG.
(5) Represents investments that economically hedge deferred compensation liabilities.
 
Merrill Lynch reviews its held-to-maturity and available-for-sale securities at least quarterly to determine whether any impairment is other-than-temporary. Factors considered in the review include


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length of time and extent to which market value has been less than cost, the financial condition and near term prospects of the issuer, and Merrill Lynch’s intent and ability to retain the security to allow for an anticipated recovery in market value. As of September 28, 2007, Merrill Lynch determined that certain available-for-sale securities primarily related to U.S. ABS CDO securities were other-than-temporarily impaired and recognized a loss of approximately $160 million for the nine months ended September 28, 2007, of which $140 million was recognized in the third quarter of 2007. At December 29, 2006, Merrill Lynch did not consider these securities to be other-than-temporarily impaired.
 
Note 6.  Securitization Transactions and Transactions with Special Purpose Entities (“SPEs”)
 
Securitizations
 
In the normal course of business, Merrill Lynch securitizes commercial and residential mortgage loans, municipal, government, and corporate bonds, and other types of financial assets. SPEs, often referred to as Variable Interest Entities (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, or for the benefit of, SPEs.
 
Merrill Lynch securitized assets of approximately $154.4 billion and $98.7 billion for the nine months ended September 28, 2007 and September 29, 2006, respectively. For the nine months ended September 28, 2007 and September 29, 2006, Merrill Lynch received $156.8 billion and $99.1 billion, respectively, of proceeds, and other cash inflows, from securitization transactions, and recognized net securitization gains of $286.8 million and $200.7 million, respectively, in Merrill Lynch’s Condensed Consolidated Statements of Earnings.
 
For the first nine months of 2007 and 2006, cash inflows from securitizations related to the following asset types:
 
                 
(dollars in millions)
 
    Nine Months Ended
     
    Sept. 28,
  Sept. 29,
    2007   2006
 
Asset category
               
Residential mortgage loans
  $ 92,558     $ 67,777  
Municipal bonds
    46,358       18,994  
Commercial loans and other
    13,502       9,155  
Corporate and government bonds
    4,430       3,220  
                 
Total
  $ 156,848     $ 99,146  
 
Retained interests in securitized assets were approximately $10.1 billion and $6.8 billion at September 28, 2007 and December 29, 2006, respectively, which related primarily to residential mortgage loan, commercial loan and bond, and municipal bond securitization transactions. A portion of the retained interest balance consists of mortgage-backed securities that have limited price transparency. The majority of these retained interests include mortgage-backed securities that Merrill Lynch had expected to sell to investors in the normal course of its underwriting activity. However, the timing of any sale is subject to current and future market conditions. A portion of the retained interests


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represent residual interests in U.S. sub-prime mortgage securitizations and is included in the Level 3 U.S. ABS CDO exposure disclosed in Note 3 to the Condensed Consolidated Financial Statements.
 
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 September 28, 2007 arising from Merrill Lynch’s residential mortgage loan, municipal bond and other securitization transactions. The pre-tax sensitivities of the current fair value of the retained interests to immediate 10% and 20% adverse changes in assumptions and parameters are also shown.
 
                         
(dollars in millions)
 
    Residential
       
    Mortgage
  Municipal
   
    Loans   Bonds   Other
 
Retained interest amount
  $ 5,946     $ 1,283     $ 2,868  
Weighted average credit losses (rate per annum)
    1.7 %     0.0 %     0.2 %
Range
    0-20.0 %     0.0 %     0-4.0 %
Impact on fair value of 10% adverse change
  $ (94 )   $ -     $ (4 )
Impact on fair value of 20% adverse change
  $ (185 )   $ -     $ (8 )
Weighted average discount rate
    11.3 %     4.2 %     5.3 %
Range
    0-76.4 %     3.5-8.0 %     0-26.6 %
Impact on fair value of 10% adverse change
  $ (262 )   $ (87 )   $ (55 )
Impact on fair value of 20% adverse change
  $ (506 )   $ (162 )   $ (107 )
Weighted average life (in years)
    4.5       6.5       2.2  
Range
    0-29.6       0-12.2       1.7-9.8  
Weighted average prepayment speed (CPR)(1)
    20.9 %     41.3 %     36.4 %
Range(1)
    0-65.5 %     8.0-47.8 %     16-92 %
Impact on fair value of 10% adverse change
  $ (136 )   $ -     $ (3 )
Impact on fair value of 20% adverse change
  $ (235 )   $ -     $ (5 )
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.
 
The weighted average assumptions and parameters used initially to value retained interests relating to securitizations that were still held by Merrill Lynch as of September 28, 2007 are as follows:
 
                                 
    Residential
           
    Mortgage
  Municipal
       
    Loans   Bonds   Other    
 
Credit losses (rate per annum)
    1.6 %     0.0 %     0.2 %        
Weighted average discount rate
    9.8 %     3.9 %     6.1 %        
Weighted average life (in years)
    5.2       6.7       2.8          
Prepayment speed assumption (CPR)(1)
    20.6 %     9.0 %     17.1 %        


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CPR=Constant Prepayment Rate
(1) Relates to select securitization transactions where assets are prepayable.
 
For residential mortgage loan and other securitizations, the investors and the securitization trust generally have no recourse to Merrill Lynch upon the event of a borrower default. See Note 12 to the Condensed Consolidated Financial Statements for information related to representations and warranties.
 
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, 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. Additional information regarding these commitments is provided in Note 12 to the Condensed Consolidated Financial Statements and in Note 12 of the 2006 Annual Report.
 
The following table summarizes the total principal amounts outstanding and delinquencies of securitized financial assets held in SPE’s, where Merrill Lynch holds retained interests, as of September 28, 2007 and December 29, 2006:
 
                         
(dollars in millions)
 
    Residential
       
    Mortgage
  Municipal
   
    Loans   Bonds   Other
 
September 28, 2007
                       
Principal Amount Outstanding
  $ 156,028     $ 22,090     $ 29,733  
Delinquencies
    9,705       -       19  
December 29, 2006
                       
Principal Amount Outstanding
  $ 124,795     $ 18,986     $ 33,024  
Delinquencies
    3,493       -       10  
 
Net credit losses associated with securitized financial assets held in these SPEs for the nine months ended September 28, 2007 and September 29, 2006 approximated $427 million and $79 million, respectively.
 
Mortgage Servicing Rights
 
In connection with its residential mortgage business, Merrill Lynch may retain or acquire servicing rights associated with certain mortgage loans that are sold through its securitization activities. These loan sale transactions create assets referred to as mortgage servicing rights, or MSRs, which are included within other assets on the Condensed Consolidated Balance Sheets.
 
In March 2006 the FASB issued SFAS No. 156, which amends SFAS No. 140, and requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if


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practicable. SFAS No. 156 also permits servicers to subsequently measure each separate class of servicing assets and liabilities at fair value rather than at the lower of amortized cost or market. Merrill Lynch adopted SFAS No. 156 on December 30, 2006. Merrill Lynch has not elected to subsequently fair value those MSRs held as of the date of adoption or those MSRs acquired or retained after December 30, 2006.
 
Retained MSRs are initially recorded at fair value and subsequently amortized in proportion to and over the period of estimated future net servicing revenues. MSRs are assessed for impairment, at a minimum, on a quarterly basis. Management’s estimates of fair value of MSRs are determined using the net discounted present value of future cash flows, which consists of projecting future servicing cash flows and discounting such cash flows using an appropriate risk-adjusted discount rate. These valuations require various assumptions, including future servicing fees, servicing costs, credit losses, discount rates and mortgage prepayment speeds. Due to subsequent changes in economic and market conditions, these assumptions can, and generally will, change from quarter to quarter.
 
Changes in Merrill Lynch’s MSR balance are summarized below:
 
         
(dollars in millions)
 
    Carrying Value
 
 
Mortgage servicing rights, December 29, 2006 (fair value is $164)
  $ 122  
Additions(1)
    505  
Amortization
    (190 )
Valuation allowance adjustments
    (1 )
         
Mortgage servicing rights, Sept. 28, 2007 (fair value is $556 )
  $ 436  
(1) Includes MSRs obtained in connection with the acquisition of First Franklin and First Republic.
 
The amount of contractually specified revenues, which are included within managed accounts and other fee-based revenues in the Condensed Consolidated Statements of Earnings include:
 
                 
(dollars in millions)        
 
    For the Three
  For the Nine
    Months Ended
  Months Ended
    Sept. 28,
  Sept. 28,
    2007   2007
 
 
Servicing fees
  $ 96     $ 262  
Ancillary and late fees
    17       47  
                 
Total
  $ 113     $ 309  
 
The following table presents Merrill Lynch’s key assumptions used in measuring the fair value of MSRs at September 28, 2007 and the pre-tax sensitivity of the fair values to an immediate 10% and 20% adverse change in these assumptions:
 
         
(dollars in millions)
 
 
Fair value of capitalized MSRs
  $ 556  
Weighted average prepayment speed (CPR)
    30.5 %
Impact of fair value of 10% adverse change
  $ (43 )
Impact of fair value of 20% adverse change
  $ (58 )
Weighted average discount rate
    16.9 %
Impact of fair value of 10% adverse change
  $ (13 )
Impact of fair value of 20% adverse change
  $ (27 )


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The sensitivity analysis above is hypothetical and should be used with caution. In particular, the effect of a variation in a particular assumption on the fair value of MSRs is calculated independent of changes in any other assumption; in practice, changes in one factor may result in changes in another factor, which may magnify or counteract the sensitivities. Further changes in fair value based on a single variation in assumptions generally cannot be extrapolated because the relationship of the change in a single assumption to the change in fair value may not be linear.
 
Variable Interest Entities
 
FIN 46R requires an entity to consolidate a VIE if that enterprise has a variable interest that will absorb a majority of the variability of the VIE’s expected losses, receive a majority of the variability of the VIE’s expected residual returns, or both. The entity required to consolidate a VIE is known as the primary beneficiary. A QSPE is 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 and FIN 46R, Merrill Lynch does not consolidate QSPEs. Information regarding QSPEs can be found in the Securitization section of this Note and the Guarantees section in Note 12 to the Condensed 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.
 
