EXHIBIT 13
This exhibit contains an excerpt from the ML&Co. 1998 Annual Report to
Stockholders:
Page(s)
-------
Selected Financial Data 25
Management's Discussion and Analysis 26-54
Management's Discussion of Financial
Responsibility 55
Description of Business 56
Independent Auditors' Report 56
Consolidated Financial Statements 57-63
Notes to Consolidated Financial
Statements 64-93
Supplemental Financial Information 94
Board of Directors 95
Executive Management 96-97
Merrill Lynch & Co., Inc. Information 98
[LOGO]
SELECTED FINANCIAL DATA
- ---------------------------------------------------------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996 1995 1994
- ---------------------------------------------------------------------------------------------------------------------------------
OPERATING RESULTS
Total Revenues $ 35,853 $ 32,499 $ 25,713 $ 22,060 $ 18,573
Interest Expense 18,306 16,243 12,092 11,445 8,614
-------- -------- -------- -------- --------
Net Revenues 17,547 16,256 13,621 10,615 9,959
Non-Interest Expenses 15,451 13,145 10,993 8,779 8,212
-------- -------- -------- -------- --------
Earnings Before Income Taxes and Dividends on
Preferred Securities Issued by Subsidiaries 2,096 3,111 2,628 1,836 1,747
Income Tax Expense 713 1,129 980 710 717
Dividends on Preferred Securities Issued by Subsidiaries 124 47 - - -
-------- -------- -------- -------- --------
Net Earnings $ 1,259 $ 1,935 $ 1,648 $ 1,126 $ 1,030
======== ======== ======== ======== ========
Net Earnings Applicable to Common Stockholders $ 1,220 $ 1,896 $ 1,602 $ 1,078 $ 1,017
======== ======== ======== ======== ========
- ---------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
Total Assets $299,804 $296,980 $217,266 $179,452 $165,920
Short-Term Borrowings(a) $ 99,550 $124,219 $103,469 $ 86,969 $ 78,735
Long-Term Borrowings $ 57,563 $ 43,143 $ 26,206 $ 17,389 $ 14,911
Preferred Securities Issued by Subsidiaries $ 2,627 $ 627 $ 327 $ 51 $ 51
Total Stockholders' Equity $ 10,132 $ 8,539 $ 7,067 $ 6,288 $ 5,951
- ---------------------------------------------------------------------------------------------------------------------------------
COMMON SHARE DATA(b)
(in thousands, except per share amounts)
Earnings Per Share:
Basic $ 3.43 $ 5.57 $ 4.63 $ 2.98 $ 2.55
======== ======== ======== ======== ========
Diluted $ 3.00 $ 4.79 $ 4.08 $ 2.68 $ 2.37
======== ======== ======== ======== ========
Weighted-Average Shares Outstanding:
Basic 355,589 340,096 346,043 361,193 399,209
Diluted 406,262 395,855 392,990 402,852 430,092
Shares Outstanding at Year End(c) 356,284 339,259 332,349 346,953 367,135
Shares Repurchased(d) - 13,301 36,606 39,861 59,790
Average Share Repurchase Price $ - $ 48.91 $ 31.30 $ 23.48 $ 18.98
Book Value Per Share $ 26.89 $ 23.63 $ 19.24 $ 16.25 $ 14.48
Dividends Paid Per Share $ 0.92 $ 0.75 $ 0.58 $ 0.505 $ 0.445
- ---------------------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Pre-tax Margin(e) 11.9% 19.1% 19.3% 17.3% 17.5%
Profit Margin(f) 7.2% 11.9% 12.1% 10.6% 10.3%
Common Dividend Payout Ratio 26.3% 13.4% 12.5% 17.0% 17.6%
Return on Average Assets 0.3% 0.7% 0.7% 0.5% 0.6%
Return on Average Common Stockholders' Equity 13.4% 26.5% 26.6% 19.8% 18.4%
Average Leverage(g) 32.9x 35.3x 33.3x 32.1x 31.3x
Average Adjusted Leverage(h) 19.2x 21.3x 19.8x 19.4x 18.6x
- ---------------------------------------------------------------------------------------------------------------------------------
EMPLOYEE STATISTICS
Full-Time Employees:
U.S 46,700 45,800 42,100 39,250 38,750
Non-U.S 17,100 13,900 10,500 9,250 7,550
-------- -------- -------- -------- --------
Total 63,800 59,700 52,600 48,500 46,300
======== ======== ======== ======== ========
Financial Consultants and Other Investment Professionals 18,200 16,600 15,600 14,900 14,500
- ---------------------------------------------------------------------------------------------------------------------------------
(a) Consists of Payables under repurchase agreements and securities loaned
transactions, Commercial paper and other short-term borrowings, and Demand
and time deposits.
(b) All share and per share data have been restated for the 1997 two-for-one
common stock split (see Note 7 to the Consolidated Financial Statements).
(c) Does not include 4,506, 4,718, 4,134, 3,932, and 3,786 shares exchangeable
into common stock (see Note 7 to the Consolidated Financial Statements) at
year-end 1998, 1997, 1996, 1995, and 1994, respectively. Also does not
include 3,078, 8,026, and 12,854 unallocated reversion shares held in the
Employee Stock Ownership Plan at year-end 1996, 1995, and 1994,
respectively, which are not considered outstanding for accounting
purposes.
(d) Does not include shares either (i) owned by employees and used to pay for
the exercise of stock options or (ii) stock withheld from employee stock
option exercises to pay associated taxes.
(e) Earnings before income taxes and Dividends on preferred securities issued
by subsidiaries to Net revenues.
(f) Net earnings to Net revenues.
(g) Average Total assets to average Total stockholders' equity and Preferred
securities issued by subsidiaries.
(h) Average Total assets less average (a) Securities received as collateral,
net of securities pledged as collateral, (b) Securities pledged as
collateral, (c) Receivables under resale agreements and securities
borrowed transactions, to average Total stockholders' equity and Preferred
securities issued by subsidiaries.
25
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
BUSINESS ENVIRONMENT ................................................... 27
RESULTS OF OPERATIONS .................................................. 28
COMMISSIONS ......................................................... 28
INTEREST AND DIVIDENDS .............................................. 29
PRINCIPAL TRANSACTIONS .............................................. 29
INVESTMENT BANKING .................................................. 30
ASSET MANAGEMENT AND PORTFOLIO SERVICE FEES ......................... 31
OTHER REVENUES ...................................................... 32
NON-INTEREST EXPENSES ............................................... 32
INCOME TAXES ........................................................ 33
STRATEGIC BUSINESS INITIATIVES ......................................... 34
BUSINESS SEGMENTS ...................................................... 34
GLOBAL OPERATIONS ...................................................... 37
BALANCE SHEET .......................................................... 40
CAPITAL ADEQUACY AND LIQUIDITY ......................................... 44
CAPITAL PROJECTS AND EXPENDITURES ...................................... 46
RISK MANAGEMENT ........................................................ 48
NON-INVESTMENT GRADE HOLDINGS AND HIGHLY LEVERAGED TRANSACTIONS ........ 52
CASH FLOWS ............................................................. 54
LITIGATION ............................................................. 54
RECENT DEVELOPMENTS .................................................... 54
================================================================================
Merrill Lynch & Co., Inc. ("ML & Co." and, together with its subsidiaries
and affiliates, "Merrill Lynch") is a holding company that, through its
subsidiaries and affiliates, provides investment, financing, advisory,
insurance, and related services worldwide. Merrill Lynch conducts its businesses
in global financial markets that are influenced by numerous uncontrollable
factors. These factors include economic conditions, monetary policies, the
liquidity of global markets, international and regional political events,
regulatory developments, the competitive environment, and investor sentiment.
These conditions or events can significantly affect the volatility of financial
markets. While greater volatility increases risk, it may also increase order
flow in businesses such as trading and brokerage. Revenues and net earnings may
vary significantly from period to period due to these unpredictable factors and
the resulting market volatility.
The financial services industry continues to be affected by the
intensifying competitive environment, as demonstrated by consolidation through
mergers and acquisitions, as well as diminishing margins in many mature products
and services. In addition, the recent relaxation of banks' barriers to entry
into the securities industry and expansion by insurance companies into
traditional brokerage products, coupled with the potential repeal of the laws
separating commercial and investment banking activities, have increased the
number of companies competing for a similar customer base.
In addition to providing historical information, Merrill Lynch may make or
publish forward-looking statements about management's expectations, strategic
objectives, business prospects, anticipated financial performance, and other
similar matters. A variety of factors, many of which are beyond its control,
affect the operations, performance, business strategy, and results of Merrill
Lynch and could cause actual results and experience to differ materially from
the expectations expressed in these statements. These factors include, but are
not limited to, those listed in the previous paragraphs, as well as:
o actions taken by both current and potential competitors,
o the impact of current and future legislation and regulation throughout the
world, and
o the other risks and uncertainties detailed in the following sections.
MERRILL LYNCH UNDERTAKES NO RESPONSIBILITY TO UPDATE OR REVISE ANY
FORWARD-LOOKING STATEMENTS.
26
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
BUSINESS ENVIRONMENT
Global financial markets experienced significant volatility during 1998,
after generally strong performances in 1997 and 1996. Continued low inflation
and falling interest rates led U.S. and European markets to new highs during the
1998 first half. During the 1998 third quarter, however, global markets were
adversely impacted by the collapse of the Russian economy, severe weakening of
several Asian economies, hedge fund liquidity concerns or default, and economic
turmoil in many emerging markets. These events triggered a significant increase
in credit risk premiums and a virtual disappearance of liquidity for emerging
market and many other debt instruments. U.S. and most European markets
subsequently rebounded during the 1998 fourth quarter, as a series of moderate
U.S. interest rate cuts provided market stability that led equity market indices
to record levels and resulted in increased liquidity in credit markets. Russian
and Latin American markets remained weak during the 1998 fourth quarter, while
certain markets in Asia, particularly Korea and Thailand, began to show signs of
recovery.
Long-term U.S. interest rates, as measured by the yield on the 30-year
U.S. Treasury bond, generally declined throughout 1998. The rally in U.S.
Treasuries during the third quarter, precipitated by investors' flight from
lower credit quality instruments, continued low inflation, and deleveraging of
hedge funds, drove long-term rates to their lowest levels since 1967. European
rates, following the U.S. trend, generally decreased during 1998 and were lower
relative to 1997. Interest rates in Latin American countries, particularly
Brazil, increased during the first nine months of 1998, but declined modestly
during the final weeks of the year.
Credit spreads, which represent the risk premium over the risk-free rate
paid by an issuer based on the issuer's credit rating or perceived
creditworthiness, widened to unprecedented levels during 1998. This extreme
movement in credit spreads, which peaked in August and September, led to large
mark-to-market losses on credit-sensitive instruments, particularly high-yield
and emerging market securities. Due to the reduced effectiveness of hedging with
U.S. Treasuries, the typical hedge for corporate debt instruments, these losses
were not offset.
U.S. equity markets experienced significant gains during 1998 as evidenced
by the 16.1% advance in the Dow Jones Industrial Average (the "Dow"). This
increase occurred despite a volatile third quarter, when concerns over global
economic markets and earnings disappointments led to a one-day 513-point drop in
the Dow in August, erasing the gains achieved during the first seven months of
the year. U.S. equity markets posted a strong recovery in the fourth quarter,
aided by a series of modest U.S. interest rate cuts beginning in September. The
Nasdaq Composite and the S&P 500 also advanced 39.6% and 26.7%, respectively,
from year-end 1997.
Global equity markets trended upward during the first quarter of 1998.
European markets flourished due to prospects for strong corporate earnings and
low interest rates, while certain Asian markets slowly recovered from 1997 price
declines. This trend continued through July in Europe, but reversed early in the
second quarter in Asia, as fears over the yen's declining value and political
unrest in certain Asian countries led to significant volatility and reduced
investor confidence. The collapse of the Russian economy and delays in
International Monetary Fund loans to Brazil in the third quarter triggered
further declines in Asian and Latin American markets and adversely impacted
European stock indices. Aided by interest rate cuts, European and certain Asian
markets, including Korea and Thailand, bounced back during the 1998 fourth
quarter, while Russian and Latin American markets continued to struggle. Despite
this severe volatility in many non-U.S. markets during 1998, the Dow Jones World
Index advanced 20.2% from year-end 1997.
Global underwriting volume reached record levels during 1998, as a robust
first six months and strong fourth quarter compensated for the slowdown of new
issuances from mid-August through mid-October. Underwriting fees for 1998 fell
slightly short of a record, however, totaling $8.8 billion industrywide, as debt
offerings, which typically yield lower fees than equity issuances, accounted for
much of the underwriting activity during the year.
Strategic services activities reached record levels in 1998, as merger and
acquisition deal values increased nearly 50% from 1997. Companies continued to
seek strategic alliances to increase earnings growth, better compete in existing
markets, and expand into new markets and businesses.
Merrill Lynch continually evaluates its businesses across varying market
conditions for profitability and alignment with long-term strategic objectives.
Businesses that fail to meet these hurdles over market cycles are resized,
restructured, or exited (e.g., certain debt trading businesses in the
27
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
1998 fourth quarter). Merrill Lynch seeks to mitigate the effect of market
downturns by expanding globally into new markets, developing and maintaining
long-term client relationships, monitoring costs and risks, and diversifying
revenue sources, including the expansion of fee-based revenues.
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
1998 vs.
(in millions, except ----------------
per share amounts) 1998 1997 1996 1997 1996
- --------------------------------------------------------------------------------
Total revenues $35,853 $32,499 $25,713 10.3% 39.4%
Net revenues 17,547 16,256 13,621 7.9 28.8
Net earnings 1,259 1,935 1,648 (34.9) (23.6)
Net earnings applicable
to common stockholders 1,220 1,896 1,602 (35.6) (23.8)
Earnings per common share:
Basic 3.43 5.57 4.63 (38.4) (25.9)
Diluted 3.00 4.79 4.08 (37.4) (26.5)
Return on average common
stockholders' equity 13.4% 26.5% 26.6%
- --------------------------------------------------------------------------------
During 1998, record revenues were achieved in investment banking,
commissions, and asset management and portfolio service fees. These revenues
were partially offset by a decrease in principal transactions revenues and
increased costs related to compensation and benefits, communications and
technology, and a staff reduction provision.
Merrill Lynch reported 1998 net earnings of $1.3 billion, which included
an after-tax provision for costs related to staff reductions of $430 million
($288 million after-tax). Excluding the staff reduction provision, 1998 net
earnings were $1.5 billion, or $3.71 per diluted share, down 20% from $1.9
billion or $4.79 per diluted share reported in 1997. Return on average common
stockholders' equity on this basis was 16.4%.
Management believes cash earnings, which exclude goodwill amortization,
are the most relevant measure of financial performance because it best
illustrates Merrill Lynch's operating performance and ability to support growth.
Earnings on a cash basis, before the staff reduction provision, were $1.8
billion, down from $2.0 billion in 1997. On the same basis, diluted earnings per
share were $4.27 versus $4.95 in 1997, and return on average common
stockholders' equity was 18.3%.
The staff reduction program and other cost savings initiatives implemented
during the 1998 fourth quarter are expected to reduce annual fixed and
semi-fixed costs by approximately $500 million and selectively resize certain
Merrill Lynch businesses. In the 1998 fourth quarter, Merrill Lynch experienced
a $271 million, or 17%, decrease in all non-compensation expenses compared to
the 1998 third quarter, due to cost savings initiatives including the staff
reduction provision. These programs were instituted to position Merrill Lynch
for 1999 in anticipation of a more challenging business environment (see the
Non-Interest Expenses section for more information).
The following discussion provides details of major revenue and expense
categories and other pertinent information on Merrill Lynch's business
activities, financial condition, liquidity, and risks. Prior year amounts have
been restated to reflect Merrill Lynch's merger with Midland Walwyn (see Note 2
to the Consolidated Financial Statements), as if Merrill Lynch and Midland
Walwyn had always been combined. In addition, certain reclassification and
format changes have been made to prior year amounts to conform with the current
year presentation.
COMMISSIONS
- --------------------------------------------------------------------------------
(in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Listed and over-the-counter $ 3,185 $ 2,759 $ 2,207
Mutual funds 1,871 1,594 1,302
Other 743 642 576
------- ------- -------
Total $ 5,799 $ 4,995 $ 4,085
======= ======= =======
- --------------------------------------------------------------------------------
Commissions revenues advanced 16% in 1998 to a record $5.8 billion,
primarily due to increases in global listed securities volume and mutual fund
commissions. Commissions from listed securities were up 16% from 1997 as a
result of higher trading volumes on the New York Stock Exchange and many
non-U.S. exchanges. Mutual fund commissions revenues rose 17%, benefiting from
strong sales of both U.S. and non-U.S. funds. Other commissions revenues
advanced 16% in 1998, largely due to increased sales of money market
instruments, commodities, and third party annuity contracts.
Commissions revenues in 1997 rose 22% from 1996 levels. Increased trading
volume led to higher listed and over-the-counter securities transaction
revenues, while strong sales of U.S. and non-U.S. mutual funds and higher
distribution fees increased mutual fund commissions.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
INTEREST AND DIVIDENDS
- --------------------------------------------------------------------------------
(in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
INTEREST AND DIVIDEND REVENUES
Resale agreements and securities
borrowed transactions $ 8,973 $ 8,121 $ 5,930
Trading assets 5,218 5,240 4,208
Margin lending 2,757 2,207 1,556
Other 2,366 1,731 1,431
------- ------- -------
19,314 17,299 13,125
------- ------- -------
INTEREST EXPENSE
Repurchase agreements and securities
loaned transactions 8,413 7,306 5,508
Borrowings 5,500 4,623 3,064
Trading liabilities 2,619 2,983 2,492
Other 1,774 1,331 1,028
------- ------- -------
18,306 16,243 12,092
------- ------- -------
NET INTEREST AND DIVIDEND PROFIT $ 1,008 $ 1,056 $ 1,033
======= ======= =======
- --------------------------------------------------------------------------------
Interest and dividend revenues and expenses are a function of the level
and mix of interest-earning assets and interest-bearing liabilities and the
prevailing level, term structure, and volatility of interest rates. Net interest
and dividend profit was down 5% from 1997, primarily due to additional financing
costs related to the Mercury Asset Management Group ("Mercury") acquisition.
In 1997, interest and dividend profit was up 2% from 1996 with increases
in net interest-earning assets offset by declining interest spreads due to the
flattening of the yield curve.
Merrill Lynch hedges its long- and short-term borrowings, primarily with
interest rate and currency swaps, to better match the interest rate and currency
characteristics of the borrowings to the assets funded by borrowing proceeds.
The effect of this hedging activity, which is included in "Borrowings" above,
decreased interest expense for 1998, 1997, and 1996 by $62 million, $81 million,
and $127 million, respectively (see Note 5 to the Consolidated Financial
Statements).
PRINCIPAL TRANSACTIONS
The table that follows provides information on trading revenues, including
related net interest. Interest revenue and expense amounts are based on
management's assessment of the cost to finance trading positions, after
consideration of the underlying liquidity of these positions.
Trading and related hedging and financing activities affect the
recognition of both principal transactions revenues and net interest and
dividend revenues. In assessing the profitability of its trading activities,
Merrill Lynch aggregates net interest and principal transactions revenues. For
financial reporting purposes, however, realized and unrealized gains and losses
on trading positions, including hedges, are recorded in principal transactions
revenues. The net interest carry (i.e., the spread representing interest earned
less financing costs) for trading positions, including hedges, is recorded
either as principal transactions revenues or net interest revenues, depending on
the nature of the specific instruments. Changes in the composition of trading
inventories and hedge positions can cause the recognition of revenues within
these categories to fluctuate.
- --------------------------------------------------------------------------------
PRINCIPAL NET NET
TRANSACTIONS INTEREST TRADING
(in millions) REVENUES REVENUES REVENUES(1)
- --------------------------------------------------------------------------------
1998
Equities and equity derivatives $ 1,634 $ 82 $ 1,716
Corporate debt and preferred stock (720) (174) (894)
Debt derivatives 817 (71) 746
Mortgages and municipals 271 266 537
Government and agency obligations 441 74 515
Foreign exchange 208 (4) 204
------- ------- -------
Total $ 2,651 $ 173 $ 2,824
======= ======= =======
- --------------------------------------------------------------------------------
1997
Equities and equity derivatives $ 1,323 $ (10) $ 1,313
Corporate debt and preferred stock 814 (109) 705
Debt derivatives 846 (78) 768
Mortgages and municipals 343 159 502
Government and agency obligations 316 125 441
Foreign exchange 185 (1) 184
------- ------- -------
Total $ 3,827 $ 86 $ 3,913
======= ======= =======
- --------------------------------------------------------------------------------
1996
Equities and equity derivatives $ 1,245 $ (31) $ 1,214
Corporate debt and preferred stock 638 50 688
Debt derivatives 711 (105) 606
Mortgages and municipals 404 114 518
Government and agency obligations 396 93 489
Foreign exchange 137 8 145
------- ------- -------
Total $ 3,531 $ 129 $ 3,660
======= ======= =======
- --------------------------------------------------------------------------------
(1) Excludes commissions. For further information on trading results, see Note
13 to the Consolidated Financial Statements.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
Net trading revenues were $2.8 billion in 1998, down 28% from 1997 due to
significant volatility in global debt markets. This decrease was attributable to
losses from corporate debt and preferred stock and lower revenues from debt
derivatives, partly offset by strong revenues in equities and equity
derivatives, mortgages and municipals, government and agency obligations, and
foreign exchange.
Equities and equity derivatives trading revenues advanced 31% from 1997 to
$1.7 billion, primarily due to significantly higher revenues from non-U.S.
equities as well as equity derivative transactions, partially offset by a
decrease in convertibles. The increase in revenues from non-U.S. equities
resulted primarily from an increase in trading volumes in European markets and
higher market share. The growth in equity derivatives revenues from 1997 was due
to increased customer demand and further synergies from the 1995 Smith New Court
acquisition. The decrease in revenues from convertibles was due to the
significant widening of credit spreads.
Corporate debt and preferred stock losses were $894 million during 1998,
compared with revenues of $705 million in 1997, as valuations of corporate and
emerging market bonds were significantly impacted by the unprecedented widening
of credit spreads during August and September and severely reduced liquidity.
These losses were compounded by the ineffectiveness of related hedges during the
1998 third quarter and into the fourth quarter.
Debt derivatives revenues were $746 million, down 3% from 1997 due in part
to credit losses on emerging market-related derivatives in the latter half of
1998.
Revenues from mortgages and municipals were $537 million, up 7% from 1997.
Higher trading revenues from mortgage products were partly offset by lower
revenues from municipals due to reduced margins on sales of shorter-term
instruments.
Government and agency revenues rose 17% during 1998 to $515 million.
Higher revenues from U.S. Government and agencies, driven by investor demand for
higher quality debt instruments, were partially offset by lower revenues from
non-U.S. governments and agencies, attributable to weak economic conditions in
Latin American, Eastern European, and other emerging markets.
Foreign exchange trading revenues increased 11% to $204 million,
attributable to fluctuations in the U.S. dollar versus various currencies.
In 1997, trading revenues were up 7% from 1996. Increased profitability
from equity derivative transactions, higher transaction volume, and price
appreciation in U.S. and certain non-U.S. equity markets led to advances in
equities and equity derivatives trading revenues (up 8%). Lower interest rates
and improved economic conditions increased demand for corporate debt and
preferred stock (up 2%). Higher revenues from emerging market-related
derivatives, improved customer demand due to market volatility, and increased
activity in credit derivatives led to advances in debt derivatives (up 27%). A
less favorable market environment and reduced margins on sales of shorter-term
instruments led to decreased revenues from mortgages and municipals,
respectively (down 3%). Lower interest rates and reduced market volatility in
certain countries led to a decline in government and agency revenues worldwide
(down 10%). Increased volume attributable to fluctuations in the U.S. dollar
versus the German mark and Japanese yen led to higher foreign exchange revenues
(up 27%).
INVESTMENT BANKING
- --------------------------------------------------------------------------------
(in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Underwriting revenues $ 2,162 $ 2,079 $ 1,592
Strategic services revenues 1,102 797 430
------- ------- -------
Total $ 3,264 $ 2,876 $ 2,022
======= ======= =======
- --------------------------------------------------------------------------------
Investment banking revenues advanced 13% from 1997 to a record $3.3
billion, benefiting from increased revenues from underwriting and record merger
and acquisition advisory fees in 1998. Higher issuances of convertible
securities and Defined Asset Funds (Service Mark) were partially offset by lower
equity and high-yield debt underwriting activity. Merrill Lynch retained its
position as the leading underwriter of total debt and equity securities for the
11th consecutive year in the U.S. and for the 10th consecutive year globally. In
addition, Merrill Lynch gained market share in 1998 for most debt and equity
categories. Merrill Lynch's underwriting market share information based on
transaction value follows:
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MANAGEMENT'S DISCUSSION AND ANALYSIS
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
1998 1997 1996
--------------- --------------- ----------------
MARKET MARKET MARKET
SHARE RANK SHARE RANK SHARE RANK
- --------------------------------------------------------------------------------
U.S. PROCEEDS
Debt 16.2% 1 15.8% 1 15.6% 1
Equity 16.6 1 15.3 1 13.5 2
Debt and Equity 16.7 1 16.1 1 16.0 1
GLOBAL PROCEEDS
Debt 13.8% 1 13.1% 1 12.2% 1
Equity 13.2 3 13.2 2 12.2 2
Debt and Equity 14.1 1 13.4 1 12.7 1
- --------------------------------------------------------------------------------
Source: Securities Data Co. ("SDC") statistics based on full credit to book
manager.
Strategic services fees were up 38% from 1997 to a record $1.1 billion,
benefiting from strong merger and acquisition activity. Merrill Lynch also
increased its market share during 1998 in both U.S. and global completed and
announced transactions. Merrill Lynch's merger and acquisition market share
information based on transaction value follows:
- --------------------------------------------------------------------------------
1998 1997 1996
--------------- --------------- ----------------
MARKET MARKET MARKET
SHARE RANK SHARE RANK SHARE RANK
- --------------------------------------------------------------------------------
COMPLETED
TRANSACTIONS
U.S. 33.4% 1 28.6% 1 24.3% 2
Global 25.7 2 19.4 2 15.9 3
ANNOUNCED
TRANSACTIONS
U.S. 31.9% 2 27.9% 1 27.9% 1
Global 25.3 2 18.8 3 18.0 2
- --------------------------------------------------------------------------------
Source: SDC statistics based on full credit to both target and acquiring
companies' advisors.
Investment banking revenues in 1997 increased 42% from 1996 due to higher
levels of equity underwriting and increased merger and acquisition activity
industrywide.
ASSET MANAGEMENT AND PORTFOLIO SERVICE FEES
- --------------------------------------------------------------------------------
(in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Asset management fees $ 2,075 $ 1,232 $ 1,010
Portfolio service fees 1,150 826 608
Account fees 451 422 383
Other fees 526 522 430
------- ------- -------
Total $ 4,202 $ 3,002 $ 2,431
======= ======= =======
- --------------------------------------------------------------------------------
Revenues from asset management and portfolio service fees rose 40% in 1998
to a record $4.2 billion, primarily due to the Mercury acquisition and strong
growth in other assets under management. Year-end client assets for 1998, 1997,
and 1996 are summarized as follows:
- --------------------------------------------------------------------------------
1998 vs.
---------------
(in billions) 1998 1997 1996 1997 1996
- --------------------------------------------------------------------------------
ASSETS IN CLIENT ACCOUNTS
OR UNDER MANAGEMENT
U.S. $ 1,164 $ 979(1) $ 792 19% 47%
Non-U.S. 278 250(2) 68 11 309
------- ------- -----
Total $ 1,442 $ 1,229 $ 860 17 68
======= ======= =====
ASSETS UNDER MANAGEMENT
Retail $ 258 $ 240 $ 194 8 33
Institutional 243 208 41 17 493
------- ------- -----
Total $ 501 $ 448(2) $ 235 12 113
======= ======= =====
FEE-BASED PROGRAM ASSETS(3) $ 64 $ 45 $ 30 42 113
401(k) ASSETS $ 99 $ 74 $ 45 34 120
- --------------------------------------------------------------------------------
(1) Includes $17 billion of assets related to the 1997 acquisition of
MasterWorks, a 401(k) service provider.
(2) Includes $167 billion of assets related to the year-end 1997 acquisition
of Mercury.
(3) Includes Merrill Lynch Consults (Registered Trademark), Merrill Lynch
Mutual Fund Advisor (Service Mark), Asset Power (Service Mark), Global
Funds Advisor (Service Mark), and Merrill Lynch Financial Advantage
(Service Mark).
Changes in client assets from year-end 1997 to year-end 1998 are described
below:
- --------------------------------------------------------------------------------
NET CHANGES DUE TO
-----------------------
YEAR-END NEW ASSET YEAR-END
(in billions) 1997 MONEY(1) APPRECIATION 1998
- --------------------------------------------------------------------------------
Assets in client accounts
or under management $ 1,229 $ 98 $ 115 $ 1,442
Assets under management 448 34 19 501
- --------------------------------------------------------------------------------
(1) Includes reinvested dividends of $11 billion.
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Asset management fees increased 68% in 1998 due to the acquisition of
Mercury and growth in Merrill Lynch Asset Management ("MLAM") assets under
management. Portfolio service fees were up 39% in 1998, benefiting from
significant growth in client accounts and asset levels for various fee-based
products, including Merrill Lynch Consults (Registered Trademark), Merrill Lynch
Mutual Fund Advisor (Service Mark), Asset Power (Service Mark), Global Funds
Advisor (Service Mark), and Merrill Lynch Financial Advantage (Service Mark).
Account fees rose 7% principally as a result of increases in the number of
customer and custodial accounts.
In 1997, asset management and portfolio service fees rose 23% from 1996,
due to increases in MLAM assets under management resulting from market
appreciation and net inflows, as well as growth in client accounts and asset
levels for other fee-based products.
OTHER REVENUES
Other revenues were $623 million in 1998, up 25% from 1997. Other revenues
include investment and real estate gains and losses and partnership
distributions. The increase in other revenues during 1998 was primarily
attributable to a pre-tax gain from the sale of Merrill Lynch's New York Stock
Exchange specialist business of approximately $100 million.
In 1997, other revenues decreased 4% to $500 million primarily due to
lower realized gains in 1997 versus 1996. Realized gains in 1997 resulted from
the sales of (i) merchant banking investments, (ii) Merrill Lynch's proxy
distribution operation, and (iii) securitized mortgages, while the sale of a
portion of Merrill Lynch's interest in Bloomberg L.P. accounted for the realized
gain in 1996.
NON-INTEREST EXPENSES
Merrill Lynch's non-interest expenses are summarized as follows. Certain
of these expenses have been reclassified from prior periods to conform to the
current period presentation.
- --------------------------------------------------------------------------------
(in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Compensation and benefits $ 9,199 $ 8,333 $ 7,012
-------- -------- --------
Non-interest expenses, excluding
compensation and benefits:
Communications and technology 1,749 1,255 1,010
Occupancy and related depreciation 867 736 742
Advertising and market development 688 613 527
Brokerage, clearing, and exchange fees 683 525 433
Professional fees 552 520 385
Goodwill amortization 226 65 50
Provision for costs related to
staff reductions 430 - -
Other 1,057 1,098 834
-------- -------- --------
Total non-interest expenses, excluding
compensation and benefits 6,252 4,812 3,981
-------- -------- --------
Total non-interest expenses $ 15,451 $ 13,145 $ 10,993
======== ======== ========
Compensation and benefits
as a percentage of net revenues 52.4%(1) 51.3% 51.5%
Compensation and benefits as a
percentage of pre-tax earnings
before compensation and benefits 78.5%(1)(2) 72.8% 72.7%
- --------------------------------------------------------------------------------
(1) These ratios, excluding Mercury and MLJS, were 51.5% and 74.8%,
respectively.
(2) Excluding provision for costs related to staff reductions.
Non-interest expenses increased 18% from 1997. Approximately $1.4 billion,
or about 60%, of this increase was attributable to the acquisition of Mercury,
the start-up of Merrill Lynch Japan Securities Co. ("MLJS"), and a staff
reduction provision.
The largest expense category, compensation and benefits, was up 10% from
1997 due to increased headcount and higher production-related compensation,
slightly offset by lower incentive compensation. Headcount of 63,800 employees
at year-end 1998 reflects an increase of approximately 4,100 employees since
year-end 1997. This increase is attributable to strategic business expansion,
including the start-up of MLJS. Production-related compensation was up due to
strong business volume associated with higher Financial Consultant productivity,
while lower profitability led to reduced incentive compensation.
Communications and technology expense rose 39% from 1997 to $1.7 billion.
Increased systems consulting costs associated with the Year 2000, European and
Economic Monetary Union, and Trusted Global Advisor (Service Mark) initiatives
(see the Capital Projects and Expenditures section) and higher technology-
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related depreciation contributed to this advance. Occupancy and related
depreciation increased 18% to $867 million as a result of continued global
expansion, including a total of $74 million associated with MLJS and Mercury.
Advertising and market development expense was $688 million, up 12% from
1997 because of increased advertising costs, partly related to the start-up of
MLJS and the Roth IRA campaign, and higher recognition program costs. Brokerage,
clearing, and exchange fees increased 30% to $683 million, primarily due to
custody and clearing costs for Mercury. Professional fees rose 6% to $552
million due to higher costs for various strategic market studies and one-time
integration costs for Midland Walwyn. Goodwill amortization increased $161
million to $226 million primarily as a result of the Mercury acquisition. Other
expenses were down 4% from 1997, attributable to reductions in provisions for
various business activities and legal matters, partly offset by higher office
and postage costs.
In the 1998 third quarter, Merrill Lynch recorded a $430 million ($288
million after-tax) provision for costs related to staff reductions aimed at
reducing fixed and semi-fixed costs and resizing certain debt trading
businesses. The staff reduction program included reductions in the workforce,
through termination and attrition, of approximately 3,400 personnel, or about 5%
of Merrill Lynch's global workforce, including producers and direct business
support staff in certain Corporate and Institutional Client Group businesses. In
addition, full-time equivalent consultants, mainly involved in technology
projects, were reduced by approximately 900. The staff reduction provision
covered primarily severance costs, as well as costs to terminate long-term
contracts and leases related to personnel reductions and resized businesses (see
Note 2 to the Consolidated Financial Statements). As of year-end 1998, these
headcount reductions had been largely implemented.
Non-interest expenses in 1997 were up 20% over 1996. Higher incentive and
production-related compensation and a 14% growth in full-time employees led to a
19% increase in compensation and benefits. Communications and technology expense
was up 24%, primarily due to increased systems consulting costs related to
various technology projects and higher technology-related depreciation.
Occupancy costs decreased 1%, reflecting a non-recurring pre-tax charge in 1996
of $40 million related to the resolution of Olympia & York's bankruptcy that
affected ML & Co.'s long-term sublease agreement in the World Financial Center,
partially offset by increased costs related to growth outside the U.S.
Advertising and market development expense rose 16%, primarily due to increased
global travel related to business development and client promotion costs.
Brokerage, clearing, and exchange fees were up 21% as a result of higher global
securities trading volume. Professional fees rose 35% attributable in part to
higher management consulting costs related to strategic market studies. Goodwill
amortization increased $15 million to $65 million as a result of recent
acquisitions. Other expenses increased 32% from 1996 due to increases in
provisions for various business activities and legal matters and higher office
and postage costs.
Presented below is a bar graph illustrating fee-based revenues as a
percentage of fixed and semi-fixed expenses for the past five years.
- -----------------------------------------------------------------
FEE-BASED REVENUES AS A PERCENTAGE OF
FIXED AND SEMI-FIXED EXPENSES
($ in millions)
- -----------------------------------------------------------------
FIXED AND
FEE-BASED SEMI-FIXED
REVENUES(2) EXPENSES %
----------- ---------- ----
1998 $5,749 $7,930 73%(1)
1997 4,145 6,569 63
1996 3,562 5,584 64
1995 3,083 4,671 66
1994 2,886 4,385 66
- -----------------------------------------------------------------
(1) The increase in this percentage compared to 1997 is primarily due to higher
fee-based revenues resulting from the Mercury acquisition.
(2) Fee-based revenues principally include asset management and portfolio
service fees and net margin interest.
INCOME TAXES
Merrill Lynch's 1998 income tax provision was $713 million, representing a
34.0% effective tax rate compared with 36.3% in 1997 and 37.3% in 1996. The
decline in the 1998
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effective tax rate was primarily attributable to higher tax-exempt income and
additional tax-advantaged financing. The effective tax rate decreased in 1997
from 1996 due to a reduction in state and local taxes associated with the
settlement of tax audits.
Deferred tax assets are recorded for the effects of temporary differences
between the tax basis of an asset or liability and its reported amount in the
financial statements. Merrill Lynch assessed its ability to realize deferred tax
assets primarily based on a strong earnings history and the absence of negative
evidence as discussed in Statement of Financial Accounting Standards ("SFAS")
No. 109, "Accounting for Income Taxes". During the last 10 years, average pre-
tax earnings were $1.7 billion. Accordingly, management believes that it is more
likely than not that deferred tax assets will be realized.
STRATEGIC BUSINESS INITIATIVES
Merrill Lynch continued to execute its global business strategy in 1998,
which included:
o Opening 33 retail offices in Japan through Merrill Lynch Japan Securities
Co.,
o Merger with Midland Walwyn Inc., one of Canada's premier securities firms,
for which approximately nine million shares of common stock or
exchangeable shares were issued,
o Purchasing a majority interest in Phatra Securities Company Limited,
Thailand's leading investment bank, for $65 million,
o Acquiring Howard Johnson & Co., a U.S. employee benefits consulting firm,
for $27 million, and
o Divesting a majority interest in Lender's Service, Inc., a residential
real estate services subsidiary, and a 100% interest in Merrill Lynch's
New York Stock Exchange specialist subsidiary.
In 1997, Merrill Lynch acquired the Mercury Asset Management Group, the
leading independent U.K. asset management firm, for approximately $5.3 billion.
The acquisition was recorded at year-end 1997 and, as a result, had no effect on
1997 operating results.
Merrill Lynch made other strategic acquisitions in 1997 in acquiring
MasterWorks, a 401(k) service provider, for $13 million and hiring the employees
of the Centaurus Corporate Finance Group, a strategic advisor in Australia.
Acquisitions made or substantially completed in 1996 included McIntosh
Securities Limited and Hotchkis and Wiley, for which aggregate consideration of
$232 million was paid. See Note 2 to the Consolidated Financial Statements for
further information on acquisitions.
BUSINESS SEGMENTS
Merrill Lynch reports the results of its four strategic business
priorities within two business segments: Wealth Management and Corporate and
Institutional Client. Wealth Management comprises Merrill Lynch's U.S. Private
Client, International Private Client, and Asset Management strategic priorities,
all of which provide services related to the accumulation and management of
wealth. The Corporate and Institutional Client Group ("CICG"), Merrill Lynch's
other strategic priority, is reported as a separate business segment due to the
distinct nature of the products it provides and the clients it serves. CICG's
activities predominantly involve providing investment banking and strategic
merger and acquisition advisory services, as well as other capital markets
services to corporate, institutional, and governmental clients throughout the
world.
Certain CICG products are distributed by the Wealth Management
distribution network, and to a more limited extent, certain Wealth Management
products are distributed through the distribution capabilities of CICG. Costs
associated with these intersegment services are borne by each segment through
transfer pricing. The following segment operating results exclude certain
corporate items (see Note 13 to the Consolidated Financial Statements).
Wealth Management
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 11,331 $ 9,505 $ 7,984
Net earnings 1,346 1,056 855
Average assets 46,251 38,276 33,496
- --------------------------------------------------------------------------------
Total employees 46,790 43,850 38,845
- --------------------------------------------------------------------------------
Wealth Management provides a wide range of fee-based products and services
that assist clients around the world in building financial assets and maximizing
client returns in relation to risk tolerance and investment objectives. These
products and services include retail brokerage, asset management, liability
management, retail and private banking, trust and
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retirement services, and insurance products. These products and services are
provided to individual investors, corporations, and institutions through various
distribution networks, including approximately 17,400 Financial Consultants and
Relationship Managers located in more than forty countries, as well as highly
specialized personnel such as banking and insurance specialists.
Financial Consultants, Relationship Managers, and other investment
professionals work with individual investors, small and medium-sized
corporations, and other organizations to address clients' financial concerns,
matching the numerous products offered by Merrill Lynch with the clients'
customized needs. These products include:
o The CMA (Registered Trademark) and CBA (Registered Trademark) accounts for
individuals, WCMA (Registered Trademark) account for small and mid-sized
businesses, and EMA (Service Mark) account for foundations and non-profit
organizations, all of which are types of flexible central asset accounts
for securities transactions, money sweeps, electronic funds-transfer
capabilities, debit card access, and many other financial management
features.
o Investment research programs, such as Merrill Lynch OnLine (Service Mark),
that provide clients with internet access to their accounts and the latest
research and investment recommendations of the firm.
o A wide array of global mutual fund portfolios covering a cross section of
industries and regions of the world.
o Various advisory programs, including Merrill Lynch Consults (Registered
Trademark), Merrill Lynch Mutual Fund Advisor (Service Mark), Asset Power
(Service Mark), Global Funds Advisor (Service Mark), and Merrill Lynch
Financial Advantage (Service Mark).
o Liability management services, in which mortgage and other consumer loans,
margin lending, and commercial financing are offered.
o Private banking services, which provide high net worth customers outside
of the U.S. with a host of products and services to meet their financial
objectives, including investing and borrowing strategies, investment
management, trust and personal holding company services, and currency
management.
o Insurance services, including annuity and life products for both
retirement and estate planning.
o Trust and other estate planning techniques to protect the assets of
clients and their families.
o Advisory and administrative activities for defined contribution, defined
benefit, and various stock plans.
Within the U.S., Wealth Management has over 670 Private Client offices,
13,600 Financial Consultants, and client assets of $1.1 trillion at year-end
1998, including $298 billion of assets under management. Outside of the U.S.,
Merrill Lynch has over 220 Private Client offices, 3,800 Relationship Managers,
and client assets of more than $300 billion at year-end 1998, including $203
billion of assets under management.