The following tables summarize Merrill Lynch’s involvement with certain VIEs as of September 28, 2007 and December 29, 2006, respectively. The table below does not include information on QSPEs or those VIEs where Merrill Lynch is the primary beneficiary and holds a majority of the voting interests in the entity.
 
                                         
(dollars in millions)
 
               
Significant Variable
    Primary Beneficiary   Interest Holder
     
    Total
  Net
  Recourse
  Total
   
    Asset
  Asset
  to Merrill
  Asset
  Maximum
    Size(4)   Size(5)   Lynch(6)   Size(4)   Exposure
 
September 28, 2007
                                       
Loan and real estate VIEs
  $ 23,555     $ 22,650     $ -     $ 287     $ 216  
Tax planning VIEs(1)
    4,997       4,997       -       483       15  
Guaranteed and other funds(2)
    4,150       3,350       156       2,237       2,997  
Credit-linked note and other VIEs(3)
    663       87       -       7,329       9,934  
 
 
December 29, 2006
                                       
Loan and real estate VIEs
  $ 4,265     $ 3,787     $ -     $ 278     $ 182  
Tax planning VIEs(1)
    -       -       -       483       15  
Guaranteed and other funds(2)
    3,184       2,615       564       6,156       6,156  
Credit-linked note and other VIEs(3)
    41       41       -       -       -  
 
 
(1) The maximum exposure for tax planning VIEs reflects indemnifications made by Merrill Lynch to investors in the VIEs.
(2) The maximum exposure for guaranteed and other funds is the fair value of Merrill Lynch’s investments, derivatives entered into with the VIEs if they are in an asset position, and liquidity and credit facilities with certain VIEs.
(3) The maximum exposure for credit-linked note and other VIEs is the notional amount of total return swaps that Merrill Lynch has entered into with the VIEs.
(4) This column reflects the total size of the assets held in the VIE.
(5) This column reflects the size of the assets held in the VIE after accounting for intercompany eliminations and any balance sheet netting of assets and liabilities as permitted by FIN 39.


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(6) This column reflects the extent, if any, to which investors have recourse to Merrill Lynch beyond the assets held in 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:
 
Loan and Real Estate VIEs
 
  •   Merrill Lynch has investments in VIEs that hold loans or real estate. Merrill Lynch may be either the primary beneficiary which would result in consolidation of the VIE, or may be a significant variable interest holder. These VIEs include entities that are primarily designed to provide financing to clients and to invest in real estate. In addition, these VIEs include securitization vehicles that Merrill Lynch is required to consolidate because QSPE status has not been met and Merrill Lynch is the primary beneficiary as it retains the residual interests. For consolidated VIEs that hold loans, the assets of the VIEs are recorded in trading assets — mortgages, mortgage-backed and asset-backed, other assets, or loans, notes, and mortgages in the Condensed Consolidated Balance Sheets. For consolidated VIEs that hold real estate investments, these assets are included in other assets in the Condensed Consolidated Balance Sheets. 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. The increase in total and net asset size in the table above for Loan and Real Estate VIEs is a result of Merrill Lynch’s inability to sell mortgage related securities because of the illiquidity in the securitization markets. Merrill Lynch’s inability to sell certain securities disqualified the VIEs as QSPEs thereby resulting in Merrill Lynch’s consolidation of the VIEs.
 
Tax Planning VIEs
 
  •   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 assets or investment securities.
 
Guaranteed and Other Funds
 
  •   Merrill Lynch is the sponsor of funds that 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 assets. In instances where Merrill Lynch is not the primary beneficiary, the guarantees related to these funds are further discussed in Note 12 to the Condensed Consolidated Financial Statements.
 
  •   Merrill Lynch has made certain investments in alternative investment fund structures that are VIEs. Merrill Lynch is the primary beneficiary of these funds as a result of its substantial


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  investment in the vehicles. Merrill Lynch records its interests in these VIEs primarily in investment securities in the Condensed Consolidated Balance Sheets.
 
  •   Merrill Lynch has established two asset-backed commercial paper conduits (“Conduits”) for which it has significant variable interests. Its significant variable interests are in the form of 1) liquidity facilities that protect commercial paper holders against short term changes in the fair value of the assets held by the Conduits in the event of a disruption in the commercial paper market, and 2) credit facilities to the Conduits that protect commercial paper investors against credit losses for up to a certain percentage of the portfolio of assets held by the respective Conduits. During the third quarter of 2007, Merrill Lynch purchased $5.1 billion of assets held by the Conduits through the exercise of the liquidity facilities. The decrease in total asset size and maximum exposure for Guaranteed and Other funds in the table above is primarily the result of the purchase of these assets. Merrill Lynch also purchased $300 million of the commercial paper issued by the Conduits. The liquidity and credit facilities are further discussed in Note 12 to the Condensed Consolidated Financial Statements.
 
Credit-linked Note and Other VIEs
 
  •   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 also takes synthetic exposure to the underlying investment grade collateral held in these VIEs, which includes mortgage-related assets, through total return swaps. Merrill Lynch’s involvement with these VIEs provides it with a significant variable interest. Merrill Lynch records its transactions with these VIEs as contractual agreements (derivatives) in the Condensed Consolidated Balance Sheets.
 
  •   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 that 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 September 28, 2007 and December 29, 2006 the assets of the VIE totaled approximately $16 million, representing a purchased credit default agreement, which is recorded in other assets on the Condensed 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.
 
Note 7. Loans, Notes, Mortgages and Related Commitments to Extend Credit
 
Loans, notes, mortgages and related commitments to extend credit include:
 
  •   Consumer loans, which are substantially secured, including residential mortgages, home equity loans, and other loans to individuals for household, family, or other personal expenditures.
 
  •   Commercial loans including corporate and institutional loans (including corporate and financial sponsor, non-investment grade lending commitments), commercial mortgages, asset-based loans, small- and middle-market business loans, and other loans to businesses.


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Loans, notes, mortgages and related commitments to extend credit at September 28, 2007 and December 29, 2006, are presented below. This disclosure includes commitments to extend credit that, if drawn upon, will result in loans held for investment or loans held for sale.
 
                                 
(dollars in millions)
 
    Loans   Commitments(1)
     
    Sept. 28,
  Dec. 29,
  Sept. 28,
  Dec. 29,
    2007   2006   2007(2)(3)   2006(3)
 
 
Consumer:
                               
Mortgages
  $ 24,499     $ 18,346     $ 7,891     $ 7,747  
Other
    6,276       4,224       1,471       547  
Commercial and small- and middle-market business:
                               
Secured investment grade
    16,982       19,582       12,644       14,657  
Secured non-investment grade
    37,753       26,062       42,344       33,704  
Unsecured investment grade
    5,326       2,870       26,860       30,607  
Unsecured non-investment grade
    3,937       2,423       2,311       9,108  
                                 
      94,773       73,507       93,521       96,370  
Allowance for loan losses
    (588 )     (478 )     -       -  
Reserve for lending-related commitments
    -       -       (893 )     (381 )
                                 
Total, net
  $ 94,185     $ 73,029     $ 92,628     $ 95,989  
 
 
(1) Commitments are outstanding as of the date the commitment letter is issued and are comprised of closed and contingent commitments. Closed commitments represent the unfunded portion of existing commitments available for draw down. Contingent commitments are contingent on the borrower fulfilling certain conditions or upon a particular event, such as an acquisition. A portion of these contingent commitments may be syndicated among other lenders or replaced with capital markets funding.
(2) See Note 12 to the Condensed Consolidated Financial Statements for a maturity profile of these commitments.
(3) In addition to the loan origination commitments included in the table above, at September 28, 2007, Merrill Lynch entered into agreements to purchase $524 million of loans that, upon settlement of the commitment, will be classified in loans held for investment and loans held for sale. Similar loan purchase commitments totaled $1.2 billion at December 29, 2006. See Note 12 to the Condensed Consolidated Financial Statements for additional information.
 
Activity in the allowance for loan losses is presented below:
 
                 
(dollars in millions)
 
    Nine Months Ended
     
    Sept. 28,
  Sept. 29,
    2007   2006
 
 
Allowance for loan losses, at beginning of period
  $ 478     $ 406  
Provision for loan losses
    96       99  
Charge-offs
    (53 )     (37 )
Recoveries
    25       12  
                 
Net charge-offs
    (28 )     (25 )
Other(1)
    42       1  
                 
Allowance for loan losses, at end of period
  $ 588     $ 481  
 
 
(1) Other activity for the nine months ended September 28, 2007 primarily relates to the deconsolidation of two VIEs during the second quarter of 2007 and the First Republic acquisition in the third quarter of 2007.
 
Consumer loans, which are substantially secured, consisted of approximately 234,200 individual loans at September 28, 2007. Commercial loans consisted of approximately 18,400 separate loans. The principal balance of non-accrual loans was $533 million at September 28, 2007 and $209 million at December 29, 2006. The investment grade and non-investment grade categorization is determined using the credit rating agency equivalent of internal credit ratings. Non-investment grade counterparties


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are those rated lower than the BBB category. In some cases Merrill Lynch enters into credit default swaps to mitigate credit exposure related to funded and unfunded commercial loans. The notional value of these swaps totaled $13.9 billion and $10.3 billion at September 28, 2007 and December 29, 2006, respectively. For information on credit risk management see Note 6 of the 2006 Annual Report.
 
The above amounts include $32.4 billion and $18.6 billion of loans held for sale at September 28, 2007 and December 29, 2006, respectively. Loans held for sale are loans that management expects to sell prior to maturity. At September 28, 2007, such loans consisted of $10.6 billion of consumer loans, primarily residential mortgages and automobile loans, and $21.8 billion of commercial loans, approximately 26% of which are to investment grade counterparties. At December 29, 2006, such loans consisted of $7.4 billion of consumer loans, primarily residential mortgages and automobile loans, and $11.2 billion of commercial loans, approximately 38% of which are to investment grade counterparties.
 