Wealth Management continued to expand its global presence during 1998
through the merger with Midland Walwyn. With Midland Walwyn's approximately
3,200 employees, including 1,300 investment professionals operating in 145
offices, Merrill Lynch has significantly enhanced its presence in Canada. In
Japan, through the formation of MLJS, individual investors are offered the same
consultative approach that Merrill Lynch has employed elsewhere in the world.
Staffed by approximately 2,000 employees, including approximately 1,000
investment professionals in 33 branch offices, Merrill Lynch is the first U.S.
firm to operate a nationwide retail securities network within the country.
The Asset Management business provides investment advisory services to a
wide variety of institutions and retail clients, including pension plans,
corporations, high net worth individuals, and mutual funds. This business was
expanded through the year-end 1997 acquisition of Mercury. Management believes
that this acquisition is critical to Merrill Lynch's global asset-gathering
strategy and, in combination with MLAM, is essential to the success of its
Wealth Management segment. Asset Management services are offered under three
distinct brand names around the world: Merrill Lynch Asset Management, Merrill
Lynch Mercury Asset Management, and Hotchkis and Wiley. Based on assets under
management, Merrill Lynch is one of the largest investment managers in the world
with $501 billion in assets at year-end 1998. These assets are well diversified
in terms of client type, asset type, and client location (see next page).
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Presented are three pie charts illustrating Merrill Lynch's assets under
management in terms of client type, asset type, and client location at year-end
1998.
- --------------------------------------------------------------------------------
ASSETS UNDER MANAGEMENT AT YEAR-END 1998
- --------------------------------------------------------------------------------
CLIENT TYPE
Retail 52%
Institutional 48
ASSET TYPE
Equity 52%
Fixed-Income and other 48
CLIENT LOCATION
U.S. 59%
Non-U.S. 41
- --------------------------------------------------------------------------------
Net earnings for Wealth Management were $1.3 billion in 1998, up 27% from
$1.1 billion in 1997 and up 57% from $855 million in 1996. Net revenues were
$11.3 billion, up 19% and 42% from 1997 and 1996, respectively. The fee-based
nature of many of Wealth Management's revenues, including commissions and asset
management and portfolio service fees, has increased the stability of Merrill
Lynch's earnings, thereby mitigating some of the market volatility experienced
by the CICG business in the latter half of 1998. Increased trading volumes on
global exchanges and the continued growth in fee-based revenues have led to
record revenues in both commissions revenues and asset management and portfolio
service fees during 1998. The profitability of the Wealth Management segment has
also improved from 1997 and 1996 because of robust markets, increased
productivity, and expanded product lines. Substantially all of Wealth
Management's fixed expenses were covered by fee-based revenues in 1998.
CICG
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 6,522 $ 6,751 $ 5,637
Net earnings 882 1,145 930
Average assets 328,184 249,864 186,328
- --------------------------------------------------------------------------------
Total employees 17,010 15,850 13,755
- --------------------------------------------------------------------------------
CICG provides investment banking and strategic merger and acquisition
advisory services, as well as equity and debt trading and capital markets
services to corporations, financial institutions, and governments around the
world. CICG raises capital for its clients on favorable terms through securities
underwriting, private placements, and loan syndication.
CICG trades securities, currencies, and other products and writes
over-the-counter derivatives to satisfy customer demand for these instruments.
With more than 2,000 equity research professionals and equity trading activities
in 23 countries, Merrill Lynch maintains one of the most powerful equity trading
and underwriting capabilities of any firm in the world. Through its expertise in
government and corporate debt trading, CICG is also the leader in global
distribution of new issue and secondary debt securities. CICG's client-focused
strategy provides investors with opportunities to diversify their portfolios,
manage risk, and enhance returns by tailoring investments and structuring
derivatives to meet clients' customized needs.
In 1998, CICG's net earnings were $882 million, down 23% from 1997 and 5%
from 1996 levels. CICG's net revenues decreased 3% from year-end 1997 to $6.5
billion, primarily due to the significant market volatility in the latter half
of the year which affected global financial markets, especially debt markets.
Revenues from equity products were a record $3.6 billion in 1998 due to
increased client demand for equities and equity derivatives in both the U.S. and
Europe. CICG's global equities business has grown substantially over the last
few years, due to the successful integration of Smith New Court, which was
acquired in 1995, as well as through acquisitions in Australia, Canada, South
Africa, Spain, and Thailand. As a result, equity revenues, both trading and
underwriting, have grown nearly 150% since 1995, with over 36% of 1998 revenues
from non-U.S. locations.
In debt products, the unprecedented movement in credit spreads during the
1998 third quarter led to valuation
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and counterparty losses that significantly impacted certain of Merrill Lynch's
debt trading businesses. Despite a favorable interest rate environment, debt
underwriting levels were also down because of reduced investor demand and issuer
activity in the second half of 1998. As a result of these market conditions,
trading inventories, particularly emerging market instruments and other
credit-sensitive products, were reduced. In addition, staff reductions in
certain debt businesses were implemented during the last quarter of the year to
better balance the cost base relative to the revenue outlook.
Merrill Lynch's investment banking and strategic services activities
reached record levels in 1998. Merrill Lynch remained the leading underwriter of
global debt and equity securities for the 10th consecutive year, with a 14.1%
market share in 1998, according to SDC. Origination revenues for debt and equity
securities were $1.3 billion, down 2% from 1997 and up 24% from 1996. In
addition, Merrill Lynch's global market share of initial public offerings nearly
doubled from 1997. CICG is also a leading advisor for mergers and acquisitions,
and in 1998 ranked No. 1 and No. 2, respectively, in U.S. completed and global
announced transactions, according to SDC. Through the strengthening of its
client relationships, CICG has steadily increased its global completed merger
and acquisition market share and revenues by 32% and 43%, respectively, as
compared with 1997 levels, and 62% and 178%, respectively, when compared with
1996.
GLOBAL OPERATIONS
Merrill Lynch's non-U.S. operations are organized into six geographic
regions:
o Europe, Middle East, and Africa,
o Asia Pacific,
o Australia and New Zealand,
o Japan,
o Canada, and
o Latin America.
In 1998, certain of Merrill Lynch's CICG businesses were impacted by
significant volatility that affected many global financial markets. The strong
performance of the Wealth Management segment, however, helped to mitigate the
effect of this volatility on Merrill Lynch's operating results.
Despite the market turbulence during 1998, Merrill Lynch continued to
strategically expand its non-U.S. operations. This expansion, which included the
integration of Mercury and Midland Walwyn and the start-up of the retail
brokerage business in Japan, coupled with synergies from previous acquisitions,
enabled Merrill Lynch to continue to benefit from increasing demand for global
investments.
The following summary of regional operating results excludes goodwill
amortization, financing costs for the Mercury acquisition, and the staff
reduction provision.
Europe, Middle East, and Africa
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 2,808 $ 1,982 $ 1,563
Earnings before income taxes 307 360 301
Average assets 134,664 73,251 59,935
- --------------------------------------------------------------------------------
Total full-time employees 7,090 6,470 4,610
- --------------------------------------------------------------------------------
Merrill Lynch operates in Europe, the Middle East, and Africa as a dealer
in a wide array of equity and debt products, as well as providing asset
management, investment banking, private banking, and research services.
Merrill Lynch enhanced its presence in the region during 1998 through the
successful integration of Mercury, the leading U.K. asset management firm. As a
result of the acquisition, Merrill Lynch now manages five of the top ten pension
funds in the world and includes 50 of the U.K.'s 100 largest public companies as
its clients. This acquisition demonstrates Merrill Lynch's commitment to its
strategic objective of becoming a global leader in the asset management business
and expands the region's depth and range of products and services.
Building on the foundations of the 1995 Smith New Court acquisition,
equities revenues in this region have increased almost four-fold over the last
three years. This growth reflects Merrill Lynch's position as a preeminent
equities firm in the region in origination, secondary trading, and research.
In 1998, net revenues for the region increased 42% from 1997, primarily
due to asset management fees relating to Mercury, as well as higher investment
banking and equity trading revenues, partially offset by lower debt trading
revenues.
The 15% decrease from 1997 in earnings before income taxes was primarily
attributable to significantly reduced
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revenues resulting from the adverse trading conditions experienced in debt
markets in the 1998 second half.
In 1997, net revenues for the Europe, Middle East, and Africa region
increased 27% from 1996. The increase was primarily attributable to higher
commissions and trading revenues. Earnings before income taxes rose 20%
resulting from higher revenues, partially offset by increases in infrastructure
costs to support business growth in the region.
Asia Pacific
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 338 $ 489 $ 361
Earnings (loss) before income taxes (165) (34) 36
Average assets 6,562 4,707 6,513
- --------------------------------------------------------------------------------
Total full-time employees 1,620 1,690 1,300
- --------------------------------------------------------------------------------
Merrill Lynch serves a broad retail and institutional client base
throughout the Asia Pacific region. From offices in the People's Republic of
China and its special administrative Hong Kong region, Singapore, Taiwan, South
Korea, Thailand, Malaysia, Indonesia, India and the Philippines, a full range of
Wealth Management and CICG products are offered. Merrill Lynch has an
established trading presence and exchange memberships in virtually all financial
markets in the region and, during 1998, obtained membership on the Korean and
Thai stock exchanges.
Despite continuing financial turbulence in 1998, Merrill Lynch continued
its commitment to expand businesses in this region through the acquisition of a
majority stake in Phatra Securities Company Limited, Thailand's leading
investment bank. Merrill Lynch has successfully integrated Phatra, and is
actively developing new product lines in the Thai markets. Client investment
opportunities in this region were enhanced during 1998 with the introduction of
Mercury mutual funds. During the year, Merrill Lynch was named the leader in
fixed-income research by "Finance Asia Magazine" and was ranked the No. 2
overall Asian research firm by "Institutional Investor".
Net revenues in the region were down 31% from 1997 as continued economic
turmoil in many markets across the region adversely impacted debt and investment
banking revenues. Debt trading results suffered from widening of credit spreads
and severely reduced liquidity across global debt markets. Currency volatility
and political uncertainty in the region also contributed to lower debt trading
and origination revenues. These reduced revenues also negatively impacted
pre-tax earnings. However, solid equity trading results and Private Client
revenues enabled Merrill Lynch to strengthen its leading position in these
businesses across the region.
In 1997, net revenues in the region were up 35% from 1996, benefiting from
strong trading volume and investment banking activity during the first half of
the year, partially offset by declining revenues in the 1997 second half as
currency devaluations across the region significantly affected equity and debt
markets. The pre-tax loss in 1997 was due to specific client provisions and
increased expenses associated with regional expansion, partially offset by
higher trading revenues.
Australia and New Zealand
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 224 $ 177 $ 60
Earnings before income taxes 36 25 7
Average assets 2,789 2,939 1,103
- --------------------------------------------------------------------------------
Total full-time employees 830 780 160
- --------------------------------------------------------------------------------
In the Australia and New Zealand region, Merrill Lynch provides a broad
mix of Wealth Management and CICG products. In 1998, Merrill Lynch established
itself as one of Australia's top three Private Client firms through extensive
recruitment of Relationship Managers and the enhancement of products such as the
Cash Management Trust (Service Mark). As a result, the region's margin lending
and asset management businesses grew substantially in 1998. Merrill Lynch was
also ranked the No. 1 brokerage firm in Australia in the recent "Financial
Products Research Group Survey".
Growth in this region was primarily attributable to the integration of the
1996 acquisition of McIntosh Securities Limited, one of the largest securities
brokerage firms in Australia and New Zealand, as well as the addition of the
staff and clients in 1997 of the Centaurus Corporate Finance Group, a top-tier
Australian merger and acquisition advisory firm. Merrill Lynch was the lead
manager on three of the four largest initial public offerings in the region
during 1998 and led the industry in institutional commissions.
Net revenues for the region increased 27% from 1997. The increase
primarily resulted from higher investment banking revenues due to several large
equity underwritings. Commissions revenues and asset management and portfolio
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service fees also benefited from synergies relating to the McIntosh and Mercury
acquisitions.
Earnings before income taxes rose 44% from 1997, reflecting increased
revenues that were partially offset by higher compensation costs due to
additional hirings in the Wealth Management segment.
Net revenues in the Australia and New Zealand region nearly tripled in
1997 from 1996 due to higher equity trading and investment banking revenues.
Earnings before income taxes rose due to increased revenues, in part offset by
increases in incentive and production-related compensation due to regional
expansion.
Japan
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 574 $ 416 $ 408
Earnings (loss) before income taxes (11) 74 109
Average assets 10,224 7,910 5,007
- --------------------------------------------------------------------------------
Total full-time employees 2,880 780 630
- --------------------------------------------------------------------------------
Following the establishment of MLJS and Merrill Lynch Mercury Asset
Management Japan ("MLMJ"), Merrill Lynch now provides an integrated range of
Wealth Management and CICG products and services in Japan.
MLJS entered the Private Client business in 1998 by hiring approximately
2,000 employees from Yamaichi Securities and opening 33 branch offices
throughout Japan. MLJS provides financial products and services to individuals
and small to mid-sized corporate and institutional clients.
During 1998, MLMJ was formed via the merger of three existing asset
management companies. Through this company, Merrill Lynch is one of the leading
managers of Japanese pension funds, a provider of a wide range of mutual funds,
and is poised to capitalize on the continuing deregulation of the Japanese asset
management industry.
The region's CICG business, which operates under the name Merrill Lynch
Japan ("MLJ"), remained strong in 1998 with record revenues achieved in debt and
equity businesses. MLJ has also seized opportunities arising from financial
services regulatory reforms in Japan, which are expected to benefit underwriting
and merger and acquisition advisory activities and trading volume.
Net revenues in the Japan region were up 38% from 1997, primarily due to
improved profitability from corporate bond trading, higher assets under
management, and increased services provided to financial institutions resulting
from regulatory reform.
The pre-tax loss in 1998 is primarily the result of a $230 million pre-tax
loss from the start-up of MLJS. Excluding MLJS, the region had record pre-tax
earnings of $219 million.
Net revenues in the Japan region in 1997 were up 2% from 1996, due to
increased derivative trading revenues and sales of cross-border products,
partially offset by lower trading revenues for local products. Earnings before
income taxes decreased 32% due to higher compensation costs associated with
regional expansion, offset in part by higher revenues.
Canada
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 625 $ 702 $ 615
Earnings before income taxes 46 134 118
Average assets 11,612 11,869 8,469
- --------------------------------------------------------------------------------
Total full-time employees 3,700 3,280 2,950
- --------------------------------------------------------------------------------
Note: Amounts have been restated to include Midland Walwyn as required under
pooling-of-interests accounting.
In 1998, Merrill Lynch merged with Midland Walwyn Inc., one of Canada's
premier securities firms. With this transaction, Merrill Lynch significantly
expanded its capabilities in Canada beyond its traditional strengths in
investment banking and debt markets. Today, Merrill Lynch is a full-service firm
in the region with a growing presence serving individual and institutional
clients, as well as corporate and government issuers.
Merrill Lynch's Private Client network in Canada ranks as one of the top
three in Canada, with a team of more than 1,300 investment professionals serving
approximately 600,000 individuals. Merrill Lynch Asset Management Group Canada,
with $2 billion in assets under management, launched the first two of a planned
series of proprietary mutual funds in 1998.
In CICG, an independent study of all underwritings in 1998 by Canadian
issuers, compiled by "FP Data Group", ranked Merrill Lynch No. 1 in
international equity and debt financings and No. 3 in all financings.
"Euromoney" ranked Merrill Lynch as the Best Foreign Securities firm in Canada
in 1998.
Net revenues for the region declined by 11% from 1997, due to declines in
underwriting, debt trading, and commissions revenues caused by global market
uncertainties. These
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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declines were partially offset by strong growth in merger and acquisition
advisory revenues and asset management fees.
Earnings before income taxes dropped significantly from 1997, because of a
decrease in revenues and $40 million in merger and integration-related expenses.
Net revenues in 1997 increased 14% from 1996, due to stronger investment
banking and commissions revenues. These higher revenues, combined with lower
expenses, led to a 14% increase in earnings before income taxes in 1997.
Latin America
- --------------------------------------------------------------------------------
(dollars in millions) 1998 1997 1996
- --------------------------------------------------------------------------------
Net revenues $ 392 $ 524 $ 435
Earnings (loss) before income taxes (67) 141 146
Average assets 11,874 10,629 5,968
- --------------------------------------------------------------------------------
Total full-time employees 980 900 850
- --------------------------------------------------------------------------------
In Latin America, Merrill Lynch provides various brokerage and investment
services. Included in this region are certain U.S. offices that primarily serve
Latin American clients. In the first half of 1998, Latin American markets
experienced a mild recovery from 1997 price declines. During the second half of
the year, political and economic events in other regions, as well as delays in
International Monetary Fund support for Brazil, adversely affected revenues in
Latin American markets. Merrill Lynch successfully completed a $4.7 billion
Telebras HOLDRs (Service Mark) (Holding Company Depositary Receipts) issuance,
in addition to obtaining memberships on the Sao Paulo and Rio de Janeiro stock
exchanges in April.
Net revenues for the region decreased 25% from 1997 as trading and
investment banking revenues decreased due to market turbulence that occurred
throughout most of the year. These declines were partially offset by higher
volume driven commissions revenues.
The pre-tax loss during 1998 was the result of increased variable
compensation, brokerage, clearing, and exchange costs, and communications and
technology expenses.
Net revenues in 1997 increased 20% from 1996, due to stronger investment
banking and commissions revenues. Earnings before income taxes decreased 3% as
increases in compensation and benefits and brokerage, clearing, and exchange
fees more than offset the higher revenues.
BALANCE SHEET
Overview
Management continually monitors and evaluates the level and composition of
the balance sheet based on average daily balances, which are determined on a
settlement date basis. Financial statement balances are recorded on a trade date
basis as required under generally accepted accounting principles.
In 1998, average total assets were $380 billion, up 31% from $289 billion
in 1997. Average total liabilities in 1998 rose 31% to $367 billion from $280
billion in 1997. The major components in the growth of average total assets and
liabilities are summarized as follows:
- --------------------------------------------------------------------------------
(in millions) INCREASE GROWTH
- --------------------------------------------------------------------------------
AVERAGE ASSETS
Receivables under resale agreements and
securities borrowed transactions $ 13,257 11%
Trading assets 34,528 32
Securities pledged as collateral 17,813 N/M
Customer receivables 11,502 41
Goodwill 4,893 N/M
AVERAGE LIABILITIES
Payables under repurchase agreements
and securities loaned transactions $ 19,641 19%
Trading liabilities 10,840 19
Obligation to return securities received
as collateral 32,458 N/M
Long-term borrowings 16,274 46
- --------------------------------------------------------------------------------
N/M Not meaningful.
The adoption of SFAS No. 127, "Deferral of the Effective Date of Certain
Provisions of FASB Statement No. 125", which requires the recognition of
collateral received or provided for certain resale and repurchase agreements,
increased the average balances of trading assets and securities pledged as
collateral by $14 billion and $18 billion, respectively, with a corresponding
increase of $32 billion in the obligation to return securities received as
collateral (for more information on SFAS No. 127, see Note 2 to the Consolidated
Financial Statements).
Balance sheet levels were, on average, higher in 1998 compared to 1997.
Year-end 1998 balances, however, generally remained consistent with year-end
1997 balances, resulting from a reduction in the balance sheet, particularly in
trading
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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inventory and secured financing transactions, during the 1998 second half. The
discussion that follows analyzes the changes in year-end financial statement
balances of major asset and liability categories.
Trading-Related Assets and Liabilities
Trading-related balances primarily consist of trading assets and
liabilities, receivables under resale agreements and securities borrowed
transactions, payables under repurchase agreements and securities loaned
transactions, and certain receivable/payable balances that result from trading
activities. Trading-related balances as a percentage of total assets and
liabilities, excluding collateral recognized under SFAS No. 127, are as follows:
Presented are two pie charts illustrating Merrill Lynch's trading-
related balances as percentages of total assets and total liabilities,
respectively, excluding collateral recognized under SFAS No. 127.
- --------------------------------------------------------------------------------
ASSETS AND LIABILITIES
- --------------------------------------------------------------------------------
TRADING-RELATED ASSETS:
Trading Assets 36%
Resale Agreements and Securities Borrowed 31
Receivables 16
----
83
NON-TRADING-RELATED ASSETS 17
----
100%
====
- -------------------------------------------------------------------------------
TRADING-RELATED LIABILITIES:
Trading Liabilities 23%
Repurchase Agreements and Securities Loaned 25
Payables 11
----
59
NON-TRADING-RELATED LIABILITIES 41(1)
----
100%
====
- -------------------------------------------------------------------------------
(1) 24% of the 41% consisted of borrowings to fund trading-related assets.
Although trading-related balances comprise a significant portion of the
balance sheet, the magnitude of these balances does not necessarily convey a
sense of the risk profile assumed by Merrill Lynch. The market and credit risks
associated with trading-related balances are mitigated through various hedging
strategies, as discussed in the following sections (see Note 3 to the
Consolidated Financial Statements for descriptions of market and credit risks).
Merrill Lynch reduces a significant portion of the credit risk associated
with trading-related receivables by requiring counterparties to post cash or
securities as collateral in accordance with collateral maintenance policies. The
chart that follows depicts the value of collateral maintained at December 25,
1998 for trading-related assets to reduce counterparty credit risk.
Presented is a bar graph illustrating the collateral maintained for the
respective balance sheet trading-related receivables.
- --------------------------------------------------------------------------------
COLLATERALIZED TRADING-RELATED RECEIVABLES
(in billions)
- --------------------------------------------------------------------------------
TRADING-RELATED COLLATERAL
RECEIVABLES MAINTAINED
--------------- ----------
Derivative Contract Receivables(a) $ 30 $ 6
Receivables under Resale Agreements 50 53
Receivables under Securities Borrowed
Transactions 37 36
Other Receivables(b) 48 29
---- ----
$165 $124
==== ====
- --------------------------------------------------------------------------------
(a) Included in trading assets. Collateral is not maintained for securities and
other cash instruments.
(b) Collateral presented does not include overcollateralization, i.e., Merrill
Lynch maintains collateral in excess of customer margin loan receivables.
"Trading Assets and Liabilities"
Trading inventory principally represents securities purchased ("long"
positions), securities sold but not yet purchased ("short" positions), and the
fair value of derivative contracts (see Note 1 to the Consolidated Financial
Statements). These positions are primarily the result of market-making, hedging,
and proprietary activities.
Merrill Lynch acts as a market-maker in a wide range of securities,
resulting in a significant amount of trading inventory to facilitate customer
transaction flow. To a lesser degree, Merrill Lynch also maintains proprietary
trading inventory in seeking to profit from existing or projected market
opportunities.
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Merrill Lynch uses both cash instruments and derivatives to manage trading
inventory market risks. As a result of these hedging techniques, a significant
portion of trading assets and liabilities represents hedges of other trading
positions. Long U.S. Government securities, for example, may be hedged with
short interest rate futures contracts. These hedging techniques, which are
generally initiated at the trading unit level, are supplemented by corporate
risk management policies and procedures (see the Risk Management section for a
description of risk management policies and procedures and a discussion of the
effectiveness of hedging techniques).
Trading assets at year-end 1998, including the $6.1 billion of collateral
recognized under SFAS No. 127, were virtually unchanged from year-end 1997. U.S.
Government and agencies securities increased while corporate debt and preferred
stock positions decreased, as a result of investors migrating to higher credit
quality instruments. Trading liabilities decreased from $71 billion to $64
billion, primarily as a result of a reduction in short U.S. Government and
agencies securities used as hedges, partially offset by higher levels of
equities, convertible debentures, and contractual agreements.
"Resale/Repurchase Agreements and Securities Borrowed/Loaned Transactions"
Repurchase agreements and, to a lesser extent, securities loaned
transactions are used to fund a significant portion of trading assets. Likewise,
Merrill Lynch uses resale agreements and securities borrowed transactions to
obtain the securities needed for delivery on short positions. These transactions
are typically short-term in nature since a significant portion are entered into
on an overnight or open basis. Resale and repurchase agreements entered into on
a term basis typically mature within 90 days.
Merrill Lynch also enters into these transactions to meet customers'
needs. These "matched-book" repurchase and resale agreements or securities
borrowed and loaned transactions are entered into with different customers using
the same underlying securities, generating a spread between the interest revenue
on the resale agreements or securities borrowed transactions and the interest
expense on the repurchase agreements or securities loaned transactions.
Exposures on these transactions are limited by their typically short-term nature
and collateral maintenance policies. The following graph illustrates the
balances related to these activities at December 25, 1998.
Presented is a bar graph illustrating the nature of resale/repurchase
agreements and securities borrowed/loaned transactions, differentiating between
matched-book and non-matched-book for total resale agreements, repurchase
agreements, securities borrowed, and securities loaned balances of $50,188
million, $59,501 million, $37,525 million, and $7,626 million, respectively.
- --------------------------------------------------------------------------------
RESALE/REPURCHASE AGREEMENTS AND
SECURITIES BORROWED/LOANED TRANSACTIONS
- --------------------------------------------------------------------------------
MATCHED- NON-MATCHED-
BOOK BOOK
-------- ------------
Resale Agreements 54% 46%
Repurchase Agreements 44 56
Securities Borrowed 14 86
Securities Loaned 69 31
- --------------------------------------------------------------------------------
Receivables under resale agreements and securities borrowed transactions
and payables under repurchase agreements and securities loaned transactions
decreased 18% and 15% from year-end 1997, respectively, as a result of lower
funding requirements due to reductions in inventory levels and matched-book
trading activity.
"Other Trading-Related Receivables and Payables"
Securities trading may lead to various customer or broker-dealer balances.
Broker-dealer balances may also result from recording trading inventory on a
trade date basis. Certain receivable and payable balances also arise when
customers or broker-dealers fail to pay for securities purchased or fail to
deliver securities sold, respectively. These receivables are generally fully
collateralized by the securities that the customer or broker-dealer purchased
but did not receive. Customer receivables also include margin loans
collateralized by customer-owned securities held by Merrill Lynch. Collateral
policies significantly limit Merrill Lynch's credit exposure to customers and
broker-dealers. Merrill Lynch, in accordance with regulatory requirements, will
sell securities that have not been paid for, or purchase securities sold but not
delivered, after a relatively short period of time, or will require additional
margin
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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collateral, as necessary. These measures reduce market risk exposure related to
these balances.
Interest receivable and payable balances related to trading inventory are
principally short-term in nature. Interest balances for resale and repurchase
agreements, securities borrowed and loaned transactions, and customer margin
loans are generally considered when determining the collateral requirements
related to these transactions.
Trading-related receivables were up $7.0 billion from 1997, primarily from
higher open agency clearing transactions and increases in margin and other
collateralized loans. Trading-related payables increased $6.8 billion during
1998 due to heightened customer activity and a net payable that results from
recording inventory on a trade date basis.
Non-Trading Assets
"Investments"
Merrill Lynch's investing activities primarily consist of holding liquid
debt and equity securities, investments of insurance subsidiaries, merchant
banking and venture capital investments, and investments to hedge deferred
compensation liabilities (see Note 4 to the Consolidated Financial Statements
for further information). Investments grew from $10.0 billion at year-end 1997
to $11.7 billion at year-end 1998, as a result of increased investments held by
non-trading entities and investments in partnerships, joint ventures, and real
estate.
"Loans, Notes, and Mortgages"
Merrill Lynch's portfolio of loans, notes, and mortgages includes mortgage
loans on residences, working capital loans to small and medium-sized businesses,
and syndicated loans. Merrill Lynch generally maintains collateral on these
extensions of credit in the form of securities, liens on real estate, perfected
security interests in other assets of the borrower, and guarantees. Loans,
notes, and mortgages rose $3.4 billion in 1998 to $7.7 billion due to increased
consumer lending activities. Merrill Lynch maintained collateral of $5.9 billion
at December 25, 1998 to reduce related default risk.
"Other"
Other non-trading assets include goodwill (related primarily to the
Mercury acquisition), equipment and facilities, and other assets, which were up
slightly from year-end 1997 levels.
Non-Trading Liabilities
"Borrowings"
Portions of trading and non-trading assets are funded through borrowings,
primarily commercial paper and long-term borrowings (see the Capital Adequacy
and Liquidity section for more information on funding sources).
Commercial paper decreased from $30.4 billion at year-end 1997 to $16.8
billion at year-end 1998 in order to reduce Merrill Lynch's use of short-term
unsecured funding. Outstanding long-term borrowings increased to $57.6 billion
at December 25, 1998 from $43.1 billion at December 26, 1997. Major components
of the change in long-term borrowings for 1998 and 1997 follow:
- --------------------------------------------------------------------------------
(dollars in billions) 1998 1997
- --------------------------------------------------------------------------------
Beginning of year $ 43.1 $ 26.2
Issuances 29.3 25.1
Maturities (15.8) (8.2)
Other 1.0 -
------ ------
End of year(1) $ 57.6 $ 43.1
====== ======
Average maturity in years of long-term borrowings,
when measured to:
Maturity 4.4 3.5
Earlier of the call or put date 4.0 3.1
- --------------------------------------------------------------------------------
(1) At year-end 1998 and 1997, $43.9 and $31.2 billion of long-term borrowings
had maturity dates beyond one year, respectively.
Demand and time deposits increased $3.0 billion in 1998 as a result of
higher customer deposits in banking subsidiaries.
"Other"
Other non-trading liabilities include liabilities of insurance
subsidiaries and other payables, which decreased slightly from year-end 1997
levels.
Preferred Securities Issued by Subsidiaries
Preferred securities issued by subsidiaries consist primarily of Trust
Originated Preferred Securities (Service Mark) ("TOPrS" (Service Mark)) (see
Note 6 to the Consolidated Financial Statements for further information). TOPrS
proceeds are utilized as part of general balance sheet funding (see the Capital
Adequacy and Liquidity section for more information). Preferred securities
issued by subsidiaries rose $2.0 billion during 1998 as a result of three TOPrS
issuances.
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Stockholders' Equity
Stockholders' equity at December 25, 1998 increased 19% to $10.1 billion
from $8.5 billion at year-end 1997. The 1998 increase resulted from net earnings
and the net effect of employee stock transactions, partially offset by
dividends.
At December 25, 1998, total common shares outstanding, excluding shares
exchangeable into common stock, were 356.3 million, 5% higher than the 339.3
million shares outstanding at December 26, 1997. The increase was attributable
principally to employee stock grants and option exercises.
Total shares exchangeable into common stock at year-end 1998, issued in
connection with the Midland Walwyn merger, were 4.5 million. In the merger,
Merrill Lynch also issued 4.2 million shares of common stock.
There were no common stock repurchases during 1998. Merrill Lynch
repurchased 13.3 million shares of common stock during 1997 at an average price
of $48.91 per share. In 1998, Merrill Lynch rescinded its share repurchase
authority in order to facilitate pooling-of-interests accounting for the Midland
Walwyn merger.
CAPITAL ADEQUACY AND LIQUIDITY
The primary objectives of Merrill Lynch's capital structure and funding
policies are to:
o Ensure sufficient equity capital to absorb losses,
o Support the business strategies, and
o Assure liquidity at all times, across market cycles, and through periods
of financial stress.
Capital Adequacy
Among U.S. institutions engaged primarily in the global securities
business, Merrill Lynch is one of the most highly capitalized, with $9.7 billion
in common equity, $425 million in preferred stock, and $2.6 billion of
subsidiaries' preferred securities at December 25, 1998.
Merrill Lynch continually reviews overall equity capital needs to ensure
that its equity capital base can support the estimated risks and needs of its
businesses, as well as the regulatory and legal capital requirements of its
subsidiaries. Merrill Lynch uses statistically based risk models, developed in
conjunction with risk management practices, to estimate potential losses arising
from market and credit risks. Equity capital needs are determined based on these
models, which dynamically capture changes in risk profile. Merrill Lynch also
assesses the need for equity capital to support business risks that may not be
adequately measured through these risk models, as well as the potential use of
equity capital to support growth. Merrill Lynch determines the appropriateness
of its equity capital composition, which includes common stock, preferred stock,
and preferred securities issued by subsidiaries, taking into account the
perpetual nature of its preferred stock and TOPrS. Based on these analyses and
criteria, management believes that Merrill Lynch's equity capital base of $12.8
billion is adequate.
Merrill Lynch operates in many regulated businesses that require various
minimum levels of capital (see Note 12 to the Consolidated Financial Statements
for further information). Merrill Lynch's broker-dealer, banking, insurance, and
futures commission merchant activities are subject to regulatory requirements
that may restrict the free flow of funds to affiliates. Regulatory approval is
generally required for paying dividends in excess of certain established levels,
making affiliated investments, and entering into management and service
agreements with affiliated companies.
Merrill Lynch's leverage ratios were as follows:
- --------------------------------------------------------------------------------
ADJUSTED
LEVERAGE LEVERAGE
RATIO(1) RATIO(2)
- --------------------------------------------------------------------------------
PERIOD-END
December 25, 1998 23.5x 15.5x
December 26, 1997 32.4x 20.7x
AVERAGE(3)
Year ended December 25, 1998 32.9x 19.2x
Year ended December 26, 1997 35.3x 21.3x
- --------------------------------------------------------------------------------
(1) Total assets to Total stockholders' equity and Preferred securities issued
by subsidiaries.
(2) Total assets less (a) Securities received as collateral, net of securities
pledged as collateral, (b) Securities pledged as collateral, (c)
Receivables under resale agreements and securities borrowed transactions,
to Total stockholders' equity and Preferred securities issued by
subsidiaries.
(3) Computed using month-end balances.
An asset-to-equity leverage ratio does not reflect the risk profile of
assets, hedging strategies, or off-balance-sheet exposures. Thus, Merrill Lynch
does not rely on overall leverage ratios to assess risk-based capital adequacy.
Liquidity
Merrill Lynch's liquidity policy is to maintain alternative funding
sources such that all debt obligations maturing within one year can be repaid
when due without issuing new
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MANAGEMENT'S DISCUSSION AND ANALYSIS
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unsecured debt or liquidating business assets. Primary alternative funding
sources to unsecured borrowings are repurchase agreements, securities loaned,
and secured bank loans, which require pledging unhypothecated marketable
securities. Other funding sources include liquidating cash equivalents;
securitizing loan assets; and drawing on committed, unsecured bank credit
facilities that, at December 25, 1998, totaled $6.9 billion and were not drawn
upon. Merrill Lynch maintains a contingency funding plan, covering an extended
time horizon, which outlines actions that would be taken in the event of a
severe funding disruption.
Merrill Lynch regularly reviews the level and mix of its assets and
liabilities to assess its ability to conduct core business activities without
issuing new unsecured debt or drawing upon its bank credit facilities. The mix
of assets and liabilities provides flexibility in managing liquidity since a
significant portion of assets turns over frequently and is typically
match-funded with liabilities having similar maturities and cash flow
characteristics. At December 25, 1998, a significant portion of Merrill Lynch's
assets was considered readily marketable by management.
Merrill Lynch typically concentrates its unsecured, general-purpose
funding at the ML & Co. level, except where tax regulations, time zone
differences, or other business considerations make this impractical. The
benefits of this strategy are enhanced control, reduced financing costs, wider
name recognition by creditors, and greater flexibility to meet variable funding
requirements of subsidiaries.
Merrill Lynch strives to expand and diversify its funding programs,
markets, and investor and creditor base. Merrill Lynch benefits by distributing
a significant portion of its liabilities and equity through its own sales force
to a large, diversified global client base. Available funding sources include:
o repurchase agreements and securities loaned transactions,
o U.S., Canadian, Euro, Japanese, and Australian commercial paper programs,
o letters of credit,
o master notes,
o demand and time deposits issued through Merrill Lynch's banking
subsidiaries,
o bank loans,
o long-term debt, including medium-term notes,
o TOPrS,
o preferred stock, and
o common stock.
Additionally, Merrill Lynch maintains access to significant uncommitted
credit lines, both secured and unsecured, from a large group of banks.
During 1998, Merrill Lynch undertook measures to extend the maturity of
its liabilities and to reduce its use of short-term unsecured funding.
Commercial paper represented 6% and 10% of total assets at year-end 1998 and
1997, respectively. Merrill Lynch maintains strict concentration standards for
commercial paper and other short-term borrowings, including limits for any
single investor.
In addition to equity capital sources, Merrill Lynch views long-term debt
as a stable funding source for its core balance sheet assets. Long-term, less
liquid assets are fully funded with long-term sources of capital, which include
the non-current portion of long-term debt, TOPrS, preferred stock, and common
equity. Generally, non-interest-earning investments and fixed assets are
financed with fixed-rate long-term debt and equity capital, while trading and
other current assets are financed with a combination of short-term funding,
floating-rate long-term debt, and equity capital. Foreign currency-denominated
assets are typically funded with like-currency-denominated borrowings. Merrill
Lynch routinely uses derivative transactions, including interest rate and
foreign currency swaps, to reduce its borrowing costs and interest rate and
currency exposures.
As part of an overall liquidity management strategy, Merrill Lynch's
insurance subsidiaries regularly review the funding requirements of their
contractual obligations for in-force, fixed-rate life insurance and annuity
contracts as well as expected future acquisition and maintenance expenses for
all contracts. The insurance subsidiaries market primarily variable life
insurance and variable annuity products. These products are not subject to the
interest rate, asset/liability matching, or credit risks attributable to
fixed-rate products, thereby reducing the insurance subsidiaries' risk profile
and liquidity demands. At December 25, 1998, approximately 85% of invested
assets of insurance subsidiaries were considered liquid by management.
"Credit Ratings"
The cost and availability of unsecured financing generally are dependent
on credit ratings. Merrill Lynch's senior long-term debt, preferred stock, and
TOPrS were rated by several recognized credit rating agencies at December 25,
1998 as follows:
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- --------------------------------------------------------------------------------
SENIOR PREFERRED STOCK
DEBT AND
RATING AGENCY RATINGS TOPrS RATINGS
- --------------------------------------------------------------------------------
Duff & Phelps Credit Rating Co. AA AA-
Fitch IBCA, Inc. AA AA-
Japan Rating & Investment Information, Inc. AA Not Rated
Moody's Investors Service, Inc. Aa3 aa3
Standard & Poor's AA- A
Thomson BankWatch, Inc. AA+ Not Rated
- --------------------------------------------------------------------------------
Approximately $75.4 billion of indebtedness at December 25, 1998 is
considered senior indebtedness as defined under various indentures.
CAPITAL PROJECTS AND EXPENDITURES
Merrill Lynch continually prepares for the future by expanding its
operations and investing in new technology to improve service to clients. To
support business expansion, for example, Merrill Lynch is building a new
European headquarters in London for approximately $650 million; $120 million has
been spent to date. Completion of this facility is expected in 2001. During
1997, Merrill Lynch also approved a plan to construct an office complex in
central New Jersey to consolidate certain operations. Construction costs are
estimated at approximately $325 million, and completion of this facility is
anticipated in 2000.
Significant technology initiatives include Merrill Lynch Trusted Global
Advisor (Service Mark) ("TGA" (Service Mark)) and Year 2000 and European
Economic and Monetary Union systems compliance. The TGA system, a technology
platform which is now available to virtually all Financial Consultants, was
completed during the 1998 third quarter. In the future, new system applications
and systems upgrades will continue to be added to the platform as necessary.
Year 2000 Compliance Initiative
As the millennium approaches, Merrill Lynch has undertaken initiatives to
address the Year 2000 problem (the "Y2K problem"). The Y2K problem is the result
of a widespread programming technique that causes computer systems to identify a
date based on the last two numbers of a year, with the assumption that the first
two numbers of the year are "19." As a result, the year 2000 would be stored as
"00," causing computers to incorrectly interpret the year as 1900. Left
uncorrected, the Y2K problem may cause information technology systems (e.g.,
computer databases) and non-information technology systems (e.g., elevators) to
produce incorrect data or cease operating completely.
Merrill Lynch believes that it has identified and evaluated its internal
Y2K problem and that it is devoting sufficient resources to renovating
technology systems that are not already Year 2000 compliant. The
resource-intensive renovation phase (as further discussed) of Merrill Lynch's
Year 2000 efforts was approximately 95% completed as of January 31, 1999.
Merrill Lynch will focus primarily on completing its renovation and testing and
on integration of the Year 2000 programs of recent acquisitions during the
remainder of 1999. In order to focus attention on the Y2K problem, management
has deferred certain other technology projects; however, this deferral is not
expected to have a material adverse effect on the company's business, results of
operations, or financial condition.
The failure of Merrill Lynch's technology systems relating to a Y2K
problem would likely have a material adverse effect on the company's business,
results of operations, and financial condition. This effect could include
disruption of normal business transactions, such as the settlement, execution,
processing, and recording of trades in securities, commodities, currencies, and
other assets. The Y2K problem could also increase Merrill Lynch's exposure to
risk and its need for liquidity.
In 1995, Merrill Lynch established the Year 2000 Compliance Initiative,
which is an enterprisewide effort to address the risks associated with the Y2K
problem, both internal and external. The Year 2000 Compliance Initiative's
efforts to address the risks associated with the Y2K problem have been organized
into six phases: planning, pre-renovation, renovation, production testing,
certification, and integration testing.
The planning phase involved defining the scope of the Year 2000 Compliance
Initiative, including its annual budget and strategy, and determining the level
of expert knowledge available within Merrill Lynch regarding particular systems
or applications. The pre-renovation phase involved developing a detailed
enterprisewide inventory of applications and systems, identifying the scope of
necessary renovations to each application or system, and establishing a
conversion schedule. During the renovation phase, source code is actually
converted, date fields are expanded or windowed (windowing is used on an
exception basis only), test data is prepared, and each system or
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application is tested using a variety of Year 2000 scenarios. The production
testing phase validates that a renovated system is functionally the same as the
existing production version, that renovation has not introduced defects, and
that expanded or windowed date fields continue to handle current dates properly.
The certification phase validates that a system can run successfully in a Year
2000 environment. The integration testing phase, which will occur throughout
1999, validates that a system can successfully interface with both internal and
external systems. Finally, as Merrill Lynch continues to implement new systems,
they are also being tested for Year 2000 readiness.