For additional information on loans, notes and mortgages, see Notes 1 and 8 of the 2006 Annual Report.
 
Note 8.  Goodwill and Other Intangibles
 
Goodwill
 
Goodwill is the cost of an acquired company in excess of the fair value of identifiable net assets at acquisition date. Goodwill is tested annually (or more frequently under certain conditions) for impairment at the reporting unit level in accordance with SFAS No. 142, Goodwill and Other Intangible Assets.
 
The following table sets forth the changes in the carrying amount of Merrill Lynch’s goodwill by business segment, for the nine months ended September 28, 2007:
 
                         
(dollars in millions)    
 
    GMI   GWM   Total
 
 
Goodwill:
                       
December 29, 2006
  $ 1,907     $ 302     $ 2,209  
Goodwill acquired
    1,003       1,071       2,074  
Translation adjustment and other
    52       2       54  
                         
September 28, 2007
  $ 2,962     $ 1,375     $ 4,337  
 
 
 
GMI activity primarily relates to goodwill acquired in connection with the acquisition of First Franklin whose operations were integrated into GMI’s mortgage securitization business. GWM activity primarily relates to goodwill acquired in connection with the acquisition of First Republic. At September 28, 2007, in response to the deterioration in the sub-prime mortgage markets, Merrill Lynch performed a goodwill impairment test. Based on this test, Merrill Lynch determined that there was no impairment of goodwill on a consolidated basis.
 
Other Intangible Assets
 
Other intangible assets consist primarily of value assigned to customer relationships and core deposits. Other intangible assets are tested annually (or more frequently under certain conditions) for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, and are amortized over their respective estimated useful lives.


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In connection with the acquisition of First Franklin, Merrill Lynch recorded identifiable intangible assets of $185 million. In response to the deterioration in the sub-prime mortgage markets, Merrill Lynch reviewed its identifiable intangible assets for impairment at September 28, 2007 and recorded an impairment charge of $107 million related to mortgage broker relationships of First Franklin.
 
The gross carrying amounts of other intangible assets were $667 million and $321 million as of September 28, 2007 and December 29, 2006, respectively. Accumulated amortization of other intangible assets amounted to $113 million and $73 million at September 28, 2007 and December 29, 2006, respectively.
 
Amortization expense for the three and nine months ended September 28, 2007 was $128 million and $171 million, respectively, which included the write-off above of identifiable intangible assets related to First Franklin mortgage broker relationships in the third quarter of 2007. Amortization expense for the three and nine months ended September 29, 2006 was $11 million and $33 million, respectively.
 
Note 9.  Borrowings and Deposits
 
ML & Co. is the primary issuer of all of Merrill Lynch’s debt instruments. For local tax or regulatory reasons, debt is also issued by certain subsidiaries.
 
The value of Merrill Lynch’s debt instruments as recorded on the Condensed Consolidated Balance Sheets does not necessarily represent the amount at which they will be repaid at maturity. This is due to the following:
 
  •   Certain debt issuances are issued at a discount to their redemption amount, which will accrete up to the redemption amount as they approach maturity;
 
  •   Certain debt issuances are accounted for at fair value and incorporate changes in Merrill Lynch’s creditworthiness as well as other underlying risks (see Note 3 to the Condensed Consolidated Financial Statements);
 
  •   Certain structured notes whose coupon or repayment terms are linked to the performance of debt and equity securities, indices, currencies or commodities will take into consideration the fair value of those risks; and
 
  •   Certain debt issuances are adjusted for the impact of the application of fair value hedge accounting (see Note 1 to the Condensed Consolidated Financial Statements).


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Total borrowings at September 28, 2007 and December 29, 2006, which are comprised of short-term borrowings, long-term borrowings and junior subordinated notes (related to trust preferred securities), consisted of the following:
 
                 
(dollars in millions)
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
Senior debt issued by ML & Co. 
  $ 140,023     $ 115,474  
Senior debt issued by subsidiaries — guaranteed by ML & Co. 
    33,986       26,664  
Subordinated debt issued by ML & Co. 
    10,875       6,429  
Structured notes issued by ML & Co. 
    49,268       25,466  
Structured notes issued by subsidiaries — guaranteed by ML & Co. 
    12,993       8,349  
Junior subordinated notes (related to trust preferred securities)
    5,154       3,813  
Other subsidiary financing — not guaranteed by ML & Co. 
    5,396       4,316  
Other subsidiary financing — non-recourse
    39,417       12,812  
                 
Total
  $ 297,112     $ 203,323  
 
 
 
Borrowing activities may create exposure to market risk, most notably interest rate, equity, commodity and currency risk. Other subsidiary financing — non-recourse is primarily attributable to consolidated entities that are VIEs. Additional information regarding VIEs is provided in Note 6 to the Condensed Consolidated Financial Statements.
 
Borrowings and Deposits at September 28, 2007 and December 29, 2006, are presented below:
 
                 
(dollars in millions)
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
 
Short-term borrowings
               
Commercial paper
  $ 11,237     $ 6,357  
Promissory notes
    3,450       -  
Secured short-term borrowings
    7,728       9,800  
Other unsecured short-term borrowings
    4,663       1,953  
                 
Total
  $ 27,078     $ 18,110  
                 
Long-term borrowings(1)
               
Fixed-rate obligations(2)(4)
  $ 100,772     $ 58,366  
Variable-rate obligations(3)(4)
    161,898       120,794  
Zero-coupon contingent convertible debt (LYONs®)
    2,210       2,240  
                 
Total
  $ 264,880     $ 181,400  
                 
Deposits
               
U.S
  $ 69,461     $ 62,294  
Non U.S
    25,516       21,830  
                 
Total
  $ 94,977     $ 84,124  
 
 
(1) Excludes junior subordinated notes (related to trust preferred securities).
(2) Fixed-rate obligations are generally swapped to floating rates.
(3) Variable interest rates are generally based on rates such as LIBOR, the U.S. Treasury Bill Rate, or the Federal Funds Rate.
(4) Included are various equity-linked or other indexed instruments.


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At September 28, 2007, long-term borrowings mature as follows:
 
                     
(dollars in millions)    
 
 
Less than 1 year
  $ 56,613       21 %    
1 - 2 years
    49,451       19      
2+ - 3 years
    28,525       11      
3+ - 4 years
    14,559       5      
4+ - 5 years
    30,273       11      
Greater than 5 years
    85,459       33      
                     
Total
  $ 264,880       100 %    
 
 
 
Certain long-term borrowing agreements contain provisions whereby the borrowings are redeemable at the option of the holder at specified dates prior to maturity. These borrowings are reflected in the above table as maturing at 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.
 
A limited number of notes whose coupon or repayment terms are linked to the performance of debt and equity securities, indices, currencies or commodities may be accelerated based on the value of a referenced index or security, in which case Merrill Lynch may be required to immediately settle the obligation for cash or other securities. Refer to Note 1 of the 2006 Annual Report, Embedded Derivatives section for additional information.
 
Except for the $2.2 billion of aggregate principal amount of floating rate zero-coupon contingently convertible liquid yield option notes (“LYONs®”) that were outstanding at September 28, 2007, senior and subordinated 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. See Note 9 of the 2006 Annual Report for additional information regarding conditions surrounding LYONs® conversion.
 
The effective weighted-average interest rates for borrowings at September 28, 2007 and December 29, 2006 were:
 
                 
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
 
Short-term borrowings
    4.99 %     5.15 %
Long-term borrowings, contractual rate
    4.67       4.23  
Junior subordinated notes (related to trust preferred securities)
    6.91       7.03  
 
 
 
See Note 9 of the 2006 Annual Report for additional information on Borrowings.
 
Merrill Lynch also obtains standby letters of credit from issuing banks to satisfy various counterparty collateral requirements, in lieu of depositing cash or securities collateral. Such standby letters of credit aggregated $4.4 billion and $2.5 billion at September 28, 2007 and December 29, 2006, respectively.


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Note 10.  Comprehensive (Loss)/Income
 
The components of comprehensive (loss)/income are as follows:
 
(dollars in millions)
                                 
 
    Three Months Ended   Nine Months Ended
     
    Sept. 28,
  Sept. 29,
  Sept. 28,
  Sept. 29,
    2007   2006   2007   2006
 
 
Net (loss)/earnings
  $ (2,241 )   $ 3,045     $ 2,056     $ 5,153  
Other comprehensive (loss)/income, net of tax:
                               
Foreign currency translation adjustment
    (9 )     48       15       4  
Net unrealized (losses)/gains on investment securities available-for-sale
    (741 )     122       (765 )     (53 )
Deferred gains on cash flow hedges
    46       17       19       17  
Defined benefit pension and postretirement plans
    4       (2 )     13       (1 )
                                 
Total other comprehensive (loss)/income, net of tax
    (700 )     185       (718 )     (33 )
                                 
Comprehensive (loss)/income
  $ (2,941 )   $ 3,230     $ 1,338     $ 5,120  
 
 
 
The majority of the net unrealized losses on available-for-sale investment securities for the three months and nine months ended September 28, 2007 relates to mortgage- and asset-backed securities. These securities are SFAS 115 investments held by ML & Co. and certain of its non-broker-dealer entities, including Merrill Lynch’s banking subsidiaries.