In 1996 and 1997, as part of the planning and pre-renovation phases, both
plans and funding of plans for inventory, preparation, renovation, and testing
of computer systems for the Y2K problem were approved. All plans for both
mission-critical and non-mission-critical systems are tracked and monitored. The
work associated with the Year 2000 Compliance Initiative has been accomplished
by Merrill Lynch employees, with the assistance of consultants where necessary.
As part of the production testing and certification phases, Merrill Lynch
has performed, and will continue to perform, both internal and external Year
2000 testing intended to address the risks from the Y2K problem. As of January
31, 1999, production testing was approximately 93% completed. In July 1998,
Merrill Lynch participated in an industrywide Year 2000 systems test sponsored
by the Securities Industry Association ("SIA"), in which selected firms tested
their computer systems in mock stock trades that simulated dates in December
1999 and January 2000. Merrill Lynch will participate in further industrywide
testing sponsored by the SIA, currently scheduled for March and April 1999,
which will involve an expanded number of firms, transactions, and conditions.
Merrill Lynch also participated in various other domestic and international
industry tests during 1998.
Merrill Lynch continues to survey and communicate with third parties whose
Year 2000 readiness is important to the company. Information technology and
non-information technology vendors and service providers are contacted in order
to obtain their Year 2000 compliance plans. Based on the nature of the response
and the importance of the product or service involved, Merrill Lynch determines
if additional testing is needed. The results of these efforts are maintained in
a database that is accessible throughout the firm. Third parties that have been
contacted include transactional counterparties, exchanges, and clearinghouses; a
process to access and rate their responses has been developed. This information
as well as other Year 2000 readiness information on particular countries and
their political subdivisions will be used by Merrill Lynch to manage risk
resulting from the Y2K problem. Management is unable at this point to ascertain
whether all significant third parties will successfully address the Y2K problem.
Merrill Lynch will continue to monitor third parties' Year 2000 readiness to
determine if additional or alternative measures are necessary. In connection
with information technology and non-information technology products and
services, contingency plans, which are developed at the business unit level, may
include selection of alternate vendors or service providers and changing
business practices so that a particular system is not needed. In the case of
securities exchanges and clearinghouses, risk mitigation could include the
re-routing of business. In light of the interdependency of the parties in or
serving the financial markets, however, there can be no assurance that all Y2K
problems will be identified and remediated on a timely basis or that all
remediation will be successful. The failure of exchanges, clearing
organizations, vendors, service providers, counterparties, regulators, or others
to resolve their own processing issues in a timely manner could have a material
adverse effect on Merrill Lynch's business, results of operations, and financial
condition.
At year-end 1998, the total estimated expenditures for the entire Year
2000 Compliance Initiative were approximately $425 million, of which
approximately $125 million was remaining. The majority of these remaining
expenditures are expected to cover testing, risk management, and contingency
planning. There can be no assurance that the costs associated with such
remediation efforts will not exceed those currently anticipated by Merrill
Lynch, or that the costs associated with the remediation efforts or the possible
failure of such remediation efforts would not have a material adverse effect on
Merrill Lynch's business, results of operations, or financial condition.
European Economic and Monetary Union
("EMU") Initiatives
As of January 1, 1999, the "euro" was adopted as the common legal currency
of participating member states of the EMU. As a consequence of the introduction
of and conversion to the euro, Merrill Lynch was required to make significant
changes to nearly 200 global business systems in order to reflect the
substitution of the euro for the 11 member national currencies and the European
currency unit. The introduction
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of the euro brings about fundamental changes in the structure and nature of
European financial markets, including the creation of a unified, more liquid
capital market in Europe. As financial markets in EMU member states converge and
local barriers are removed, competition is expected to increase.
The introduction of the euro affects all Merrill Lynch facilities that
transact, distribute, or provide custody or recordkeeping for securities or cash
denominated in the currency of a participating member state. Merrill Lynch's
systems or procedures that handle such securities or cash were modified in order
to implement the conversion to the euro. The implementation phase is continuing
into the first quarter of 1999 to resolve any post-conversion issues. The
success of Merrill Lynch's euro conversion efforts was dependent on the
euro-compliance of third parties, such as trading counterparties, financial
intermediaries (e.g., securities and commodities exchanges, depositories,
clearing organizations, and commercial banks), and vendors.
As of the end of the 1998 fiscal year, the total estimated expenditures
associated with the introduction of and conversion to the euro were
approximately $79 million, of which $1 million is remaining to be spent during
the first quarter of 1999 on compliance efforts and project administration.
Management believes that it has identified and evaluated all of the systems and
operational modifications necessary for the conversion to the euro. On January
4, 1999 and since then, Merrill Lynch has conducted normal business operations,
having successfully completed its conversion program. Management does not expect
the introduction of the euro to have a negative effect on its future business,
currency risk, or competitive positioning in the European markets.
RISK MANAGEMENT
Through its operating activities, Merrill Lynch is exposed to market,
credit, and other risks. These risks are continually monitored, evaluated, and
managed firmwide through a comprehensive risk management process. The proper
execution of this process leads to more effective management of these risks,
helping to reduce the likelihood of earnings volatility over time.
The primary responsibility in the risk management process rests with
individual business units in managing the risks that arise from individual
transactions or portfolios of similar transactions. Business units manage these
risks by adhering to established risk policies and procedures, advanced hedging
techniques, and the distribution strength of our global sales force.
To supplement risk management at the business unit level, Merrill Lynch
has developed corporate governance policies and procedures that require
corporate personnel, who are independent of business units, to participate in
the risk management process (see the Corporate Governance section). To ensure a
proper system of checks and balances, these units are independent of the
business units and report to other senior executives in the firm.
Merrill Lynch's firmwide risk management process is based on the belief
that there is more to risk management than identifying and measuring risk. The
process itself has been strengthened by experience, but the underlying
philosophy is essentially unchanged. This philosophy is based on the following
eight principles:
1. The most important tools in any risk process are experience, judgment, and
constant communication.
2. Vigilance, discipline, and an awareness of risk must be continuously
emphasized throughout the firm.
3. Management must provide a clear and simple statement as to what can and
cannot be done in committing capital.
4. Risk policies and procedures must be clear, well communicated, and
understood.
5. Risk managers must consider the unexpected, probe for potential problems,
test for weaknesses, and help identify potential for loss.
6. Reporting on risk exposures and variables must be accurate and timely.
7. The process must be flexible to permit adaptation to changing
environments, including the evolving goals of Merrill Lynch itself.
8. The key objective must be to minimize the possibility of incurring
unacceptable loss. Such losses usually arise from unexpected events that
most statistical model-based risk methodologies cannot predict.
The overall effectiveness of Merrill Lynch's risk management process is
illustrated by analyzing actual net trading-related revenues over time. The
nature of Merrill Lynch's trading-related activities, which are principally
client order flow-driven, combined with its risk management strategies, help to
reduce earnings volatility. A distribution of weekly net trading-related
revenues, net of reserves, for each of the last three years is presented in the
graph that follows:
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Presented is a bar graph illustrating the distribution of weekly net
trading-related revenues by revenue band for 1996, 1997, and 1998.
- --------------------------------------------------------------------------------
DISTRIBUTION OF WEEKLY NET
TRADING-RELATED REVENUES BY YEAR
($ IN MILLIONS)
- --------------------------------------------------------------------------------
Number of weeks
---------------
1996 1997 1998
---- ---- ----
Less than $0 - - 5
$0-50 1 4 7
$50-100 31 12 9
$100-150 20 31 17
Over $150 - 5 14
---- ---- ----
52 52 52
==== ==== ====
- --------------------------------------------------------------------------------
Corporate Governance
Merrill Lynch's corporate governance policies and procedures require
specific resource units to assist in the identification, assessment, and control
of risks. The groups responsible for the maintenance of these policies and
procedures include Global Risk and Credit Management ("Risk Management"), as
well as Finance, Audit, Treasury, Operations, and Law and Compliance ("Control
Units").
Risk Management is organized into divisions overseeing market and credit
risks ("Market Risk Division" and "Credit Risk Division", respectively). These
divisions are managed by a single head of Risk Management, who is a member of
the Executive Management Committee.
Risk Management has the authority to set and monitor firmwide risk levels
related to trading exposures and counterparty credit limits, and to veto
proposed transactions (see further discussion in the Market Risk and Credit Risk
sections). Many transactions are subject to prior approval from Risk Management,
including underwriting commitments of equity, high-yield, and emerging market
securities, real estate financings, and bridge loans, as well as most
derivatives and syndicated loans. In addition, Risk Management and
representatives from other Control Units approve new types of transactions as
part of the new product review process.
In addition to independent risk management responsibilities, senior
management from Risk Management and the Control Units take an active role in the
oversight of the risk management process through the Risk Control and Reserve
Committees.
The Risk Control Committee provides general risk oversight for all
institutional trading activities, which includes setting quantitative limits for
market and credit risks and developing guidelines for the approval of new
products. The Risk Control Committee, chaired by the head of Risk Management,
reports periodically to the Audit and Finance Committee of the Board of
Directors and is independent of Merrill Lynch's business units.
The Reserve Committee monitors valuation and certain other risks
associated with assets and liabilities. Merrill Lynch establishes balance sheet
reserves for existing conditions, events, or circumstances that may indicate
that the realizable value of an asset has been reduced below its carrying value
or that a liability has been incurred. The Reserve Committee, chaired by the
Chief Financial Officer, reviews and approves firmwide reserve levels, as well
as changes in reserve methodologies. The Reserve Committee meets monthly to
review current market conditions and to act on specific issues. Merrill Lynch's
reserves take into account management's judgment and are generally based on:
o identification of specific risks and exposures,
o formulas, and
o aging, concentration, and liquidity analyses.
The following discussions of market, credit, operating, and other risks
highlight specific policies and procedures for risk identification, assessment,
and control. For information on qualitative aspects of market and credit risk,
see Note 3 to the Consolidated Financial Statements.
Market Risk
Market risk is the potential change in a financial instrument's value
caused by fluctuations in interest and currency exchange rates, equity and
commodity prices, and credit spreads. The Market Risk Division is responsible
for measuring, monitoring, and controlling market risk on trading positions,
including the establishment of trading limits throughout the firm, which may not
be exceeded without prior approval.
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The Market Risk Division comprises three functional groups: the
Quantitative Risk Management Group; the Analytics, Reporting, and Technology
Group; and the Risk Managers Group. The Quantitative Risk Management Group
independently tests and reviews valuation and risk models used throughout the
firm's trading businesses. The Analytics, Reporting, and Technology Group
designs and develops risk processes and analytics which support portfolio
measurement, establishment of trading limits, and compliance with various
reporting requirements. The Risk Managers Group has primary responsibility for
the independent risk assessment and limits establishment of individual trading
units and is organized along geographic and product lines to ensure direct and
frequent communication with the business areas.
The Market Risk Division has established certain controls and guidelines
to supplement hedging of market risks at the trading unit level (see Trading
Assets and Liabilities in the Balance Sheet section for further information on
these techniques). In addition, the Division performs regular, formal risk
reviews with senior trading managers.
The Market Risk Division uses several proprietary risk technology tools,
including a scenario/value-at-risk system, a risk inventory database, a trading
limit monitoring system, and trading system access. The scenario/value-at-risk
system performs daily sensitivity and value-at-risk analysis on trading
positions. The risk inventory database provides daily consolidation of
securities inventory exposure by product, credit rating, country, etc., along
with concentrations of exposure. The trading limit monitoring system enables the
Division to review compliance with established limits. Access to trading systems
allows the Division to monitor positions and perform computerized analytics.
Merrill Lynch uses mathematical risk models, including value-at-risk and
sensitivity analysis, to help estimate its exposure to market risk.
Nevertheless, management believes that the use of mathematical risk models alone
may provide a greater sense of security than warranted; therefore, reliance on
these models should be limited. In fact, because of the inability of
mathematical risk models to quantify large-scale potential financial events with
any precision, these models only serve to supplement other risk management
efforts. The 1998 third quarter market turmoil is an example of such a financial
event.
Value-at-risk is a statistical measure of the potential loss in the fair
value of a portfolio due to adverse movements in underlying risk factors. For
these disclosures, Merrill Lynch uses a historical simulation approach to
estimate value-at-risk using a 99% confidence level and a two-week holding
period for trading and non-trading instruments. Sensitivities to market risk
factors are aggregated and combined with a database of historical biweekly
changes in market factors to simulate a series of profits and losses. The level
of loss that is exceeded in that series 1% of the time is used as the estimate
for the 99% confidence level value-at-risk. The Market Risk Division continually
enhances its value-at-risk model both in terms of analytic methodology and
historical time series data, both of which can impact final value-at-risk
numbers. Trading units communicate daily to the Division the sensitivity of
their positions to changes in risk factors.
A number of assumptions must be made to obtain the sensitivities and
simulated profits and losses. There is no reason to believe that the
historically simulated profits and losses have any predictive power for the
future distribution of profits and losses. For instance, the unprecedented
volatility experienced in the 1998 third quarter demonstrated the limitations of
value-at-risk models. Prior to that period, the largest widening of credit
spreads in emerging markets ever experienced over a one-month period was
approximately 200 basis points, including the peso crisis in 1994. In contrast,
emerging market spreads widened by approximately 900 basis points during a
three-week period in the 1998 third quarter. Value-at-risk, even using a 99%
confidence level, would only have considered a widening of approximately 200
basis points.
Hypothetical gains and losses from simulated changes in risk factors for
trading instruments would be reflected in earnings since these instruments are
accounted for at fair value. Hypothetical gains and losses from simulated
changes in risk factors for non-trading instruments generally would not be
reflected in earnings since these instruments are typically accounted for at
historical cost.
The overall total value-at-risk amounts are presented across major risk
categories, including exposure to volatility risk found in certain products,
e.g., options. The table that follows presents Merrill Lynch's value-at-risk for
trading instruments at year-end 1998 and 1997 and the 1998 average value-at-risk
calculated on a quarterly basis.
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- --------------------------------------------------------------------------------
YEAR-END YEAR-END AVERAGE
(in millions) 1998 1997 1998
- --------------------------------------------------------------------------------
TRADING VALUE-AT-RISK
Interest rate(1) $ 116 $ 85 $ 97
Equity 4 53 27
Commodity 4 24 12
Currency 25 39 33
Volatility 13 103 38
----- ----- -----
162 304 207
Diversification benefit (49) (144) (79)
----- ----- -----
Overall $ 113(2) $ 160(2) $ 128
===== ===== =====
- --------------------------------------------------------------------------------
(1) Includes credit spread risk.
(2) Overall value-at-risk using a 95% confidence level and a one-day holding
period was $21 and $69 million at year-end 1998 and 1997, respectively.
While trading interest rate value-at-risk increased, Merrill Lynch
decreased its equity, commodity, currency, and volatility values-at-risk across
trading businesses during 1998. These risk reductions reduced overall
value-at-risk by 29% from year-end 1997 to year-end 1998.
The table that follows presents Merrill Lynch's value-at-risk for
non-trading instruments at year-end 1998 and 1997 and the 1998 average
value-at-risk calculated on a quarterly basis:
- --------------------------------------------------------------------------------
YEAR-END YEAR-END AVERAGE
(in millions) 1998 1997 1998
- --------------------------------------------------------------------------------
NON-TRADING VALUE-AT-RISK
Interest rate(1) $ 179 $ 15 $ 78
Currency 82 23 53
Equity 11 7 11
----- ---- ----
272 45 142
Diversification benefit (86) (15) (45)
----- ---- ----
Overall $ 186(2) $ 30(2) $ 97
===== ==== ====
- --------------------------------------------------------------------------------
(1) Includes credit spread risk.
(2) Overall value-at-risk using a 95% confidence level and a one-day holding
period was $34 and $5 million at year-end 1998 and 1997, respectively.
The increase in non-trading interest rate value-at-risk is primarily due
to the issuance of $4 billion in fixed-rate financing, including TOPrS. Merrill
Lynch did not hedge the resulting interest rate risk since long-term
non-interest-earning assets are partially financed with fixed-rate long-term
debt (see the Capital Adequacy and Liquidity section for further information).
The increase in non-trading currency value-at-risk is attributable to greater
British pound exposure resulting from growth in non-U.S. operations.
Credit Risk
Credit risk represents the loss that Merrill Lynch would incur if a
counterparty or issuer failed to perform its contractual obligations. Policies
and procedures have been established with the objective of protecting against
unacceptable credit losses, including:
o reviewing and establishing limits for credit exposures,
o further mitigating counterparty credit exposures through various
techniques, including maintaining collateral, and obtaining the right to
terminate transactions or collect collateral in the event of a credit
rating downgrade, and
o continually assessing the creditworthiness of counterparties and issuers.
The Credit Risk Division is organized geographically, with industry
specialization in the U.S.
Within the Credit Risk Division, counterparty credit approval levels are
established based on counterparty or issuer credit quality and the potential
risk of the transaction. Credit officers set limits by counterparty or issuer,
recommend credit reserves, and manage credit exposures. Transactions that exceed
prescribed levels must be approved by the Credit Committee, which includes
several Directors of Corporate Credit and the Chief Credit Officer. Regional
credit groups, in addition to evaluating the creditworthiness of specific
counterparties, enhance country analysis by ensuring that total credit risks are
within country concentration limits. Within the Credit Department, the Sovereign
Risk group analyzes the political, economic, and financial conditions of
individual countries, establishes country credit ratings, and recommends overall
country risk limits.
The credit system tracks information from automated and manual sources to
enable the Credit Risk Division to monitor counterparty/issuer, product, and
country concentrations. This system aggregates credit exposure by
counterparty/issuer, maintains overall counterparty/issuer and specific product
limits, and identifies limit review dates by counterparty/issuer. Detailed
information on firmwide inventory positions and executed transactions, including
current and potential credit exposure, is updated frequently and compared with
limits. Collateral holdings, which reduce credit exposure, are also tracked on
the credit system.
Credit exposures related to Merrill Lynch's retail customer business,
including mortgages and home equity lines of credit, customer margin accounts,
and working capital facilities to small businesses, are continually monitored.
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Operating Risk
Operating risk focuses on Merrill Lynch's ability to accumulate, process,
protect, and communicate information necessary to conduct business in a global
market environment, and also includes the execution of legal, fiduciary, and
agency responsibilities. Merrill Lynch manages operating risk in many ways,
including maintaining backup facilities, using technology, employing experienced
personnel, and maintaining a comprehensive system of internal controls.
Merrill Lynch maintains key backup facilities worldwide and updates
systems and equipment as required in response to changes in business conditions
and technology needs. An example is the extensive work currently being performed
to become Year 2000-compliant (see the Capital Projects and Expenditures
section). In addition, experienced operations personnel provide support and
control for trading, clearance, and settlement activities and perform custodial
functions for customer and proprietary assets. Merrill Lynch regularly reviews
its framework of internal controls, taking into account changing circumstances.
Corrective actions are taken to address control deficiencies, and opportunities
for improvement are implemented when cost-effective.
From a legal standpoint, risk arises from the enforceability of clients'
and counterparties' obligations to, and receivables from, Merrill Lynch,
including obtaining contractual provisions intended to reduce credit exposure by
providing for the netting of mutual obligations. The firm seeks to mitigate such
risk by:
o developing policies that enhance enforceability of transactions,
o monitoring compliance with internal policies and external regulations, and
o requiring consultation with internal and external legal advisors for
non-standard transactions.
Fiduciaries and agents have obligations to act on behalf of others. Such
risks are inherent in brokerage and investment management activities. Merrill
Lynch has a number of policies in place to ensure that fiduciary obligations to
clients are met and that Merrill Lynch is in compliance with applicable legal
and regulatory requirements.
Other Risks
Liquidity risk arises in the course of Merrill Lynch's general funding
activities and in the management of the balance sheet. This risk includes both
the risk of being unable to raise funding with appropriate maturity and interest
rate characteristics and the risk of being unable to liquidate an asset in a
timely manner at a reasonable price. For more information on how Merrill Lynch
manages liquidity risk, see the Capital Adequacy and Liquidity section.
Other risks Merrill Lynch encounters include political, tax, and
regulatory risks. These risks revolve around the impact that changes in local
laws, regulatory requirements, or tax statutes would have on the viability,
profitability, or cost-effectiveness of existing or future transactions. To help
mitigate the effects of these risks, Merrill Lynch constantly reviews new and
pending legislation and regulations by employing professionals in the
jurisdictions in which the company operates to actively follow these issues and
participate in related interest groups.
NON-INVESTMENT GRADE HOLDINGS AND HIGHLY LEVERAGED TRANSACTIONS
Non-investment grade holdings and highly leveraged transactions involve
risks related to the creditworthiness of the issuers or counterparties and the
liquidity of the market for such investments. Merrill Lynch recognizes these
risks and, whenever possible, employs strategies to mitigate exposures. The
specific components and overall level of non-investment grade and highly
leveraged positions may vary significantly from period to period as a result of
inventory turnover, investment sales, and asset redeployment.
In the normal course of business, Merrill Lynch underwrites, trades, and
holds non-investment grade cash instruments in connection with its investment
banking, market-making, and derivative structuring activities. Non-investment
grade trading inventories have increased in recent years to satisfy growing
client demand for higher-yielding investments, including emerging market and
other non-U.S. securities. During the second half of 1998, however, these
exposures were intentionally reduced as a result of market volatility.
Non-investment grade holdings have been defined as debt and preferred equity
securities rated as BB+ or lower, or equivalent ratings by recognized credit
rating agencies, sovereign debt in emerging markets, amounts due under
derivative contracts from non-investment grade counterparties, and other
instruments that, in the opinion of management, are non-investment grade.
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Derivatives may also expose Merrill Lynch to credit risk related to the
underlying security where a derivative contract can either synthesize ownership
of the underlying security (e.g., long total return swap) or potentially force
ownership of the underlying security (e.g., short put option). In addition,
derivatives may subject Merrill Lynch to credit spread or issuer default risk,
in that changes in credit spreads or in the credit quality of the underlying
securities may adversely affect the derivatives' fair values. Merrill Lynch
engages in various hedging strategies to reduce its exposure associated with
non-investment grade positions, such as purchasing an option to sell the related
security or entering into other offsetting derivative contracts.
In addition to engaging in business involving non-investment grade
positions, Merrill Lynch provides financing and advisory services to, and
invests in, companies entering into leveraged transactions, which may include
leveraged buyouts, recapitalizations, and mergers and acquisitions. Merrill
Lynch provides extensions of credit to leveraged companies in the form of senior
and subordinated debt, as well as bridge financing on a select basis. In
addition, Merrill Lynch syndicates loans for non-investment grade companies or
in connection with highly leveraged transactions and may retain a residual
portion of these loans.
Merrill Lynch holds direct equity investments in leveraged companies and
interests in partnerships that invest in leveraged transactions. Merrill Lynch
has also committed to participate in limited partnerships that invest in
leveraged transactions. Future commitments to participate in limited
partnerships and other direct equity investments will be made on a select basis.
Trading Exposures
The following table summarizes trading exposures to non-investment grade
or highly leveraged issuers or counterparties at year-end 1998 and 1997:
- --------------------------------------------------------------------------------
(in millions) 1998 1997
- --------------------------------------------------------------------------------
Trading assets:
Cash instruments $ 7,932 $ 13,049
Derivatives 4,939 3,420
Trading liabilities - cash instruments (920) (2,970)
Collateral on derivative assets (2,457) (599)
------- --------
Net trading asset exposure 9,494 12,900
Derivative notionals with credit exposure(1) 2,633 3,654
Derivative notionals that hedge credit exposure(1) (3,927) (4,235)
------- --------
Net exposure $ 8,200 $ 12,319
======= ========
- --------------------------------------------------------------------------------
(1) Represents amount subject to strike or reference price.
Included in the preceding table are debt and equity securities and bank
loans of companies in various stages of bankruptcy proceedings or in default. At
December 25, 1998, the carrying value of such debt and equity securities totaled
$74 million, of which 84% resulted from Merrill Lynch's market-making activities
in such securities. This compared with $142 million at December 26, 1997, of
which 56% related to market-making activities. In addition, Merrill Lynch held
distressed bank loans totaling $156 million and $432 million at year-end 1998
and 1997, respectively.
Non-Trading Exposures
The following table summarizes non-trading exposures to non-investment
grade or highly leveraged issuers or counterparties at year-end 1998 and 1997:
- --------------------------------------------------------------------------------
(in millions) 1998 1997
- --------------------------------------------------------------------------------
Marketable investment securities $ 39 $ 648
Investments of insurance subsidiaries 148 192
Loans (net of allowance for loan losses):
Bridge loans 66 -
Other loans(1) 1,099 467
Other investments:
Partnership interests(2) 852(3) 315
Other equity investments(4) 459 170
- --------------------------------------------------------------------------------
(1) Represented outstanding loans to 82 and 48 companies at year-end 1998 and
1997, respectively.
(2) Included is $279 and $233 million in investments at year-end 1998 and
1997, respectively, related to deferred compensation plans, for which the
default risk of the investments rests with the participating employees.
(3) Included in this amount is a $300 million investment in the hedge fund
Long Term Capital Portfolio, L.P.
(4) Invested in 89 and 72 enterprises at year-end 1998 and 1997, respectively.
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The following table summarizes Merrill Lynch's commitments with exposure
to non-investment grade or highly leveraged counterparties at year-end 1998 and
1997:
- --------------------------------------------------------------------------------
(in millions) 1998 1997
- --------------------------------------------------------------------------------
Additional commitments to invest in partnerships $ 227 $ 60
Unutilized revolving lines of credit and other
lending commitments 1,678(1) 485
- --------------------------------------------------------------------------------
(1) Includes a $1.1 billion commitment to a counterparty related to
acquisition financing. Subsequent to year-end, the acquisition was
completed, with substantially all of the acquisition financing syndicated
to third parties.
At December 25, 1998, the largest industry exposure was to the financial
services sector, which accounted for 43% of total non-investment grade positions
and highly leveraged transactions.
CASH FLOWS
During 1998, Merrill Lynch disbursed $5.3 billion to acquire the
outstanding shares of Mercury. This purchase was financed primarily with
proceeds from long-term borrowings.
LITIGATION
Certain actions have been filed against Merrill Lynch in connection with
Merrill Lynch's business activities. Although the ultimate outcome of these
actions cannot be ascertained at this time and the results of legal proceedings
cannot be predicted with certainty, it is the opinion of management that the
resolution of these actions will not have a material adverse effect on the
financial condition or the results of operations of Merrill Lynch as set forth
in the Consolidated Financial Statements contained herein.
RECENT DEVELOPMENTS
New Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and for Hedging Activities". SFAS
No. 133 requires all derivatives, including certain derivatives embedded in
other contracts, to be recorded on the balance sheet at fair value. SFAS No.
133, which is effective for Merrill Lynch beginning January 1, 2000, will
primarily impact Merrill Lynch's accounting and reporting of derivatives used to
hedge borrowings and other non-trading assets and liabilities. Merrill Lynch is
currently evaluating the expected impact of adopting this standard.
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MANAGEMENT'S DISCUSSION OF FINANCIAL RESPONSIBILITY
Management of Merrill Lynch & Co., Inc. is responsible for preparing the
financial statements and related notes contained in this Annual Report. The
consolidated financial statements and notes are prepared in accordance with
generally accepted accounting principles. Other financial data included in the
Annual Report are consistent with those in the financial statements.
Management recognizes the importance of safeguarding Merrill Lynch's
assets and integrity. Therefore, Management devotes considerable attention to
understanding the risks of its businesses, promoting the highest standards of
ethical conduct, exercising responsible stewardship over Merrill Lynch's assets,
and presenting fair financial statements.
Merrill Lynch regularly reviews its framework of internal controls, taking
into account changing circumstances. Corrective actions are taken to address
control deficiencies, and other opportunities for improvement are implemented
when cost effective.
The framework of internal control includes policies, procedures, and
organizational structures that are overseen by a predominantly independent Board
of Directors. Several committees of the Board actively participate in setting
policy and monitoring controls. The Audit and Finance Committee, which consists
of five independent directors, examines Merrill Lynch's compliance with
acceptable business standards and ethics in accordance with its written charter
of responsibilities and duties. It also reviews significant financial issues and
recommends overall policies regarding market and credit risk, as well as funding
requirements. The Management Development and Compensation Committee, also
composed entirely of independent directors, oversees procedures for developing
and assessing the performance of Merrill Lynch's employees with an emphasis on
ethical business behavior.
Oversight is provided by independent units within Merrill Lynch, working
together to maintain Merrill Lynch's internal control standards.
Corporate Audit reports directly to the Audit and Finance Committee,
providing independent appraisals of Merrill Lynch's internal accounting controls
and compliance with established policies and procedures.
Finance establishes accounting policies and procedures, measures and
monitors financial risk, and prepares financial statements that fairly present
the underlying transactions and events of Merrill Lynch.
Global Risk and Credit Management is both independent from business line
management and has oversight responsibility for Merrill Lynch's market and
credit risks. This group has clear authority to enforce trading and credit
limits using various systems and procedures to monitor positions and risks.
Law and Compliance serves in a counseling and advisory role to Management.
In this role, the group develops policies; monitors compliance with internal
policies, external rules, and industry regulations; and provides support in
connection with the execution of various transactions.
The independent auditors, Deloitte & Touche LLP, perform annual audits of
Merrill Lynch's financial statements in accordance with generally accepted
auditing standards, including a review of the internal accounting control
system. The independent auditors openly discuss with the Audit and Finance
Committee their views on the quality of the financial statements and related
disclosures and the adequacy of Merrill Lynch's internal accounting controls.
Quarterly review reports on the interim financial statements are also issued by
Deloitte & Touche LLP. Merrill Lynch's independent auditors are appointed each
year by the Audit and Finance Committee and are given unrestricted access to all
financial records and related data, including minutes of meetings of
stockholders, Board of Directors, and committees of the Board.
/s/ David H. Komansky /s/ Herbert M. Allison, Jr. /s/ E. Stanley O'Neal
David H. Komansky Herbert M. Allison, Jr. E. Stanley O'Neal
Chairman of the Board President and Executive Vice President and
and Chief Executive Officer Chief Operating Officer Chief Financial Officer
55
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- --------------------------------------------------------------------------------
DESCRIPTION OF BUSINESS
Merrill Lynch & Co., Inc. ("ML & Co.") is a holding company that provides
investment, financing, insurance, and related services to individuals and
institutions on a global basis through its broker, dealer, banking, insurance,
and other financial services subsidiaries. Its principal subsidiaries include:
o Merrill Lynch, Pierce, Fenner & Smith Incorporated, a U.S.-based
broker-dealer in securities;
o Merrill Lynch International, a U.K.-based broker-dealer in securities and
dealer in equity derivatives;
o Merrill Lynch Government Securities Inc., a dealer in U.S. Government
securities; and
o Merrill Lynch Capital Services, Inc., a dealer in interest rate, currency,
and credit derivatives.
Services provided to clients by ML & Co. and subsidiaries include:
o securities brokerage, trading, and underwriting;
o investment banking, strategic services, and other corporate finance
advisory activities, including loan syndication;
o asset management and other investment advisory and recordkeeping services;
o dealing and brokerage of swaps, options, forwards, futures, and other
derivatives;
o securities clearance services;
o debt, equity, and economic research activities;
o banking, trust, and lending services; and
o insurance sales and underwriting services.
INDEPENDENT AUDITORS' REPORT
[LOGO]
To the Board of Directors and Stockholders of
Merrill Lynch & Co., Inc.:
We have audited the accompanying consolidated balance sheets of Merrill
Lynch & Co., Inc. and subsidiaries ("Merrill Lynch") as of December 25, 1998 and
December 26, 1997 and the related consolidated statements of earnings, changes
in stockholders' equity, comprehensive income and cash flows for each of the
three years in the period ended December 25, 1998. These financial statements
are the responsibility of Merrill Lynch's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Merrill Lynch at December 25,
1998 and December 26, 1997, and the results of its operations and its cash flows
for each of the three years in the period ended December 25, 1998 in conformity
with generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in 1998
Merrill Lynch changed its method of accounting for certain internal-use software
development costs to conform with Statement of Position 98-1.
/s/ Deloitte & Touche LLP
New York, New York
February 22, 1999
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CONSOLIDATED STATEMENTS OF EARNINGS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996
- --------------------------------------------------------------------------------------
REVENUES
Commissions $ 5,799 $ 4,995 $ 4,085
Interest and dividends 19,314 17,299 13,125
Principal transactions 2,651 3,827 3,531
Investment banking 3,264 2,876 2,022
Asset management and portfolio service fees 4,202 3,002 2,431
Other 623 500 519
------- ------- -------
TOTAL REVENUES 35,853 32,499 25,713
Interest Expense 18,306 16,243 12,092
------- ------- -------
NET REVENUES 17,547 16,256 13,621
------- ------- -------
NON-INTEREST EXPENSES
Compensation and benefits 9,199 8,333 7,012
Communications and technology 1,749 1,255 1,010
Occupancy and related depreciation 867 736 742
Advertising and market development 688 613 527
Brokerage, clearing, and exchange fees 683 525 433
Professional fees 552 520 385
Goodwill amortization 226 65 50
Provision for costs related to staff reductions 430 - -
Other 1,057 1,098 834
------- ------- -------
TOTAL NON-INTEREST EXPENSES 15,451 13,145 10,993
------- ------- -------
EARNINGS BEFORE INCOME TAXES AND DIVIDENDS ON
PREFERRED SECURITIES ISSUED BY SUBSIDIARIES 2,096 3,111 2,628
Income Tax Expense 713 1,129 980
Dividends on Preferred Securities Issued by Subsidiaries 124 47 -
------- ------- -------
NET EARNINGS $ 1,259 $ 1,935 $ 1,648
======= ======= =======
NET EARNINGS APPLICABLE TO COMMON STOCKHOLDERS $ 1,220 $ 1,896 $ 1,602
======= ======= =======
EARNINGS PER COMMON SHARE
Basic $ 3.43 $ 5.57 $ 4.63
======= ======= =======
Diluted $ 3.00 $ 4.79 $ 4.08
======= ======= =======
- --------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
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CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amount)
DECEMBER 25, 1998 DECEMBER 26, 1997
- ----------------------------------------------------------------------------------------------------------
ASSETS
CASH AND CASH EQUIVALENTS $ 12,530 $ 12,073
--------- ---------
CASH AND SECURITIES SEGREGATED FOR REGULATORY PURPOSES OR
DEPOSITED WITH CLEARING ORGANIZATIONS 6,590 5,357
--------- ---------
RECEIVABLES UNDER RESALE AGREEMENTS AND
SECURITIES BORROWED TRANSACTIONS 87,713 107,443
--------- ---------
MARKETABLE INVESTMENT SECURITIES 4,605 3,309
--------- ---------
TRADING ASSETS, AT FAIR VALUE
Equities and convertible debentures 25,318 24,031
Contractual agreements 21,979 21,205
Corporate debt and preferred stock 21,166 32,537
U.S. Government and agencies 15,421 9,848
Non-U.S. governments and agencies 7,474 10,221
Mortgages, mortgage-backed, and asset-backed 7,023 7,312
Other 3,358 2,937
--------- ---------
101,739 108,091
Securities received as collateral, net of securities
pledged as collateral 6,106 -
--------- ---------
Total 107,845 108,091
--------- ---------
SECURITIES PLEDGED AS COLLATERAL 8,184 -
--------- ---------
OTHER RECEIVABLES
Customers (net of allowance for doubtful accounts of $48
in 1998 and $50 in 1997) 29,559 27,319
Brokers and dealers 8,872 5,182
Interest and other 9,278 8,185
--------- ---------
Total 47,709 40,686
--------- ---------
INVESTMENTS OF INSURANCE SUBSIDIARIES 4,485 4,833
LOANS, NOTES, AND MORTGAGES (net of allowance for loan losses
of $124 in 1998 and $130 in 1997) 7,687 4,310
OTHER INVESTMENTS 2,590 1,829
EQUIPMENT AND FACILITIES (net of accumulated depreciation
and amortization of $3,482 in 1998 and $2,955 in 1997) 2,761 2,099
GOODWILL (net of accumulated amortization of $338 in 1998
and $131 in 1997) 5,364 5,467
OTHER ASSETS 1,741 1,483
--------- ---------
TOTAL ASSETS $ 299,804 $ 296,980
========= =========
- ----------------------------------------------------------------------------------------------------------
58
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- --------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
- ----------------------------------------------------------------------------------------------------------
LIABILITIES
PAYABLES UNDER REPURCHASE AGREEMENTS AND SECURITIES LOANED
TRANSACTIONS $ 67,127 $ 79,167
--------- ---------
COMMERCIAL PAPER AND OTHER SHORT-TERM BORROWINGS 18,679 34,340
--------- ---------
DEMAND AND TIME DEPOSITS 13,744 10,712
--------- ---------
TRADING LIABILITIES, AT FAIR VALUE
Contractual agreements 23,840 20,632
Equities and convertible debentures 21,558 15,817
U.S. Government and agencies 7,939 18,186
Non-U.S. governments and agencies 7,245 10,460
Corporate debt and preferred stock 2,878 5,764
Other 254 355
--------- ---------
Total 63,714 71,214
--------- ---------
OBLIGATION TO RETURN SECURITIES RECEIVED AS COLLATERAL 14,290 -
--------- ---------
OTHER PAYABLES
Customers 20,972 17,514
Brokers and dealers 7,899 4,224
Interest and other 18,738 22,784
--------- ---------
Total 47,609 44,522
--------- ---------
LIABILITIES OF INSURANCE SUBSIDIARIES 4,319 4,716
LONG-TERM BORROWINGS 57,563 43,143
--------- ---------
TOTAL LIABILITIES 287,045 287,814
--------- ---------
PREFERRED SECURITIES ISSUED BY SUBSIDIARIES 2,627 627
--------- ---------
STOCKHOLDERS' EQUITY
PREFERRED STOCKHOLDERS' EQUITY 425 425
--------- ---------
COMMON STOCKHOLDERS' EQUITY
Shares exchangeable into common stock 66 66
Common stock (par value $1.33 1/3 per share; authorized:
1,000,000,000 shares; issued: 472,660,324 shares) 630 630
Paid-in capital 1,427 1,001
Accumulated other comprehensive loss (net of tax) (122) (47)
Retained earnings 10,475 9,579
--------- ---------
12,476 11,229
Less: Treasury stock, at cost (1998 - 116,376,259 shares;
1997 - 133,400,971 shares) 2,101 2,677
Employee stock transactions 668 438
--------- ---------
TOTAL COMMON STOCKHOLDERS' EQUITY 9,707 8,114
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 10,132 8,539
--------- ---------
TOTAL LIABILITIES, PREFERRED SECURITIES ISSUED BY
SUBSIDIARIES, AND STOCKHOLDERS' EQUITY $ 299,804 $ 296,980
========= =========
- ----------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
- --------------------------------------------------------------------------------
(dollars in millions)
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
PREFERRED STOCKHOLDERS' EQUITY
9% CUMULATIVE PREFERRED STOCK, SERIES A
Balance, beginning and end of year $ 425 $ 425 $ 425
======= ======= =======
REMARKETED PREFERRED STOCK, SERIES C
Balance, beginning of year - 194 194
Redeemed - (194) -
------- ------- -------
Balance, end of year - - 194
======= ======= =======
TOTAL PREFERRED STOCKHOLDERS' EQUITY $ 425 $ 425 $ 619
======= ======= =======
COMMON STOCKHOLDERS' EQUITY
SHARES EXCHANGEABLE INTO COMMON STOCK
Balance, beginning of year $ 66 $ 46 $ 44
Net activity 5 20 2
Exchanges (5) - -
------- ------- -------
Balance, end of year 66 66 46
======= ======= =======
COMMON STOCK
Balance, beginning and end of year 630 630 630
======= ======= =======
PAID-IN CAPITAL
Balance, beginning of year 1,001 925 858
Issuance of stock:
To employees 430 76 67
Other (4) - -
------- ------- -------
Balance, end of year 1,427 1,001 925
======= ======= =======
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
Foreign Currency Translation Adjustment (net of tax)
Balance, beginning of year (85) 7 8
Translation adjustment (net of tax) (53) (92) (1)
------- ------- -------
Balance, end of year (138) (85) 7
------- ------- -------
Net Unrealized Gains on Investment Securities Available-for-Sale (net of tax)
Balance, beginning of year 38 9 25
Net unrealized gains (losses) on investment securities
available-for-sale (60) 34 (97)
Other adjustments(a) 38 (5) 81
------- ------- -------
Balance, end of year 16 38 9
------- ------- -------
Balance, end of year $ (122) $ (47) $ 16
======= ======= =======
- ----------------------------------------------------------------------------------------------------------------
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- --------------------------------------------------------------------------------
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996
- ---------------------------------------------------------------------------------------
RETAINED EARNINGS
Balance, beginning of year $ 9,579 $ 7,938 $ 6,535
Net earnings 1,259 1,935 1,648
Cash dividends declared:
9% Cumulative Preferred stock (38) (38) (38)
Remarketed Preferred stock - (1) (9)
Common stock (325) (255) (198)
-------- ------- -------
Balance, end of year 10,475 9,579 7,938
======== ======= =======
TREASURY STOCK, AT COST
Balance, beginning of year (2,677) (2,769) (2,114)
Treasury stock purchased - (644) (1,146)
Issued out of treasury (net of reacquisitions):
Employees 556 736 491
Other 20 - -
-------- ------- -------
Balance, end of year (2,101) (2,677) (2,769)
======== ======= =======
UNALLOCATED ESOP REVERSION SHARES, AT COST
Balance, beginning of year - (24) (63)
Allocation of shares to participants - 24 39
-------- ------- -------
Balance, end of year - - (24)
======== ======= =======
EMPLOYEE STOCK TRANSACTIONS
Balance, beginning of year (438) (314) (254)
Net issuance of employee stock grants (599) (351) (251)
Amortization of employee stock grants 359 218 183
Repayment of employee loans 10 9 8
-------- ------- -------
Balance, end of year (668) (438) (314)
======== ======= =======
TOTAL COMMON STOCKHOLDERS' EQUITY $ 9,707 $ 8,114 $ 6,448
======== ======= =======
TOTAL STOCKHOLDERS' EQUITY $ 10,132 $ 8,539 $ 7,067
======== ======= =======
- ---------------------------------------------------------------------------------------
(a) Other adjustments relate to policyholder liabilities, deferred policy
acquisition costs, and deferred income taxes.