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Note 11.  Stockholders’ Equity and Earnings Per Share
 
The following table presents the computations of basic and diluted earnings per share (“EPS”):
 
                                 
(dollars in millions, except per share amounts)
    Three Months Ended   Nine Months Ended
     
    Sept. 28,
  Sept. 29,
  Sept. 28,
  Sept. 29,
    2007   2006   2007   2006
 
 
Net (loss)/earnings from continuing operations
  $ (2,266 )   $ 3,019     $ 1,971     $ 5,084  
Net earnings from discontinued operations
    25       26       85       69  
Preferred stock dividends
    (73 )     (50 )     (197 )     (138 )
                                 
Net (loss)/earnings applicable to common
shareholders - for basic EPS
  $ (2,314 )   $ 2,995     $ 1,859     $ 5,015  
Interest expense on LYONs®(1)
    -       -       -       1  
                                 
Net (loss)/earnings applicable to common
shareholders - for diluted EPS
  $ (2,314 )   $ 2,995     $ 1,859     $ 5,016  
 
 
                                 
(shares in thousands)
                               
Weighted-average basic shares outstanding(2)
    821,565       855,844       832,222       874,985  
Effect of dilutive instruments:
                               
Employee stock options(3)
    -       38,938       36,764       41,364  
FACAAP shares(3)
    -       21,834       20,552       21,452  
Restricted shares and units(3)
    -       28,235       23,524       27,884  
Convertible LYONs®(1)
    -       415       3,213       865  
ESPP shares(3)
    -       8       11       11  
                                 
Dilutive potential common shares
    -       89,430       84,064       91,576  
                                 
Diluted Shares(4)(5)
    821,565       945,274       916,286       966,561  
 
 
Basic EPS from continuing operations
  $ (2.85 )   $ 3.47     $ 2.13     $ 5.65  
Basic EPS from discontinued operations
  $ 0.03     $ 0.03     $ 0.10     $ 0.08  
                                 
Basic EPS
  $ (2.82 )   $ 3.50     $ 2.23     $ 5.73  
Diluted EPS from continuing operations
  $ (2.85 )   $ 3.14     $ 1.94     $ 5.12  
Diluted EPS from discontinued operations
  $ 0.03     $ 0.03     $ 0.09     $ 0.07  
                                 
Diluted EPS
  $ (2.82 )   $ 3.17     $ 2.03     $ 5.19  
 
 
(1) See Note 9 of the 2006 Annual Report for additional information on LYONs®.
(2) Includes shares exchangeable into common stock
(3) See Note 14 of the 2006 Annual Report for a description of these instruments.
(4) Excludes 10 million of instruments for the nine month period ended September 28, 2007, and 33 million of instruments for the three and nine months periods ended September 29, 2006, that were considered antidilutive and thus were not included in the above calculations.
(5) Due to the net loss in the third quarter of 2007, the Diluted EPS calculation excludes 112 million of employee stock options, 37 million of FACAAP shares, 43 million of restricted shares and units, and 183 thousand of ESPP shares, as they were antidilutive.
 
During the third quarter of 2007, Merrill Lynch repurchased 19.9 million common shares at an average repurchase price of $73.91 per share.
 
At September 28, 2007, there was $4.0 billion of authorized repurchase capacity remaining from the $6.0 billion repurchase program authorized by the Board of Directors in April 2007.
 
On March 20, 2007, Merrill Lynch issued $1.5 billion in aggregate principal amount of Floating Rate, Non-Cumulative, Perpetual Preferred Stock, Series 5.


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On September 21, 2007, in connection with the acquisition of First Republic, Merrill Lynch issued two new series of preferred stock, $65 million in aggregate principal amount of 6.70% Non-Cumulative, Perpetual Preferred Stock, Series 6, and $50 million in aggregate principal amount of 6.25% Non-Cumulative, Perpetual Preferred Stock, Series 7. Upon closing the First Republic acquisition, Merrill Lynch also issued 11.6 million shares of common stock, par value $1.331/3 per share, as consideration.
 
Note 12. Commitments, Contingencies and Guarantees
 
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.
 
Some of the legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or otherwise in financial distress. Merrill Lynch is also involved in investigations and/or proceedings by governmental and self-regulatory agencies.
 
Merrill Lynch believes it has strong defenses to, and where appropriate, will vigorously contest, many of these matters. Given the number of these matters, some are likely to result in adverse judgments, penalties, injunctions, fines, or other relief. Merrill Lynch may explore potential settlements before a case is taken through trial because of the uncertainty, risks, and costs inherent in the litigation process. 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 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. Merrill Lynch continues to assess these cases and believes, based on information available to it, that the resolution of these matters will not have a material adverse effect on the financial condition of Merrill Lynch as set forth in the Condensed Consolidated Financial Statements, but may be material to Merrill Lynch’s operating results or cash flows for any particular period and may impact ML & Co.’s credit ratings.
 
Commitments
 
At September 28, 2007, Merrill Lynch’s commitments had the following expirations:
 
                                         
(dollars in millions)
 
        Commitment expiration
        Less than
           
    Total   1 year   1 - 3 years   3+- 5 years   Over 5 years
 
 
Commitments to extend credit(1)
  $ 93,521     $ 38,700     $ 12,442     $ 27,632     $ 14,747  
Purchasing and other commitments
    9,990       5,774       539       845       2,832  
Operating leases
    3,967       612       1,169       953       1,233  
Commitments to enter into resale agreements
    6,988       6,988       -       -       -  
                                         
Total
  $ 114,466     $ 52,074     $ 14,150     $ 29,430     $ 18,812  
 
 
(1) See Note 7 to the Condensed Consolidated Financial Statements.


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Lending Commitments
 
Merrill Lynch primarily enters into commitments to extend credit, predominantly at variable interest rates, in connection with corporate finance, corporate and institutional transactions and asset-based lending transactions. Clients may also be extended loans or lines of credit collateralized by first and second mortgages on real estate, certain liquid assets of small businesses, or securities. These commitments usually have a fixed expiration date and are contingent on certain contractual conditions that may require payment of a fee by the counterparty. Once commitments are drawn upon, Merrill Lynch may require the counterparty to post collateral depending upon creditworthiness and general market conditions. See Note 7 to the Condensed Consolidated Financial Statements for additional information.
 
The contractual amounts of these commitments represent the amounts at risk should the contract be fully drawn upon, the client defaults, and the value of the existing collateral becomes worthless. The total amount of outstanding commitments may not represent future cash requirements, as commitments may expire without being drawn upon.
 
For lending commitments where the loan will be classified as held for sale upon funding, liabilities are calculated at the lower of cost or market, capturing declines in the fair value of the respective credit risk. For loan commitments where the loan will be classified as held for investment upon funding, liabilities are calculated considering both market and historical loss rates. Loan commitments held by entities that apply broker-dealer industry level accounting are accounted for at fair value.
 
Purchasing and Other Commitments
 
In the normal course of business, Merrill Lynch enters into institutional and margin-lending transactions, some of which are on a committed basis, but most of which are not. Margin lending on a committed basis only includes amounts where Merrill Lynch has a binding commitment. These binding margin lending commitments totaled $494 million at September 28, 2007 and $782 million at December 29, 2006.
 
Merrill Lynch had commitments to purchase partnership interests, primarily related to private equity and principal investing activities, of $1.9 billion and $928 million at September 28, 2007 and December 29, 2006, respectively. Merrill Lynch also has entered into agreements with providers of market data, communications, systems consulting, and other office-related services. At September 28, 2007 and December 29, 2006, minimum fee commitments over the remaining life of these agreements aggregated $258 million and $357 million, respectively. Merrill Lynch entered into commitments to purchase loans of $6.4 billion (which upon settlement of the commitment will be included in trading assets, loans held for investment and loans held for sale) at September 28, 2007. Such commitments totaled $10.3 billion at December 29, 2006. Other purchasing commitments amounted to $0.9 billion and $2.1 billion at September 28, 2007 and December 29, 2006, respectively.
 
In the normal course of business, Merrill Lynch enters into commitments for underwriting transactions. Settlement of these transactions as of September 28, 2007 would not have a material effect on the consolidated financial condition of Merrill Lynch.
 
In connection with trading activities, Merrill Lynch enters into commitments to enter into resale agreements.


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Leases
 
As disclosed in Note 12 of the 2006 Annual Report, Merrill Lynch has entered into various noncancellable long-term lease agreements for premises that expire through 2024. Merrill Lynch has also entered into various noncancellable short-term lease agreements, which are primarily commitments of less than one year under equipment leases.
 
On June 19, 2007, Merrill Lynch sold its ownership interest in Chapterhouse Holdings Limited, whose primary asset is Merrill Lynch’s London Headquarters, for approximately $950 million. Merrill Lynch leased the premises back for an initial term of 15 years under an agreement which is classified as an operating lease. The leaseback also includes renewal rights extending significantly beyond the initial term. The sale resulted in a pre-tax gain of approximately $370 million which was deferred and is being recognized over the lease term as a reduction of occupancy expense.
 
Guarantees
 
Merrill Lynch issues various guarantees to counterparties in connection with certain leasing, securitization and other transactions. In addition, Merrill Lynch enters into certain derivative contracts that meet the accounting definition of a guarantee under Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indebtedness of Others (“FIN 45”). These guarantees and their expiration at September 28, 2007 are summarized as follows:
 
                                                 
(dollars in millions)
 
    Maximum
                   
    Payout /
  Less than
          Over
  Carrying
    Notional   1 year   1 - 3 years   3+- 5 years   5 years   Value
 
Derivative contracts
  $ 4,082,422     $ 665,833     $ 664,899     $ 1,151,865     $ 1,599,825     $ 111,258  
Liquidity and default facilities
    52,461       50,156       2,206       99       -       129  
Residual value guarantees
    1,020       91       407       116       406       14  
Standby letters of credit and other
guarantees
    5,770       1,845       1,240       1,139       1,546       23  
 
 
 
Derivative Contracts
 
The derivatives in the above table meet the accounting definition of a guarantee under FIN 45 and include certain written options and credit default swaps that contingently require Merrill Lynch to make payments based on changes in an underlying. Because the maximum exposure to loss could be unlimited for certain derivatives (e.g., interest rate caps) and the maximum exposure to loss is not considered when assessing the risk of contracts, the notional value of these contracts has been included to provide information about the magnitude of Merrill Lynch’s involvement with these types of transactions. Merrill Lynch records all derivative instruments at fair value on its Condensed Consolidated Balance Sheets.
 