See Notes to Consolidated Financial Statements.
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
- --------------------------------------------------------------------------------
(dollars in millions)
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996
- ---------------------------------------------------------------------------------------------
NET EARNINGS $ 1,259 $ 1,935 $ 1,648
------- ------- -------
OTHER COMPREHENSIVE INCOME
Foreign currency translation adjustment:
Foreign currency translation losses, net of gains (131) (96) (17)
Deferred income taxes 78 4 16
------- ------- -------
Total (53) (92) (1)
------- ------- -------
Net unrealized gains (losses) on investment securities
available-for-sale:
Net unrealized holding gains (losses) arising
during the period (10) 50 (68)
Reclassification adjustment for gains
included in net earnings (50) (16) (29)
------- ------- -------
Net unrealized gains (losses) on investment securities (60) 34 (97)
Adjustments for:
Policyholder liabilities 16 10 64
Deferred policy acquisition costs 4 - 9
Deferred income taxes 18 (15) 8
------- ------- -------
Total (22) 29 (16)
------- ------- -------
Total Other Comprehensive Loss (75) (63) (17)
------- ------- -------
COMPREHENSIVE INCOME $ 1,184 $ 1,872 $ 1,631
======= ======= =======
- ---------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
(dollars in millions)
YEAR ENDED LAST FRIDAY IN DECEMBER
1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Earnings $ 1,259 $ 1,935 $ 1,648
Noncash items included in earnings:
Depreciation and amortization 585 473 436
Policyholder reserves 227 240 269
Goodwill amortization 226 65 50
Other 278 1,336 869
(Increase) decrease in operating assets(a):
Trading assets 6,332 (31,246) (15,574)
Cash and securities segregated for regulatory purposes or
deposited with clearing organizations (1,233) (2,242) (266)
Receivables under resale agreements and securities borrowed transactions 19,940 (22,373) (19,328)
Customer receivables (2,229) (7,957) (3,845)
Brokers and dealers receivables (3,690) 1,132 3,043
Other 188 (4,068) (704)
Increase (decrease) in operating liabilities(a):
Trading liabilities (7,474) 26,770 10,219
Payables under repurchase agreements and securities loaned transactions (12,040) 12,346 6,573
Customer payables 3,458 4,731 686
Brokers and dealers payables 3,675 399 (2,660)
Other 864 2,274 2,515
-------- -------- --------
CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 10,366 (16,185) (16,069)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from (payments for):
Maturities of available-for-sale securities 3,983 3,376 3,057
Sales of available-for-sale securities 3,426 2,198 1,341
Purchases of available-for-sale securities (8,676) (6,383) (4,374)
Maturities of held-to-maturity securities 831 1,081 920
Purchases of held-to-maturity securities (877) (752) (555)
Loans, notes, and mortgages (3,405) (989) (1,196)
Acquisitions, net of cash acquired (5,235) (13) (135)
Sales of subsidiaries, net of cash disposed 202 - -
Other investments and other assets (1,398) (240) (388)
Equipment and facilities (1,231) (863) (483)
-------- -------- --------
CASH USED FOR INVESTING ACTIVITIES (12,380) (2,585) (1,813)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from (payments for):
Commercial paper and other short-term borrowings (15,661) 7,019 8,763
Demand and time deposits 3,032 1,336 1,163
Issuance and resale of long-term borrowings 29,269 25,087 16,509
Settlement and repurchase of long-term borrowings (15,833) (8,242) (7,440)
Issuance of subsidiaries' preferred securities 2,000 300 276
Common and preferred stock transactions 27 (694) (919)
Dividends (363) (294) (245)
-------- -------- --------
CASH PROVIDED BY FINANCING ACTIVITIES 2,471 24,512 18,107
-------- -------- --------
INCREASE IN CASH AND CASH EQUIVALENTS 457 5,742 225
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 12,073 6,331 6,106
-------- -------- --------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 12,530 $ 12,073 $ 6,331
======== ======== ========
- ----------------------------------------------------------------------------------------------------------------
(a) Net of effects of acquisitions and divestitures.
SUPPLEMENTAL DISCLOSURES
Cash paid for:
Income taxes $ 579 $ 910 $ 1,139
Interest 18,357 15,390 11,801
See Notes to Consolidated Financial Statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
TABLE OF CONTENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ..................... 64
NOTE 2. OTHER SIGNIFICANT EVENTS ....................................... 69
NOTE 3. TRADING AND RELATED ACTIVITIES ................................. 70
NOTE 4. INVESTMENTS AND OTHER NON-TRADING ASSETS ....................... 74
NOTE 5. BORROWINGS AND OTHER NON-TRADING LIABILITIES ................... 77
NOTE 6. PREFERRED SECURITIES ISSUED BY SUBSIDIARIES .................... 79
NOTE 7. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE .................... 79
NOTE 8. COMMITMENTS AND CONTINGENCIES .................................. 81
NOTE 9. EMPLOYEE BENEFIT PLANS ......................................... 83
NOTE 10. EMPLOYEE INCENTIVE PLANS ....................................... 86
NOTE 11. INCOME TAXES ................................................... 89
NOTE 12. REGULATORY REQUIREMENTS AND DIVIDEND RESTRICTIONS .............. 90
NOTE 13. SEGMENT, PRODUCT, AND GEOGRAPHIC INFORMATION ................... 91
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Merrill Lynch & Co., Inc. ("ML & Co.") provides investment, financing,
insurance, and related services to individuals and institutions on a global
basis through its broker, dealer, banking, insurance, and other financial
services subsidiaries. Its principal subsidiaries include:
o Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S"), a
U.S.-based broker-dealer in securities;
o Merrill Lynch International ("MLI"), a U.K.-based broker-dealer in
securities and dealer in equity derivatives;
o Merrill Lynch Government Securities Inc. ("MLGSI"), a dealer in U.S.
Government securities; and
o Merrill Lynch Capital Services, Inc., a dealer in interest rate, currency,
and credit derivatives.
Services provided to clients by ML & Co. and subsidiaries (collectively,
"Merrill Lynch") include:
o securities brokerage, trading, and underwriting;
o investment banking, strategic services, and other corporate finance
advisory activities, including loan syndication;
o asset management and other investment advisory and recordkeeping services;
o dealing and brokerage of swaps, options, forwards, futures, and other
derivatives;
o securities clearance services;
o debt, equity, and economic research activities;
o banking, trust, and lending services; and
o insurance sales and underwriting services.
Basis of Presentation
The Consolidated Financial Statements include the accounts of Merrill
Lynch and are presented in accordance with U.S. generally accepted accounting
principles and prevailing industry practices. All material intercompany
transactions and balances have been eliminated.
Certain reclassifications and format changes have been made to prior year
amounts to conform to the current year presentation. Prior period amounts have
also been restated to reflect the merger of Midland Walwyn Inc. with Merrill
Lynch, which has been accounted for as a pooling-of-interests. The Consolidated
Financial Statements reflect the results of operations, financial position,
changes in stockholders' equity, and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
cash flows as if the two companies had always been combined (see Note 2 for
further information).
The Consolidated Financial Statements are presented in U.S. dollars. Many
non-U.S. subsidiaries have a functional currency (i.e., the currency in which
activities are primarily conducted) that is other than the U.S. dollar, often
the currency of the country in which a subsidiary is domiciled. Subsidiaries'
assets and liabilities are translated to U.S. dollars at year-end exchange
rates, while revenues and expenses are translated at average exchange rates
during the year. Adjustments that result from translating amounts in a
subsidiary's functional currency, net of hedging gains or losses and related tax
effects, are reported in stockholders' equity as a component of Accumulated
other comprehensive income. All other translation adjustments are included in
earnings.
In presenting the Consolidated Financial Statements, management makes
estimates regarding certain trading inventory valuations, the outcome of
litigation, the carrying amount of goodwill, the realization of deferred tax
assets and 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. As such, actual results could differ materially from those
estimates.
Merrill Lynch defines cash equivalents as short-term, highly liquid
securities and interest-earning deposits with original maturities of 90 days or
less, other than those used for trading purposes. For purposes of the
Consolidated Statements of Cash Flows, cash flows from derivatives are
classified in operating activities.
At December 25, 1998 and December 26, 1997, substantially all financial
instrument assets are carried at fair value or amounts that approximate fair
value. Fair values of financial instruments are disclosed in Notes 3, 4, 5,
and 8.
Trading Activities
Merrill Lynch's trading activities consist primarily of securities
brokerage, trading, and underwriting; derivatives dealing and brokerage; and
securities financing transactions. Trading assets and trading liabilities
consist of cash instruments (such as securities) and derivative instruments used
for trading purposes or for hedging other trading inventory.
"Securities"
Trading securities and other cash instruments (e.g., loans held for
trading purposes) are recorded on a trade date basis at fair value. Included in
trading liabilities are securities that Merrill Lynch has sold but did not own
and will therefore be obligated to purchase at a future date ("short sales").
Changes in fair value (i.e., unrealized gains and losses) are recognized as
principal transactions revenues in the current period. Realized gains and losses
and any related interest amounts are included in principal transactions revenues
and interest revenues and expenses, depending on the nature of the instrument.
Fair values of trading securities are based on quoted market prices,
pricing models (utilizing indicators of general market conditions or other
economic measurements), or management's estimates of amounts to be realized on
settlement, assuming current market conditions and an orderly disposition over a
reasonable period of time.
"Derivatives"
A derivative is typically defined as an instrument whose value is
"derived" from an underlying instrument or index such as a future, forward,
swap, or option contract, or other financial instrument with similar
characteristics. The derivative definition excludes all cash instruments,
including those that derive their values or contractually required cash flows
from an underlying instrument or index, such as mortgage-backed securities,
interest-only and principal-only obligations, and indexed debt instruments. It
also excludes option features embedded in cash instruments, such as conversion
features and call provisions embedded in bonds.
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). Different types of derivatives can also be combined
to meet specialized needs (e.g., swaptions).
Derivatives are often referred to as off-balance-sheet instruments since
their notional amounts or underlying instruments are not reflected on the
balance sheet; however, the fair values of trading derivatives are recorded in
trading assets and liabilities. Derivatives are reported separately as assets
and liabilities unless a legal right of setoff exists under a
65
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
master netting agreement enforceable at law. Balances related to swap and
forward transactions and foreign currency options are included in Contractual
agreements on the Consolidated Balance Sheets. All other derivative balances are
recorded in the related cash instrument caption. The fair value of equity
options purchased, for example, is recorded in the Equities and convertible
debentures trading asset caption.
Changes in fair values of derivatives are recorded as principal
transactions revenues in the current period. Fair values for certain
exchange-traded derivatives, principally futures and certain options, are based
on quoted market prices. Fair values for over-the-counter ("OTC") derivative
financial instruments, principally forwards, options, and swaps, represent
amounts that would be received from or paid to a third party in settlement of
these instruments. These amounts are determined using pricing models based on
the present value of estimated future cash flows employing mid-market valuations
with appropriate adjustments. These adjustments are integral components of the
mark-to-market process and relate to credit quality and concentration, market
liquidity, and exposure close-out costs associated with unmatched positions.
Adjustments are also made for administrative costs incurred to service periodic
cash flows and to maintain hedges over the life of the contract. A portion of
income related to long-term contracts is recognized as the related
administrative costs are incurred.
New, complex products may have immature or limited two-way markets. The
precision of the pricing model for a complex product, which involves multiple
variables and assumptions, will evolve over time. As these products develop,
Merrill Lynch continually refines its pricing models based on experience to
correlate more closely to the market risk of these instruments.
"Securities Financing Transactions"
Merrill Lynch enters into repurchase and resale agreements and securities
borrowed and loaned transactions to accommodate customers (i.e., matched-book),
finance firm inventory positions, and obtain securities for settlement. Merrill
Lynch also engages in securities financing for customers through margin lending
(see Customer Transactions).
Resale and repurchase agreements are accounted for as collateralized
financing transactions and are recorded at their contractual amounts plus
accrued interest. Merrill Lynch's policy is to obtain possession of collateral
with a market value equal to or in excess of the principal amount loaned under
resale agreements. To ensure that the market value of the underlying collateral
remains sufficient, collateral is valued daily, and Merrill Lynch may require
counterparties to deposit additional collateral or return collateral pledged,
when appropriate. Substantially all repurchase and resale activities are
transacted under master netting agreements that give Merrill Lynch the right, in
the event of default, to liquidate collateral held and to offset receivables and
payables with the same counterparty. Merrill Lynch offsets certain repurchase
and resale agreement balances with the same counterparty on the Consolidated
Balance Sheets.
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. Although
substantially all securities borrowing and lending activities are transacted
under master netting agreements, such receivables and payables with the same
counterparty are not set off on the Consolidated Balance Sheets.
Merrill Lynch recognizes, on the balance sheet, collateral received or
provided in certain resale and repurchase agreements (see Note 2 for further
information).
Investment Banking and Advisory Services
Underwriting revenues and fees for merger and acquisition advisory
services are accrued when services for the transactions are substantially
completed. Deal-related expenses are deferred to match revenue recognition.
Customer Transactions
Customer securities and commodities transactions are recorded on a
settlement date basis. Receivables from and payables to customers include
amounts due on cash and margin transactions. Securities owned by customers,
including those that collateralize margin or other similar transactions, are not
reflected on the Consolidated Balance Sheets.
Commissions charged for executing customer transactions are accrued on a
trade date basis and are included in
66
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
current period earnings. Production-related compensation and benefits expense is
accrued to match revenue recognition.
Mutual fund distribution fee revenues are accrued as earned, and
redemption fee revenues are recognized upon receipt. Certain compensation costs
related to sales of rear-load open-end mutual funds are deferred to match
revenue recognition.
Investing Activities
Merrill Lynch's non-broker-dealer subsidiaries hold debt and equity
investments, which are principally classified as held-to-maturity, trading, or
available-for-sale.
Held-to-maturity investments are debt securities that Merrill Lynch has
the positive intent and ability to hold to maturity. These investments are
recorded at amortized cost unless a decline in value is deemed
other-than-temporary, in which case the carrying value is reduced. The
amortization of premiums or accretion of discounts and any unrealized losses
deemed other-than-temporary are included in current period earnings.
Debt and equity securities purchased principally for the purpose of resale
in the near-term are classified as trading investments and are reported at fair
value. Unrealized gains or losses on these investments are included in current
period earnings.
Other debt and equity securities that are not categorized as
held-to-maturity or trading are classified as available-for-sale and reported at
fair value. Unrealized gains or losses on these securities are reported in
stockholders' equity as a component of Accumulated other comprehensive income,
net of applicable income taxes and other related items.
Restricted equity investment securities or equity investment securities
without available market quotations are reported at the lower of cost or
estimated net realizable value. Adjustments in carrying values are included in
current period earnings.
Realized gains and losses on investments are included in current period
earnings. The cost basis of each investment sold is specifically identified for
purposes of computing realized gains and losses.
Lending Activities
Merrill Lynch's lending activities include loan originations,
syndications, securitizations, and servicing. Merrill Lynch also engages in
secondary market loan trading and margin lending (see Trading Activities and
Customer Transactions, respectively).
Loans held for investment purposes, including consumer and small business
loans and the residual portion of commercial loans syndicated by Merrill Lynch,
are carried at their principal amount outstanding. The allowance for loan losses
is established through provisions that are based on management's assessment of
the collectibility of the loan portfolio. Loans are charged off against the
allowance for loan losses when management determines that collection of
principal is unlikely.
Loans held for sale, which include certain residential mortgage and home
equity loans, are reported at the lower of cost (less allowance for loan losses)
or estimated fair value determined on a portfolio basis. Mortgage servicing
assets and residual interests in mortgage loans underlying Real Estate Mortgage
Investment Conduits and revolving trusts are (1) recognized upon sales of loans
when servicing is retained, and (2) amortized into income in proportion to and
over the estimated life of the net servicing revenue. Mortgage servicing assets
are recognized at the present value of future cash flows, periodically evaluated
for impairment, and included in Other assets on the Consolidated Balance Sheets.
Residual interests are categorized as available-for-sale (see Investing
Activities) and reported in Other investments on the Consolidated Balance
Sheets.
Borrowing Activities
Merrill Lynch's unsecured general-purpose funding is principally obtained
from commercial paper and long-term borrowings. Commercial paper, which is
issued at a discount, is recorded at the proceeds received and accreted to its
par value. Long-term borrowings are carried at the principal amount borrowed,
net of unamortized discounts or premiums.
As part of overall asset/liability management, Merrill Lynch monitors the
interest rate, currency, equity, and other risk exposures of its assets and
liabilities. Derivatives are common tools used to manage these risks.
Derivatives that hedge borrowings and other non-trading assets and liabilities
are accounted for on an accrual basis, with amounts to be paid or received
recognized as adjustments to the related interest expense or revenue. Unrealized
gains and losses on other financing derivatives are recognized currently.
Derivatives used for hedging borrowings and other non-trading assets and
liabilities must be effective at reducing the risk being managed
67
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
and be designated as a hedge at inception. Realized gains and losses on early
terminations of derivatives are deferred over the remaining lives of the hedged
assets or liabilities. At December 25, 1998 and December 26, 1997, there were no
deferred amounts related to terminated contracts.
Insurance Activities
Insurance liabilities are future benefits payable under annuity and
interest-sensitive life insurance contracts and include deposits received plus
interest credited during the contract accumulation period, the present value of
future payments for contracts which have annuitized, and a mortality provision
for certain products. Certain policyholder liabilities are also adjusted for
those investments classified as available-for-sale. Liabilities for unpaid
claims consist of the mortality benefit for reported claims and an estimate of
unreported claims based upon prior experience.
Substantially all security investments of insurance subsidiaries are
classified as available-for-sale and recorded at fair value. These investments
support Merrill Lynch's in-force, universal life-type contracts. Merrill Lynch
records adjustments to deferred acquisition costs and policyholder account
balances which, when combined, are equal to the adjustment that would have been
recorded if those available-for-sale investments had been sold at their
estimated fair values and the proceeds reinvested at current yields. The
corresponding credits or charges for these adjustments are recorded in
stockholders' equity as a component of Accumulated other comprehensive income,
net of applicable income taxes.
Certain variable costs related to the sale or acquisition of new and
renewal insurance contracts have been deferred, to the extent deemed
recoverable, and amortized over the estimated lives of the contracts in
proportion to the estimated gross profit for each group of contracts.
Merrill Lynch maintains separate accounts representing segregated funds
held for purposes of funding variable life and annuity contracts. Separate
account assets are accounted for as customer assets since the contract holders
bear the risk of ownership, consistent with Merrill Lynch's other investment
products. Accordingly, separate account assets and the related liabilities are
not consolidated with the assets and liabilities of Merrill Lynch.
Stock-Based Compensation
Merrill Lynch accounts for stock-based compensation in accordance with the
intrinsic value-based method in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees", rather than the fair value-based
method in Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation". Compensation expense for stock
options is not recognized since Merrill Lynch grants stock options without any
intrinsic value. Compensation expense related to other stock-based compensation
plans is recognized over the vesting period. For certain stock-based
compensation grants, the unamortized portion of the grant value is reflected as
a reduction of stockholders' equity in Employee stock transactions on the
Consolidated Balance Sheets.
Goodwill
Goodwill, which represents the cost of acquired businesses in excess of
fair value of the related net assets at acquisition, is amortized on a
straight-line basis. Goodwill associated with the purchase of the Mercury Asset
Management Group is amortized over 30 years (see Note 2 for additional
information). Goodwill related to other acquisitions is amortized over periods
generally not exceeding fifteen years. Goodwill is evaluated periodically for
impairment.
Equipment and Facilities
Equipment and facilities primarily consist of technology hardware and
software and leasehold improvements. Equipment and facilities are reported at
historical cost, net of accumulated depreciation and amortization, except for
land which is reported at historical cost.
Depreciation and amortization are computed using the straight-line method.
Equipment is depreciated over its estimated useful life, while leasehold
improvements are amortized over the lesser of the improvement's estimated
economic useful life or the term of the lease. Maintenance and repair costs are
expensed as incurred.
Included in the Occupancy and related depreciation expense category was
depreciation and amortization of $190, $167, and $163, in 1998, 1997, and 1996,
respectively. Depreciation and amortization recognized in the Communications and
technology expense category was $395, $306, and $273, for 1998, 1997, and 1996,
respectively.
68
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
In 1998, Merrill Lynch also began capitalizing certain costs incurred in
the development of internal-use software (see Note 2). These amounts are
amortized over the useful life of the developed software, which is generally
three years.
Income Taxes
ML & Co. and certain of its wholly owned subsidiaries file a consolidated
U.S. federal income tax return.
Merrill Lynch uses the asset and liability method in providing income
taxes on all transactions that have been recognized in the Consolidated
Financial Statements. The asset and liability method requires that deferred
taxes be adjusted to reflect the tax rates at which future taxable amounts will
be settled or realized. The effects of tax rate changes on future deferred tax
liabilities and deferred tax assets, as well as other changes in income tax
laws, are recognized in net earnings in the period such changes are enacted.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amounts expected to be realized.