Merrill Lynch funds selected assets, including CDOs and collateralized loan obligations (“CLOs”), via derivative contracts with third party structures that are not consolidated on its balance sheet. Approximately $25 billion is term financed through facilities provided by commercial banks, $35 billion of long term funding is provided by third party special purpose vehicles and $16 billion is financed with asset backed commercial paper conduits. In certain circumstances, Merrill Lynch may be required to purchase these assets which would not result in additional gain or loss to the firm as such exposure is already reflected in the fair value of Merrill Lynch’s derivative contracts.


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Liquidity and Default Facilities
 
The liquidity facilities and default facilities in the above table relate primarily to municipal bond securitization SPEs and asset-backed commercial paper conduits (“Conduits”).
 
Merrill Lynch acts as liquidity provider to municipal bond securitization SPEs. As of September 28, 2007, the value of the assets held by the SPE plus any additional collateral pledged to Merrill Lynch exceeds the amount of beneficial interests issued, which provides additional support to Merrill Lynch in the event that the standby facility is drawn. As of September 28, 2007, the maximum payout if the standby facilities are drawn was $39.3 billion and the value of the municipal bond assets to which Merrill Lynch has recourse in the event of a draw was $42.8 billion. In certain instances, Merrill Lynch also provides default protection in addition to liquidity facilities. If the default protection is drawn, Merrill Lynch may claim the underlying assets held by the SPEs. As of September 28, 2007, the maximum payout if an issuer defaults was $7.9 billion, and the value of the assets to which Merrill Lynch has recourse, in the event that an issuer of a municipal bond held by the SPE defaults on any payment of principal and/or interest when due, was $8.8 billion.
 
In addition, Merrill Lynch, through a U.S. bank subsidiary has liquidity and credit facilities outstanding to Conduits. The assets in these Conduits are loans and asset-backed securities. In the event of a disruption in the commercial paper market, the Conduit may draw upon their liquidity facility and sell certain of their assets to Merrill Lynch, thereby protecting commercial paper holders against certain changes in the fair value of the assets held by the Conduits. The credit facilities protect commercial paper investors against credit losses for up to a certain percentage of the portfolio of assets held by the respective Conduits. The outstanding amount of the facilities is approximately $4.8 billion as of September 28, 2007. This amount is net of $5.1 billion of assets that Merrill Lynch purchased and $1.2 billion that Merrill Lynch loaned to the Conduits under these liquidity facilities during the three months ended September 28, 2007. In addition, Merrill Lynch purchased $523 million of commercial paper from these Conduits, including $300 million from Conduits for which it has a significant variable interest. These liquidity and credit facilities are recorded off-balance sheet, unless a liability is deemed necessary when a contingent payment is deemed probable and estimable. A liability of $41 million related to this contingency was recorded as of September 28, 2007.
 
Residual Value Guarantees
 
The amounts in the above table include residual value guarantees associated with the Hopewell campus and aircraft leases of $322 million at September 28, 2007.
 
Stand-by Letters of Credit and Other Guarantees
 
Merrill Lynch provides guarantees to counterparties in the form of standby letters of credit in the amount of $2.7 billion. Merrill Lynch held marketable securities of $563 million as collateral to secure these guarantees at September 28, 2007.
 
Further, in conjunction with certain principal-protected mutual funds, Merrill Lynch guarantees the return of the initial principal investment at the termination date of the fund. At September 28, 2007, Merrill Lynch’s maximum potential exposure to loss with respect to these guarantees is $634 million assuming that the funds are invested exclusively in other general investments (i.e., the funds hold no risk-free assets), and that those other general investments suffer a total loss. As such, this measure significantly overstates Merrill Lynch’s exposure or expected loss at September 28, 2007. These transactions met the SFAS No. 149 definition of derivatives and, as such, were carried as a liability with a fair value of approximately $6 million at September 28, 2007.


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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 at September 28, 2007 is $165 million; however, Merrill Lynch believes that the likelihood of loss with respect to these arrangements is remote, and therefore has not recorded any liabilities in respect of these guarantees.
 
In connection with certain asset sales and securitization transactions, Merrill Lynch typically makes representations and warranties about the underlying assets conforming to specified guidelines. If the underlying assets do not conform to the specifications, Merrill Lynch may have an obligation to repurchase the assets or indemnify the purchaser against any loss. To the extent these assets were originated by others and purchased by Merrill Lynch, Merrill Lynch seeks to obtain appropriate representations and warranties in connection with its acquisition of the assets. For residential mortgage loan and other securitizations, the maximum potential amount that could be required to be repurchased is the current outstanding asset balance. The liability recorded for losses under these arrangements was approximately $205 million at September 28, 2007. In all other arrangements, no liability is carried in the Condensed Consolidated Balance Sheets because Merrill Lynch believes the potential for loss is remote.
 
See Note 12 of the 2006 Annual Report for additional information on guarantees.
 
Note 13.  Employee Benefit Plans
­ ­
 
Merrill Lynch provides pension and other postretirement benefits to its employees worldwide through defined contribution pension, defined benefit pension, and other postretirement plans. These plans vary based on the country and local practices. Merrill Lynch reserves the right to amend or terminate these plans at any time. Refer to Note 13 of the 2006 Annual Report for a complete discussion of employee benefit plans.
 
Defined Benefit Pension Plans
 
Pension cost for the three and nine months ended September 28, 2007 and September 29, 2006, for Merrill Lynch’s defined benefit pension plans, included the following components:
 
                                                 
(dollars in millions)
 
    Three Months Ended
    Sept. 28,
  Sept. 29,
    2007   2006
     
    U.S.
  Non-U.S.
      U.S.
  Non-U.S.
   
    Plans   Plans   Total   Plans   Plans   Total
 
Service cost
  $ -     $ 7     $ 7     $ -     $ 7     $ 7  
Interest cost
    24       20       44       24       16       40  
Expected return on plan assets
    (29 )     (21 )     (50 )     (28 )     (15 )     (43 )
Amortization of net (gains)/losses, prior
service costs and other
    (1 )     7       6       -       5       5  
                                                 
Total defined benefit pension cost
  $ (6 )   $ 13     $ 7     $ (4 )   $ 13     $ 9  
 


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(dollars in millions)
 
    Nine Months Ended
    Sept. 28,
  Sept. 29,
    2007   2006
     
    U.S.
  Non-U.S.
      U.S.
  Non-U.S.
   
    Plans   Plans   Total   Plans   Plans   Total
 
 
Service cost
  $ -     $ 21     $ 21     $ -     $ 21     $ 21  
Interest cost
    72       60       132       72       47       119  
Expected return on plan assets
    (87 )     (60 )     (147 )     (84 )     (45 )     (129 )
Amortization of net (gains)/losses, prior
                                               
service costs and other
    (3 )     22       19       -       14       14  
                                                 
Total defined benefit pension cost
  $ (18 )   $ 43     $ 25     $ (12 )   $ 37     $ 25  
 
Merrill Lynch disclosed in its 2006 Annual Report that it expected to pay $23 million of benefit payments to participants in the U.S. non-qualified pension plan and Merrill Lynch expected to contribute $70 million to its non-U.S. defined benefit pension plans in 2007. Merrill Lynch does not expect contributions to differ significantly from amounts previously disclosed.
 
Postretirement Benefits Other Than Pensions
 
Other postretirement benefit cost for the three and nine months ended September 28, 2007 and September 29, 2006, included the following components:
 
                                 
(dollars in millions)
 
    Three Months Ended   Nine Months Ended
     
    Sept. 28,
  Sept. 29,
  Sept. 28,
  Sept. 29,
    2007   2006   2007   2006
 
 
Service cost
  $ 2     $ 2     $ 5     $ 6  
Interest cost
    4       4       12       12  
Amortization of net (gains)/losses, prior service costs and other
    (2 )     1       (5 )     (2 )
                                 
Total other postretirement benefits cost
  $ 4     $ 7     $ 12     $ 16  
 
 
 
Approximately 90% of the postretirement benefit cost components for the period relate to the U.S. postretirement plan.
 
Note 14.  Income Taxes
­ ­
 
Merrill Lynch adopted FIN 48 effective the beginning of the first quarter of 2007 and recognized a decrease to beginning retained earnings and an increase to the liability for unrecognized tax benefits of approximately $66 million.
 
The total amount of unrecognized tax benefits as of the date of adoption of FIN 48 was approximately $1.5 billion. Of this total, approximately $1.0 billion (net of federal benefit of state issues, competent authority and foreign tax credit offsets) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective tax rate in future periods.

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Merrill Lynch paid an assessment to Japan in 2005 for the fiscal years April 1, 1998 through March 31, 2003, in relation to the taxation of income that was originally reported in other jurisdictions. During the third quarter of 2005, Merrill Lynch started the process of obtaining clarification from international tax authorities on the appropriate allocation of income among multiple jurisdictions to prevent double taxation. In addition, Merrill Lynch filed briefs with the U.S. Tax Court in 2005 with respect to a tax case, which had been remanded for further proceedings in accordance with a 2004 opinion of the U.S. Court of Appeals for the Second Circuit. The U.S. Court of Appeals affirmed the initial adverse conclusion of the U.S. Tax Court rendered in 2003 against Merrill Lynch, with respect to a 1987 transaction. The U.S. Tax Court has yet to issue a decision on this remanded matter, and it is uncertain as to when a decision will be rendered. The unrecognized tax benefits with respect to this case and the Japanese assessment, while paid, have been included in the $1.5 billion and the $1.0 billion amounts above.
 
Merrill Lynch recognizes the accrual of interest and penalties related to unrecognized tax benefits in income tax expense. Interest and penalties accrued as of the beginning of the year were approximately $107 million.
 
Merrill Lynch is under examination by the Internal Revenue Service (“IRS”) and other tax authorities in countries including 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. The IRS audits are in progress for the tax years 2004-2006 and are expected to be completed in 2008. Japan tax authorities have recently commenced the audit for the fiscal tax years March 31, 2004 through March 31, 2007. In the United Kingdom, the audit for the tax year 2005 is in progress. The Canadian tax authorities have commenced the audit of the tax years 2004-2005. New York State and New York City audits are in progress for the years 2002-2006.
 
As indicated above, the IRS audits for the years 2004-2006 are expected to be completed in 2008. It is also reasonably possible that audits in other countries and states may conclude in 2008. It is also reasonably possible that, in 2008, Merrill Lynch will obtain clarification from international tax authorities on the appropriate allocation of income among multiple jurisdictions (transfer pricing) to prevent double taxation resulting from the tax assessment paid to Japan in 2005. While it is reasonably possible that a significant reduction in unrecognized tax benefits may occur within 12 months of September 28, 2007, quantification of an estimated range cannot be made at this time due to the uncertainty of the potential outcome of outstanding issues.
 
Note 15.   Regulatory Requirements
 
Effective January 1, 2005, Merrill Lynch became a consolidated supervised entity (“CSE”) as defined by the SEC. As a CSE, Merrill Lynch is subject to group-wide supervision, which requires Merrill Lynch to compute allowable capital and risk allowances on a consolidated basis. At September 28, 2007, Merrill Lynch was in compliance with applicable CSE standards.
 
Certain U.S. and non-U.S. subsidiaries are subject to various securities, banking, and insurance regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. These regulatory restrictions may impose regulatory capital requirements and limit the amounts that these subsidiaries can pay in dividends or advance to Merrill Lynch. Merrill Lynch’s principal regulated subsidiaries are discussed below.


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Securities Regulation
 
As a registered broker-dealer, Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”) is subject to the net capital requirements of Rule 15c3-1 under the Securities Exchange Act of 1934 (“the Rule”). Under the alternative method permitted by the Rule, the minimum required net capital, as defined, shall be the greater of 2% of aggregate debit items (“ADI”) arising from customer transactions or $500 million. At September 28, 2007, MLPF&S’s regulatory net capital of $3,970 million was approximately 14.0% of ADI, and its regulatory net capital in excess of the minimum required was $3,336 million.
 
As a futures commission merchant, MLPF&S is also subject to the capital requirements of the Commodity Futures Trading Commission (“CFTC”), which requires that minimum net capital should not be less than 8% of the total customer risk margin requirement plus 4% of the total non-customer risk margin requirement. MLPF&S substantially exceeds both standards.
 
Merrill Lynch International (“MLI”), a U.K. regulated investment firm, is subject to capital requirements of the Financial Services Authority (“FSA”). Financial resources, as defined and as such, must exceed the total financial resources requirement set by the FSA. For September 28, 2007, MLI reported $1,142 million in excess capital prior to additional post-close write-downs for the third quarter of 2007. These additional write-downs were determined subsequent to MLI’s September 28, 2007 regulatory filing. In support of the additional write-downs, MLI received $3,500 million share capital during October 2007.
 
Merrill Lynch Government Securities Inc. (“MLGSI”), a primary dealer in U.S. Government securities, is subject to the capital adequacy requirements of the Government Securities Act of 1986. This rule requires dealers to maintain liquid capital in excess of market and credit risk, as defined, by 20% (a 1.2-to-1 capital-to-risk standard). At September 28, 2007, MLGSI’s liquid capital of $2,660 million was 318.0% of its total market and credit risk, and liquid capital in excess of the minimum required was $1,658 million.
 
Merrill Lynch Japan Securities Co. Ltd. (“MLJS”), a Japan-based regulated broker-dealer, is subject to capital requirements of the Japanese Financial Services Agency (“JFSA”). Net capital, as defined, must exceed 120% of the total risk equivalents requirement of the JFSA. At September 28, 2007, MLJS’s net capital was $1,595 million, exceeding the minimum requirement by $943 million.
 
Banking Regulation
 
Merrill Lynch Bank USA (“MLBUSA”) is a Utah-chartered industrial bank, regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the State of Utah Department of Financial Institutions (“UTDFI”). Merrill Lynch Bank & Trust Co., FSB (“MLBT-FSB”) is a full service thrift institution regulated by the Office of Thrift Supervision (“OTS”), whose deposits are insured by the FDIC. Both MLBUSA and MLBT-FSB are required to maintain capital levels that at least equal minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory, and possibly additional discretionary, actions by the regulators that, if undertaken,


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could have a direct material effect on the banks. The following table illustrates the actual capital ratios and capital amounts for MLBUSA and MLBT-FSB as of September 28, 2007.
 
                                         
(dollars in millions)
 
        MLBUSA   MLBT-FSB
         
    Well
               
    Capitalized
  Actual
  Actual
  Actual
  Actual
    Minimum   Ratio   Amount   Ratio   Amount
 
 
Tier 1 leverage
    5 %     9.76 %   $ 6,616       8.19 %   $ 2,344  
Tier 1 capital
    6 %     10.19 %     6,616       11.74 %     2,344  
Total capital
    10 %     11.62 %     7,546       15.07 %     3,007  
 
 
 
As a result of its ownership of MLBT-FSB, ML & Co. is registered with the OTS as a savings and loan holding company (“SLHC”) and subject to regulation and examination by the OTS as a SLHC. ML & Co. is classified as a unitary SLHC, and will continue to be so classified as long as it and MLBT-FSB continue to comply with certain conditions. Unitary SLHCs are exempt from the material restrictions imposed upon the activities of SLHCs that are not unitary SLHCs. SLHCs other than unitary SLHCs are generally prohibited from engaging in activities other than conducting business as a savings association, managing or controlling savings associations, providing services to subsidiaries or engaging in activities permissible for bank holding companies. Should ML & Co. fail to continue to qualify as a unitary SLHC, in order to continue its present businesses that would not be permissible for a SLHC, ML & Co. could be required to divest control of MLBT-FSB.
 
Merrill Lynch International Bank Limited (“MLIB”), an Ireland-based regulated bank, is subject to the capital requirements of the Financial Regulator of Ireland. MLIB is required to meet minimum regulatory capital requirements under the European Union (“EU”) banking law as implemented in Ireland by the Financial Regulator. At September 28, 2007, MLIB’s capital ratio was above the minimum requirement at 10.9% and its financial resources were $10,293 million, exceeding the minimum requirement by $811 million.
 
Note 16.   Acquisitions
 
On December 30, 2006, Merrill Lynch acquired the First Franklin mortgage origination franchise and related servicing platform from National City Corporation for $1.3 billion. First Franklin originates sub-prime residential mortgage loans through a wholesale network. The results of operations of First Franklin are included in GMI.
 
On September 21, 2007, Merrill Lynch acquired all of the outstanding common shares of First Republic Bank (“First Republic”) in exchange for a combination of cash and stock for a total transaction value of $1.8 billion. First Republic provides personalized, relationship-based banking services, including private banking, private business banking, real estate lending, trust, brokerage and investment management. The results of operations of First Republic are included in GWM. In conjunction with the acquisition of First Republic, Merrill Lynch issued $65 million of 6.70% non-cumulative perpetual preferred stock and $50 million of 6.25% non-cumulative preferred stock in exchange for First Republic Bank’s preferred stock Series A and B, respectively. Upon closing the First Republic acquisition, Merrill Lynch also issued 11.6 million shares of common stock, par value $1.331/3 per share, as consideration.


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Note 17.  Discontinued Operations
 
On August 13, 2007, Merrill Lynch announced that it will form a strategic business relationship with AEGON, N.V. (“AEGON”) in the areas of insurance and investment products. As part of this relationship, Merrill Lynch has agreed to sell Merrill Lynch Life Insurance Company and ML Life Insurance Company of New York (together “Merrill Lynch Insurance Group” or “MLIG”) to AEGON for $1.3 billion. Merrill Lynch will continue to serve the insurance needs of its clients through its core distribution and advisory capabilities. This transaction is expected to close by the end of the fourth quarter of 2007, subject to regulatory approvals. Results for MLIG have been included within discontinued operations for all periods presented and the assets and liabilities were not considered material for separate presentation. The results of MLIG were formerly reported in the Global Wealth Management business segment. Certain financial information included in discontinued operations is shown below:
 
                                 
(dollars in millions)
 
    Three Months Ended   Nine Months Ended
     
    Sept. 28,
  Sept. 29,
  Sept. 28,
  Sept. 29,
    2007   2006   2007   2006
 
 
Total net revenues
  $ 65     $ 73     $ 199     $ 202  
Earnings before income taxes
    38       38       128       103  
Income taxes
    13       12       43       34  
                                 
Net earnings from discontinued operations
  $ 25     $ 26     $ 85     $ 69  
 
 
 
The following assets and liabilities are related to discontinued operations as of September 28, 2007 and December 29, 2006:
 
                 
(dollars in millions)
 
    Sept. 28,
  Dec. 29,
    2007   2006
 
 
Assets:
               
Separate accounts assets
  $ 12,588     $ 12,312  
Other assets
    3,242       3,497  
                 
Total Assets
  $ 15,830     $ 15,809  
                 
Liabilities:
               
Separate accounts liabilities
  $ 12,588     $ 12,312  
Other payables
    2,630       2,772  
                 
Total Liabilities
  $ 15,218     $ 15,084  
 
 


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders of Merrill Lynch & Co., Inc.:
 
We have reviewed the accompanying condensed consolidated balance sheet of Merrill Lynch & Co., Inc. and subsidiaries (“Merrill Lynch”) as of September 28, 2007, and the related condensed consolidated statements of earnings for the three-month and nine-month periods ended September 28, 2007 and September 29, 2006, and of cash flows for the nine-month periods ended September 28, 2007 and September 29, 2006. These interim financial statements are the responsibility of Merrill Lynch’s management.
 
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
 
Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
 
As discussed in Notes 1, 3 and 14 to the condensed consolidated interim financial statements, in 2007 Merrill Lynch adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurement,” Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115,” and FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109.
 
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Merrill Lynch as of December 29, 2006, and the related consolidated statements of earnings, changes in stockholders’ equity, comprehensive income and cash flows for the year then ended (not presented herein); and in our report dated February 26, 2007, we expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the change in accounting method in 2006 for share-based payments to conform to Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 29, 2006 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
 
/s/  Deloitte & Touche LLP
 
New York, New York
November 7, 2007


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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Forward-Looking Statements and Non-GAAP Financial Measures
 
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”, “we”, “our” or “us”) beliefs regarding future performance, which is inherently uncertain. There are a variety of factors, many of which are beyond our control, which affect our operations, performance, business strategy and results and could cause our 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 in the Annual Report on Form 10-K for the year ended December 29, 2006 (“2006 Annual Report”). 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. We do 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 we may make in future filings of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.
 
From time to time, we may also disclose financial information on a non-GAAP basis where management uses this information and believes this information will be valuable to investors in gauging the quality of our financial performance, identifying trends in our results and providing more meaningful period-to-period comparisons. For a reconciliation of non-GAAP measures presented throughout this report see Exhibit 99.1.
Overview
 
Introduction
 
Merrill Lynch was formed in 1914 and became a publicly traded company on June 23, 1971. In 1973, we created the holding company, ML & Co., a Delaware corporation that, through its subsidiaries, is one of the world’s leading capital markets, advisory and wealth management companies with offices in 38 countries and territories and total client assets of approximately $1.8 trillion at September 28, 2007. As an investment bank, we are a leading global trader and underwriter of securities and derivatives across a broad range of asset classes, and we serve as a strategic advisor to corporations, governments, institutions and individuals worldwide. In addition, we own a 45% voting interest and approximately half of the economic interest of BlackRock, Inc. (“BlackRock”), one of the world’s largest publicly traded investment management companies with over $1 trillion in assets under management at September 28, 2007.
 
On August 13, 2007, we announced that we will form a strategic business relationship with AEGON, N.V. (“AEGON”) in the areas of insurance and investment products. As part of this relationship, we have agreed to sell Merrill Lynch Life Insurance Company and ML Life Insurance Company of New York (together “Merrill Lynch Insurance Group” or “MLIG”) to AEGON for $1.3 billion. We will continue to serve the insurance needs of our clients through our core distribution and advisory


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capabilities. This transaction is expected to close by the end of the fourth quarter of 2007, subject to regulatory approvals. We have included results for MLIG within discontinued operations for all periods presented. We previously reported the results of MLIG in the Global Wealth Management (“GWM”) business segment. Refer to Note 17 to the Condensed Consolidated Financial Statements for additional information.
 
Since the fourth quarter of 2006, our business segment reporting reflects the management reporting lines established after the merger of our Merrill Lynch Investment Managers (“MLIM”) business with BlackRock on September 29, 2006 (the “BlackRock merger”), as well as the economic and long-term financial performance characteristics of the underlying businesses.
 
Prior to the fourth quarter of 2006, we reported our business activities in three business segments: Global Markets and Investment Banking (“GMI”), Global Private Client (“GPC”), and MLIM. Effective with the BlackRock merger, MLIM ceased to exist as a separate business segment. Accordingly, a new business segment, GWM, was created, consisting of GPC and Global Investment Management (“GIM”). GWM along with GMI are now our business segments. We have restated prior period segment information to conform to the current period presentation and, as a result, are presenting GWM as if it had existed for these prior periods. See Note 2 to the Condensed Consolidated Financial Statements for further information on segments.
 
The BlackRock merger closed on the last day of our third fiscal quarter of 2006. For more information on the BlackRock merger, refer to Note 2 of the 2006 Annual Report.
 
The following is a description of our business segments, including MLIM, which ceased to exist as a separate business segment effective with the BlackRock merger:
 
•  GMI, our institutional business segment, provides trading, capital markets services, investment banking and advisory services to corporations, financial institutions, institutional investors, and 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 used to satisfy client demands. In addition, GMI also engages in certain proprietary trading activities. Global Markets also provides clients with financing, securities clearing, settlement, and custody services and also engages in principal and private equity investing. GMI’s Investment Banking division provides a wide range of securities 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. GMI’s growth strategy entails a program of investments in personnel and technology to gain further scale in certain asset classes and geographies.
 
•  GWM, our 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. Within the GPC division, most of our services are delivered by our 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 Visa® cards; trust and generational planning; retirement services; and insurance products. GWM’s GIM division includes a business that creates and manages hedge fund and other alternative investment products for GPC clients, and Merrill Lynch’s share of net earnings from its ownership positions in other investment management companies, including our investment in BlackRock. GWM’s growth priorities include continued growth in client assets, 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


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enhance productivity and efficiency, and disciplined expansion into additional geographic areas globally.
 
•  MLIM, our asset management segment prior to the BlackRock merger, offered a wide range of investment management capabilities to retail and institutional investors through proprietary and third-party distribution channels globally. Asset management capabilities included equity, fixed income, money market, index, enhanced index and alternative investments, which were offered through vehicles such as mutual funds, privately managed accounts, and retail and institutional separate accounts.
Critical Accounting Policies And Estimates
 
The following is a summary of our critical accounting policies. For a full description of these and other accounting policies see Note 1 of the 2006 Annual Report and Note 1 to the Condensed Consolidated Financial Statements.
 
Use of Estimates
 
In presenting the Condensed Consolidated Financial Statements, management makes estimates regarding:
•  Valuations of assets and liabilities requiring fair value estimates including:
  •  Trading inventory and investment securities;
  •  Private equity and principal investments;
  •  Certain receivables under resale agreements and payables under repurchase agreements;
  •  Loans and allowance for loan losses and liabilities recorded for unfunded commitments;
  •  Certain long-term borrowings, primarily structured debt;
•  The outcome of litigation;
•  The realization of deferred taxes and the recognition and measurement of uncertain tax positions;
•  Assumptions and cash flow projections used in determining whether VIEs should be consolidated and the determination of the qualifying status of special purpose entities;
•  The carrying amount of goodwill and other intangible assets;
•  The amortization period of intangible assets with definite lives;
•  Valuation of share-based payment compensation arrangements;
•  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 Condensed 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 of the 2006 Annual Report.
 
Valuation of Financial Instruments
 
Proper valuation of financial instruments is a critical component of our financial statement preparation. Merrill Lynch accounts for a significant portion of its financial instruments at fair value or considers fair value in their measurement. Merrill Lynch accounts for certain financial assets and liabilities at fair value under various accounting literature, including SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 133, Accounting for Derivative Instruments and


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Hedging Activities, and SFAS No. 159, Fair Value Option for Certain Financial Assets and Liabilities. Merrill Lynch also accounts for certain assets at fair value under applicable industry guidance, namely broker-dealer and investment company accounting guidance.
 
In presenting the Condensed Consolidated Financial Statements, management makes estimates regarding valuations of assets and liabilities requiring fair value measurements. These assets and liabilities include:
  •  Trading inventory and investment securities;
  •  Private equity and principal investments;
  •  Certain receivables under resale agreements and payables under repurchase agreements;
  •  Loans and allowance for loan losses and liabilities recorded for unrealized losses on unfunded commitments; and
  •  Certain long-term borrowings, primarily structured debt.
 
See further discussion in Note 1 to our Condensed Consolidated Financial Statements.
 
We early adopted the provisions of SFAS No. 157 Fair Value Measurements (“SFAS No. 157”) in the first quarter of 2007. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date (i.e., the exit price). An exit price notion does not assume that the transaction price is the same as the exit price, thus permitting the recognition of inception gains and losses on a transaction in certain circumstances. In addition, an exit price notion requires the valuation to consider what a marketplace participant would pay to buy an asset or receive to assume a liability. Therefore, Merrill Lynch must rely upon observable market data before it can utilize internally derived valuations.
 
Fair values for exchange-traded securities and certain exchange-traded derivatives, principally certain options contracts, are based on quoted market prices. Fair values for over-the-counter (“OTC”) derivatives, principally forwards, options, and swaps, represent amounts estimated to be received from or paid to a market participant 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 and other inputs such as quoted interest and currency indices, while taking into account the counterparty’s credit rating, or our own credit rating 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 that market participants would use in pricing the instrument, which may impact the results of operations reported in the Condensed Consolidated Financial Statements. For long-dated and illiquid contracts, we apply extrapolation methods to observed market data in order to estimate inputs and assumptions that are not directly observable. This enables us to mark to fair value 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, we continually refine our pricing models 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. In addition, during periods of market illiquidity, the valuation of certain cash products can also require significant judgment and the use of estimates by management.
 
Prior to adoption of SFAS No. 157, Merrill Lynch followed the provisions of EITF 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF 02-3”). Under EITF 02-3, recognition of day one gains and losses on derivative transactions where model inputs that significantly impact valuation are not observable were prohibited. Day one gains and losses deferred at inception under EITF 02-3 were recognized at the earlier of when the valuation of such derivative became observable or at the


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termination of the contract. SFAS No. 157 nullifies this guidance in EITF 02-3. Although this guidance in EITF 02-3 has been nullified, the recognition of significant inception gains and losses that incorporate unobservable inputs are reviewed by management to ensure such gains and losses are derived from observable inputs and/or incorporate reasonable assumptions about the unobservable component, such as implied bid-offer adjustments.
 
Valuation adjustments
 
Certain financial instruments recorded at fair value are initially measured using mid-market prices which results in gross long and short positions marked-to-market at the same pricing level prior to the application of position netting. The resulting net positions are then adjusted to fair value representing the exit price as defined in SFAS No. 157. These significant adjustments include:
 
Liquidity
 
Merrill Lynch makes adjustments to bring a position from a mid-market to a bid or offer price, depending upon the net open position. Merrill Lynch values net long positions at bid prices and net short positions at offer prices. These adjustments are based upon either observable or implied bid-offer prices.
 
Credit Risk
 
In determining fair value we consider both the credit risk of our counterparties, as well as our own creditworthiness. Credit risk to third parties is generally mitigated by entering into netting and collateral arrangements. Net exposure is then measured with consideration of market observable pricing of a counterparty’s credit risk and is incorporated into the fair value of the respective instruments. The calculation of the credit adjustment for derivatives is generally based upon observable credit derivative spreads. Alternatively, the calculation for cash products generally considers observable bond spreads.
 
SFAS No. 157 also requires that Merrill Lynch’s own creditworthiness be considered when determining the fair value of an instrument. The approach to measuring the impact of Merrill Lynch’s own credit on an instrument is the same approach as that used to measure third party credit risk.
 
In accordance with SFAS No. 157, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.
 
Financial assets and liabilities recorded on the Condensed Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as follows:
 
Level 1.  Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that Merrill Lynch has the ability to access (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).


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Level 2.  Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:
 
  a)  Quoted prices for similar assets or liabilities in active markets (for example, restricted stock);
 
  b)  Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently);
 
  c)  Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives including interest rate and currency swaps); and
 
  d)  Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).
 
Level 3.  Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long-dated options on gas and power). See Note 3 to the Condensed Consolidated Financial Statements for additional information.
 
Valuation controls
 
Given the prevalence of fair value measurement in our financial statements, the control functions surrounding the fair valuation process are a critical component of our business operations. Prices and model inputs provided by the trading desk are verified to external pricing sources to ensure that the use of observable market data is used whenever possible. Similarly, valuation models created by the trading desks are verified and tested. These controls are performed by departments independent of the trading desks with the appropriate levels of expertise to verify the trading desk’s valuations.
 
Litigation
 
We have been named as a defendant in various legal actions, including arbitrations, class actions, and other litigation arising in connection with our activities as a global diversified financial services institution. We are also involved in investigations and/or proceedings by governmental and self-regulatory agencies. In accordance with SFAS No. 5, Accounting for Contingencies, we 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, we cannot predict what the eventual loss or range of loss related to such matters will be. See Note 12 to the Condensed Consolidated Financial Statements and Other Information — Legal Proceedings for further information.


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Variable Interest Entities (VIEs)
 
In the normal course of business, we enter into a variety of transactions with VIEs. The applicable accounting guidance requires us to perform a qualitative and/or quantitative analysis of each new VIE at inception to determine whether we must consolidate the VIE. In performing this analysis, we make 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 unless a reconsideration event occurs. If a VIE meets the conditions to be considered a QSPE, it is typically not required to be consolidated by us. A QSPE is a passive entity whose 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 that 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 management judgment.
 
Income Taxes
 
Tax laws are complex and subject to different interpretations by Merrill Lynch and the various taxing authorities. Merrill Lynch regularly assesses the likelihood of assessments in each of the taxing jurisdictions by making judgments and interpretations about the application of these complex tax laws and estimating the impact to our financial statements.
 
Merrill Lynch is under examination by the Internal Revenue Service (“IRS”) and other tax authorities in countries including 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. The IRS audits are in progress for the tax years 2004-2006 and are expected to be completed in 2008. Japan tax authorities have recently commenced the audit for the fiscal tax years March 31, 2004 through March 31, 2007. In the United Kingdom, the audit for the tax year 2005 is in progress. The Canadian tax authorities have commenced the audit of the tax years 2004-2005. New York State and New York City audits are in progress for the years 2002-2006. Also, Merrill Lynch paid an assessment to Japan in 2005 for the fiscal years April 1, 1998 through March 31, 2003, in relation to the taxation of income that was originally reported in other jurisdictions. During the third quarter of 2005, we started the process of obtaining clarification from international tax authorities on the appropriate allocation of income among multiple jurisdictions to prevent double taxation. Merrill Lynch believes that the estimate of the level of unrecognized tax benefits is appropriate in relation to the potential for additional assessments. Merrill Lynch adjusts the level of unrecognized tax benefits when there is more information available, or when an event occurs requiring a change. The reassessment of unrecognized tax benefits could have a material impact on Merrill Lynch’s effective tax rate in the period in which it occurs.


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Business Environment(1)
 
Global financial markets experienced significant stress during the third quarter of 2007, primarily driven by challenging conditions in the markets related to U.S. sub-prime mortgages (including Collateralized Debt Obligations (“CDOs”) based on sub-prime collateral), and the markets for loans and bonds related to leveraged finance transactions. This adverse market environment began to intensify towards the end of July and was characterized by significant credit spread widening, prolonged illiquidity, reduced price transparency and increased volatility. As conditions in these markets deteriorated, other areas such as the asset-backed commercial paper market also experienced decreased liquidity, and the equity markets experienced short-term weakness and increased volatility. For example, during the third quarter ABX indices experienced significant widening, with the A and AAA classes moving substantially off par for the first time in 2007. In response to these conditions, the Federal Reserve and other central banks injected significant liquidity into the markets during the quarter and in September the U.S. Federal Reserve System’s Federal Open Market Committee lowered benchmark interest rates by 50 basis points to 4.75%. These actions helped to stabilize and improve market conditions. Long-term interest rates, as measured by the 10-year U.S. Treasury bond, ended the third quarter at 4.58%, down from 5.03% at the end of the second quarter of 2007. In the equity markets, despite significant volatility in August, major U.S. equity indices increased slightly during the third quarter of 2007 with the Dow Jones Industrial Average, the NASDAQ Composite Index and the Standard & Poor’s 500 Index up by 4%, 4% and 2%, respectively. Oil prices hit a record high and the U.S. dollar hit a low against the euro during the quarter. Overall the global economy continued to grow during the third quarter, albeit at a slower pace than during the first half of the year.
 
Global fixed income trading volumes increased during the quarter in asset classes such as Government and Agency securities with average daily trading volumes up approximately 16% and 18%, respectively. Volumes across mortgage-backed securities declined approximately 7% during the quarter.
 
Global equity indices generally ended the quarter with mixed results. In Europe, the Dow Jones STOXX 50 Index and the FTSE 100 Index fell 3% and 2%, respectively. Asian equity markets were mixed as Japan’s Nikkei 225 Stock Average fell 7% while Hong Kong’s Hang Seng Index surged 25%. India’s Sensex Index rose 18%. In Latin America, Brazil’s Bovespa Index was up 11%.
 
U.S. Equity trading volumes increased in the third quarter as both the dollar volume and number of shares traded on the New York Stock Exchange and on the Nasdaq increased compared to the second quarter of 2007. Equity market volatility increased significantly for both the S&P 500 and the Nasdaq 100 in the quarter, as indicated by higher average levels for the Chicago Board Options Exchange SPX Volatility Index and the American Stock Exchange QQQ Volatility Index, respectively. In Europe, equity market volatility also increased, although not as significantly, as indicated by a higher average level for the VSTOXX Index.
 
Third quarter global debt and equity underwriting volumes of $1.2 trillion were down 46% sequentially and down 23% from the year-ago quarter. Global debt underwriting volumes of $1.1 trillion were down 46% sequentially and down 26% compared to the year-ago quarter, while global equity underwriting volumes of $161 billion were down 45% sequentially, but up 12% compared to the year-ago quarter.
 
Merger and acquisition (“M&A”) activity was weak during the quarter as the value of global announced deals was $1.0 trillion, a decrease of 38% sequentially, but still up 29% from the year-ago quarter. Global completed M&A activity was $1.1 billion, up 3% sequentially and up 28% from the year-ago quarter.
 
 
(1)  Debt and equity underwriting and merger and acquisition volumes were obtained from Dealogic.


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Despite higher volatility and the typical seasonality associated with the third quarter, money flows remained strong relative to the year-ago quarter, including flows into money market funds.
 
While our results may vary based on global economic and market trends, we believe that the outlook for growth in most of our global businesses, including Equity Markets, Investment Banking, Global Wealth Management and certain Fixed Income, Currencies and Commodities (“FICC”) businesses remains favorable due to positive underlying fundamentals, high market volumes, and the resiliency of these markets. This remains especially true for markets outside of the U.S., such as the Pacific Rim. However, the challenging conditions in certain credit markets, such as the CDO and related sub-prime mortgage markets, have continued into the fourth quarter.
 
At the end of the third quarter, we maintained exposures to these markets through cash positions, loans, derivatives and commitments. During the third quarter, FICC revenues were adversely affected by the substantial deterioration in the value of many of these exposures, particularly towards quarter end. See U.S. Sub-prime Residential Mortgage-Related and ABS CDO Activities on page 73 for further detail.
 
The markets for U.S. ABS CDO exposures remain extremely illiquid and as a result, valuation of these exposures is complex and involves a comprehensive process including the use of quantitative modeling and management judgment. Valuation of these exposures will also continue to be impacted by external market factors including default rates, rating agency actions, and the prices at which observable market transactions occur. Our ability to mitigate our risk by selling or hedging our exposures is also limited by the market environment. Our future results may continue to be materially impacted by the valuation adjustments applied to these positions.


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Consolidated Results Of Operations
<
                                                 
(dollars in millions, except per share amounts)
 
    For the Three Months Ended   For the Nine Months Ended
     
    Sept. 28,
  Sept. 29
  %
  Sept. 28,
  Sept. 29
  %
    2007   2006   Change   2007   2006   Change
 
Net revenues
                                               
Principal transactions
  $ (5,930 )   $ 1,673       N/M %   $ 351     $ 4,841       (93 )%
Commissions
    1,860       1,345       38       5,360       4,462       20  
Investment banking
    1,281       922       39       4,333       3,166       37  
Managed accounts and other fee-based revenues
    1,397       1,714       (18 )     4,038       5,047       (20 )
Revenues from consolidated investments
    508       210       142       772       500       54  
Other
    (918 )     773       N/M       880       2,436       (64 )
                                                 
Subtotal
    (1,802 )     6,637       N/M