NOTE 2. OTHER SIGNIFICANT EVENTS
Accounting Changes
In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires
capitalization of certain internal-use software development costs. The SOP was
adopted early for 1998 and resulted in the capitalization of software
development costs of $72 in 1998, or $.12 per diluted share.
In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of
Start-Up Activities", which requires that all start-up costs be expensed as
incurred. Closed-end mutual fund distribution costs, previously deferred and
amortized by Merrill Lynch over a four-year period, are required to be expensed
under the SOP. The SOP was adopted early as of the beginning of 1998, and the
impact of adoption was not material.
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", issued by the Financial Accounting
Standards Board in 1996, provides guidance for determining whether a transfer of
a financial asset is treated as a sale or a financing. Merrill Lynch adopted the
provisions of SFAS No. 125 not deferred by SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of Statement No. 125", for all transactions
entered into after December 31, 1996.
In 1998, Merrill Lynch adopted SFAS No. 127, which requires balance sheet
recognition of collateral related to certain secured financing transactions
entered into after December 31, 1997. The adoption of such provisions creates
the following additional captions on Merrill Lynch's balance sheet:
o Securities received as collateral, net of securities pledged as
collateral;
o Securities pledged as collateral; and
o Obligation to return securities received as collateral.
The balances recognized in these captions primarily represent securities
received as collateral in matched-book term resale and repurchase agreements for
which the collateral provider does not have the explicit contractual right to
substitute.
Mergers, Acquisitions, and Divestitures
On August 26, 1998, Merrill Lynch acquired the outstanding shares of
Midland Walwyn Inc. ("Midland"), a Canadian broker-dealer, in a share exchange.
Each Midland shareholder received either 0.24 shares of ML & Co. common stock or
0.24 exchangeable shares of Merrill Lynch & Co., Canada Ltd. for every Midland
share held (see Note 7). The merger was accounted for as a pooling-of-interests;
prior period financial statements have been restated (see Note 1).
During 1998, Merrill Lynch acquired a U.S. employee benefits consulting
firm and a majority interest in a non-U.S. investment bank, in transactions
accounted for as purchases. Aggregate consideration of $92 was paid, and
goodwill of $56 was recorded in connection with these acquisitions.
In 1998, Merrill Lynch sold a U.S. residential real estate services
subsidiary and a New York Stock Exchange specialist subsidiary, recognizing
pre-tax gains totaling $138.
At year-end 1997, Merrill Lynch recorded the acquisition of the Mercury
Asset Management Group ("Mercury"), a U.K.-based global asset manager. In 1998,
approximately $5.3 billion in cash was paid as consideration. Goodwill of
approximately $4.8 billion was recorded related to the acquisition. In 1997,
Merrill Lynch also acquired a 401(k) service provider for $13, recognizing
goodwill of $10.
Merrill Lynch completed several acquisitions in 1996, including two
non-U.S. securities firms and a U.S. asset man-
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
ager. Aggregate consideration of $232 was paid and goodwill of $167 was recorded
in connection with these acquisitions.
For acquisitions accounted for as purchases, the operating results of
acquired companies are included in Merrill Lynch's results of operations
commencing with the acquisition date.
Provision for Costs Related to Staff Reductions
During the 1998 third quarter, Merrill Lynch recognized a $430 provision
for costs related to staff reductions ($288 after-tax). The provision covered
primarily severance costs, but also included costs to terminate long-term
contracts and leases related to personnel reductions and resized businesses. The
staff reduction program includes reductions, through termination and attrition,
of approximately 3,400 personnel, or about 5% of the global workforce.
Approximately 63% of terminated personnel were producers and direct support
staff in certain Corporate and Institutional Client Group businesses, and the
remaining were personnel in Wealth Management businesses and certain corporate
areas. In addition, full-time equivalent consultants, mainly involved in
technology projects, were reduced by approximately 900. Severance payments,
which may be in the form of one-time or periodic payments, are made once the
employee ceases employment.
At December 25, 1998, 87% of the personnel had been terminated or notified
of termination, and severance payments of $48 were made. The provision liability
at December 25, 1998 was $369, which primarily represented severance payments
for personnel receiving periodic payments. At January 29, 1999, the cumulative
severance benefits paid and the remaining provision liability were $215 and
$197, respectively. The staff reductions were substantially completed as of
January 29, 1999 and are expected to be fully completed by March 1999.
NOTE 3. TRADING AND RELATED ACTIVITIES
As part of its trading activities, Merrill Lynch provides to clients
brokerage, dealing, financing, and underwriting services for a broad range of
products. While trading activities are primarily generated by client order flow,
Merrill Lynch also takes selective proprietary positions based on expectations
of future market movements and conditions. Merrill Lynch's trading strategies
rely on the integrated management of its client-driven and proprietary
positions, along with the related hedging and financing.
Interest revenue and expense are integral components of trading
activities. In assessing the profitability of trading activities, Merrill Lynch
views net interest and principal transactions revenues in the aggregate. For
further information on Merrill Lynch's net trading results, see Management's
Discussion and Analysis (unaudited) - Principal Transactions.
Certain trading activities expose Merrill Lynch to market and credit
risks. These risks are managed in accordance with established risk management
policies and procedures that are described in Management's Discussion and
Analysis (unaudited) - Risk Management.
Market Risk
Market risk is the potential change in an instrument's value caused by
fluctuations in interest and currency exchange rates, equity and commodity
prices, credit spreads, or other risks. The level of market risk is influenced
by the volatility and the liquidity in the markets in which financial
instruments are traded.
Merrill Lynch seeks to mitigate market risk associated with trading
inventories by employing hedging strategies that correlate rate, price, and
spread movements of trading inventories and related financing and hedging
activities. Merrill Lynch uses a combination of cash instruments and derivatives
to hedge its market exposures. The following discussion describes the types of
market risk faced by Merrill Lynch.
"Interest Rate Risk"
Interest rate risk arises from the possibility that changes in interest
rates will affect the value of financial instruments. Interest rate swap
agreements, Eurodollar futures, and U.S. Treasury securities and futures are
common interest rate risk management tools. The decision to manage interest rate
risk using futures or swap contracts, as opposed to buying or selling short U.S.
Treasury or other securities, depends on current market conditions and funding
considerations.
Interest rate swap agreements used by Merrill Lynch include caps, collars,
floors, basis swaps, and leveraged swaps. Interest rate caps and floors provide
the purchaser protection against rising and falling interest rates,
respectively. Interest rate collars combine a cap and a floor, providing the
purchaser with a predetermined interest rate range. Basis swaps are a type of
interest rate swap agreement where variable rates are
70
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
received and paid, but are based on different index rates. Leveraged swaps are
another type of interest rate swap where changes in the variable rate are
multiplied by a contractual leverage factor, such as four times three-month
LIBOR (London Interbank Offered Rate). Merrill Lynch's exposure to interest rate
risk resulting from these leverage factors is typically hedged with other
financial instruments.
"Currency Risk"
Currency risk arises from the possibility that fluctuations in foreign
exchange rates will impact the value of financial instruments. Merrill Lynch's
trading assets and liabilities include both cash instruments denominated in and
derivatives linked to over 70 currencies, including the Japanese yen, German
mark, Swiss franc, British pound, and Italian lira. Currency forwards and
options are commonly used to manage currency risk associated with these
instruments. Currency swaps may also be used in situations where a long-dated
forward market is not available or where the end-user needs a customized
instrument to hedge a foreign currency cash flow stream. Typically, parties to a
currency swap initially exchange principal amounts in two currencies, agreeing
to exchange interest payments and to re-exchange the currencies at a future date
and exchange rate.
"Equity Price Risk"
Equity price risk arises from the possibility that equity security prices
will fluctuate, affecting the value of equity securities and other instruments
that derive their value from a particular stock, a defined basket of stocks, or
a stock index. Instruments typically used by Merrill Lynch to manage equity
price risk include equity options, warrants, and equity securities. Equity
options, for example, can require the writer to purchase or sell a specified
stock or to make a cash payment based on changes in the market price of that
stock, basket of stocks, or stock index.
"Credit Spread Risk"
Credit spread risk arises from the possibility that changes in credit
spreads will affect the value of financial instruments. Credit spreads represent
the credit risk premiums required by market participants for a given credit
quality, i.e., the additional yield that a debt instrument issued by a AA-rated
entity must produce over a risk-free alternative (e.g., U.S. Treasury
instrument). Certain instruments are used by Merrill Lynch to manage this type
of risk. Swaps and options, for example, can be designed to mitigate losses due
to changes in credit spreads, as well as credit downgrade or default of the
issuer. Credit risk resulting from default on counterparty obligations is
discussed in the Credit Risk section.
"Commodity Price and Other Risks"
Merrill Lynch views its commodity contracts as financial instruments since
they are generally settled in cash and not by delivery of the underlying
commodity. Commodity price risk results from the possibility that the price of
the underlying commodity may rise or fall. Cash flows from commodity contracts
are based on the difference between an agreed-upon fixed price and a price that
varies with changes in a specified commodity price or index. Commodity contracts
held by Merrill Lynch principally relate to energy, precious metals, and base
metals.
Merrill Lynch is also a party to financial instruments that contain risks
not correlated to typical financial risks. Securities or derivatives, for
example, may be linked to the occurrence of certain weather conditions or
natural catastrophes. Merrill Lynch generally mitigates the risk associated with
these transactions by entering into offsetting derivative transactions.
Credit Risk
Merrill Lynch is exposed to risk of loss if an issuer or a counterparty
fails to perform its obligations under contractual terms and the collateral
held, if any, is deemed worthless ("default risk"). Both cash instruments and
derivatives expose Merrill Lynch to default risk. Credit risk arising from
changes in credit spreads was previously discussed in the Market Risk section.
Merrill Lynch has established policies and procedures for mitigating
credit risk on principal transactions, including reviewing and establishing
limits for credit exposure, maintaining collateral, and continually assessing
the creditworthiness of counterparties. For further information, see
Management's Discussion and Analysis (unaudited) - Risk Management - Credit
Risk.
In the normal course of business, Merrill Lynch executes, settles, and
finances various customer securities transactions. Execution of these
transactions includes the purchase and sale of securities by Merrill Lynch.
These activities may expose Merrill Lynch to default risk arising from the
71
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
potential that customers or counterparties may fail to satisfy their
obligations. In these situations, Merrill Lynch may be required to purchase or
sell financial instruments at unfavorable market prices to satisfy obligations
to other customers or counterparties. In addition, Merrill Lynch seeks to
control the risks associated with its customer margin activities by requiring
customers to maintain collateral in compliance with regulatory and internal
guidelines.
Liabilities to other brokers and dealers related to unsettled transactions
(i.e., securities failed-to-receive) are recorded at the amount for which the
securities were acquired, and are paid upon receipt of the securities from other
brokers or dealers. In the case of aged securities failed-to-receive, Merrill
Lynch may purchase the underlying security in the market and seek reimbursement
for losses from the counterparty.
"Concentrations of Credit Risk"
Merrill Lynch's exposure to credit risk (both default and credit spread)
associated with its trading and other activities is measured on an individual
counterparty basis, as well as by groups of counterparties that share similar
attributes. Concentrations of credit risk can be affected by changes in
political, industry, or economic factors. To reduce the potential for risk
concentration, credit limits are established and monitored in light of changing
counterparty and market conditions.
At December 25, 1998, Merrill Lynch's most significant concentration of
credit risk was with the U.S. Government and its agencies. This concentration
consists of both direct and indirect exposures. Direct exposure, which primarily
results from trading asset and investment security positions in instruments
issued by the U.S. Government and its agencies, amounted to $17,377 and $11,708
at December 25, 1998 and December 26, 1997, respectively. Merrill Lynch's
indirect exposure results from maintaining U.S. Government and agencies
securities as collateral, primarily for resale agreements and securities
borrowed transactions. Merrill Lynch's direct credit exposure on these
transactions is with the counterparty; thus Merrill Lynch has credit exposure to
the U.S. Government and its agencies only in the event of the counterparty's
default. Securities issued by the U.S. Government or its agencies held as
collateral at December 25, 1998 and December 26, 1997 totaled $54,784 and
$60,868, respectively.
At December 25, 1998, Merrill Lynch had concentrations of credit risk with
other counterparties, including a European sovereign rated AA by recognized
credit rating agencies. Total exposure to this counterparty was $1,197, or 0.4%
of total assets. At December 26, 1997, Merrill Lynch had concentrations of
credit risk with a European sovereign and an investment company totaling $3,405,
or 1.1% of total assets, excluding collateral held.
Merrill Lynch's most significant industry credit concentration is with
financial institutions. Financial institutions include other brokers and
dealers, commercial banks, finance companies, insurance companies, and
investment companies. This concentration arises in the normal course of Merrill
Lynch's brokerage, trading, financing, and underwriting activities. Merrill
Lynch also monitors credit exposures worldwide by region. Within these regions,
sovereign governments represent the most significant concentration, followed by
financial institutions.
In the normal course of business, Merrill Lynch purchases, sells,
underwrites, and makes markets in non-investment grade instruments. In
conjunction with merchant banking activities, Merrill Lynch also provides
extensions of credit and makes equity investments to facilitate leveraged
transactions. These activities expose Merrill Lynch to a higher degree of credit
risk than is associated with trading, investing in, and underwriting investment
grade instruments and extending credit to investment grade counterparties. See
Management's Discussion and Analysis (unaudited) - Non-Investment Grade Holdings
and Highly Leveraged Transactions for further information.
Trading Derivatives
Merrill Lynch's trading derivatives consist of derivatives provided to
customers and derivatives entered into for proprietary trading strategies or
risk management purposes.
The fair values of derivatives used in trading activities at year-end 1998
and 1997 follow:
- --------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
---------------------- ----------------------
ASSETS LIABILITIES ASSETS LIABILITIES
------- ----------- ------- -----------
Swap agreements $17,938 $19,747 $16,189 $15,703
Forward contracts 2,882 2,822 3,805 3,539
Options 8,841 12,195 5,987 10,970
- --------------------------------------------------------------------------------
The following table presents the average fair values of Merrill Lynch's
trading derivatives for 1998 and 1997, calculated on a monthly basis:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
- --------------------------------------------------------------------------------
AVERAGE FAIR VALUE
---------------------------------------------------------
1998 1997
------------------------- -------------------------
ASSETS LIABILITIES ASSETS LIABILITIES
-------- ----------- -------- -----------
Swap agreements $ 19,096 $ 17,272 $ 13,888 $ 12,002
Forward contracts 3,227 3,178 2,340 2,181
Options 8,551 11,420 4,946 7,131
- --------------------------------------------------------------------------------
The notional or contractual amounts of derivatives provide only a measure
of involvement in these types of transactions and represent neither the amounts
subject to the various types of market risk nor the future cash requirements
under these instruments.
The notional or contractual amounts of derivatives used for trading
purposes by type of risk follow:
- --------------------------------------------------------------------------------
RISK
---------------------------------------------------------
INTEREST EQUITY COMMODITY
(in billions) RATE(1)(2) CURRENCY(3) PRICE AND OTHER
- --------------------------------------------------------------------------------
DECEMBER 25, 1998
Swap agreements $ 2,006 $ 170 $ 19 $ 5
Forward contracts 62 229 - 6
Futures contracts 184 2 10 3
Options purchased 254 93 71 4
Options written 192 96 58 6
DECEMBER 26, 1997
Swap agreements $ 1,482 $ 159 $ 17 $ 2
Forward contracts 59 196 1 15
Futures contracts 202 1 15 2
Options purchased 99 71 60 3
Options written 133 73 44 3
- --------------------------------------------------------------------------------
(1) Certain derivatives subject to interest rate risk are also exposed to the
credit spread risk of the underlying financial instrument.
(2) Forward contracts subject to interest rate risk principally represent "To
Be Announced" mortgage pools that bear interest rate as well as principal
prepayment risk.
(3) Included in the currency risk category are certain contracts that are also
subject to interest rate risk.
Most of Merrill Lynch's trading derivative transactions are relatively
short-term in duration with a weighted-average maturity of approximately 2.9
years at December 25, 1998 and 2.8 years at December 26, 1997. For trading
derivatives outstanding at December 25, 1998, the following table presents the
notional or contractual amounts of derivatives expiring in future years based on
contractual expiration:
After
(in billions) 1999 2000 2001 2002 2002 Total
- --------------------------------------------------------------------------------
Swap agreements $ 533 $ 376 $ 236 $ 204 $ 851 $ 2,200
Forward contracts 276 3 14 2 2 297
Futures contracts 70 51 25 8 45 199
Options purchased 266 40 21 21 74 422
Options written 166 65 29 24 68 352
------- ----- ----- ----- ------- -------
Total $ 1,311 $ 535 $ 325 $ 259 $ 1,040 $ 3,470
======= ===== ===== ===== ======= =======
- --------------------------------------------------------------------------------
The notional or contractual values of derivatives do not represent default
risk exposure. Default risk is limited to the current cost of replacing
derivative contracts in a gain position. Default risk exposure varies by type of
derivative. Swap agreements and forward contracts are generally OTC-transacted
and thus are exposed to default risk to the extent of their replacement cost.
Since futures contracts are exchange-traded and usually require daily cash
settlement, the related risk of accounting loss is generally limited to a
one-day net positive change in market value. Option contracts can be
exchange-traded or OTC-transacted. Purchased options have default risk to the
extent of their replacement cost. Written options represent a potential
obligation to counterparties and, accordingly, do not subject Merrill Lynch to
default risk.
Merrill Lynch attempts to enter into International Swaps and Derivatives
Association, Inc. master agreements or their equivalent ("master netting
agreements") with each of its counterparties. Master netting agreements provide
protection in bankruptcy in certain circumstances and, in some cases, enable
receivables and payables with the same counterparty to be offset on the
Consolidated Balance Sheets, providing for a more meaningful balance sheet
presentation of credit exposure.
To reduce default risk, Merrill Lynch requires collateral, principally
U.S. Government and agencies securities, on certain derivative transactions.
From an economic standpoint, Merrill Lynch evaluates default risk exposures net
of related collateral. The following is a summary of counterparty credit ratings
for the replacement cost (net of $5,700 of collateral) of trading derivatives in
a gain position by maturity at December 25, 1998.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
- --------------------------------------------------------------------------------
YEARS TO MATURITY CROSS-
CREDIT ------------------------------------- MATURITY
RATING(1) 0-3 3-5 5-7 OVER 7 NETTING(2) TOTAL
- --------------------------------------------------------------------------------
AAA $ 1,753 $ 583 $ 396 $ 388 $ (176) $ 2,944
AA+/AA 1,760 1,012 403 1,256 (999) 3,432
AA- 2,435 1,163 676 899 (832) 4,341
A+/A 3,458 1,371 407 838 (716) 5,358
A- 1,396 1,017 338 349 (293) 2,807
BBB 1,267 1,025 571 332 (598) 2,597
BB+ 632 323 73 322 (249) 1,101
Other 905 488 390 397 (799) 1,381
-------- ------- ------- ------- ------- --------
Total $ 13,606 $ 6,982 $ 3,254 $ 4,781 $(4,662) $ 23,961
======== ======= ======= ======= ======= ========
- --------------------------------------------------------------------------------
(1) Represents credit rating agency equivalent.
(2) Represents netting of payable balances with receivable balances for the
same counterparty across maturity band categories. Receivable and payable
balances with the same counterparty in the same maturity category,
however, are net within the maturity category.
In addition to obtaining collateral, Merrill Lynch attempts to mitigate
default risk on derivatives by entering into transactions with provisions that
enable Merrill Lynch to terminate or reset the terms of the derivative contract.
Securities Financing Transactions
Merrill Lynch enters into secured borrowing and lending transactions to
finance trading inventory positions, obtain securities for settlement, and meet
customers' needs (see Management's Discussion and Analysis (unaudited) - Balance
Sheet for further information). Outstanding receivables and payables under
resale and repurchase agreements and securities borrowed and loaned transactions
at year-end 1998 and 1997 are as follows:
- --------------------------------------------------------------------------------
1998 1997
-------- --------
RECEIVABLES UNDER:
Resale agreements $ 50,188 $ 71,904
Securities borrowed transactions 37,525 35,539
-------- ---------
Total $ 87,713 $ 107,443
======== =========
- --------------------------------------------------------------------------------
PAYABLES UNDER:
Repurchase agreements $ 59,501 $ 72,127
Securities loaned transactions 7,626 7,040
-------- ---------
Total $ 67,127 $ 79,167
======== =========
- --------------------------------------------------------------------------------
Due to the short-term nature of most of these transactions, the fair value
of these receivables and payables approximate their carrying value. Included
above are also certain long-term resale agreements for which interest rate risk
is hedged using derivatives. At December 25, 1998 and December 26, 1997, the
notional amounts of these derivatives were $7 billion and $5 billion,
respectively. The combined fair value of these long-term resale agreements and
related hedges approximate their combined carrying value on both dates.
Under these agreements and 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. When
providing collateral for these transactions, Merrill Lynch delivers its own
securities, securities borrowed from counterparties, and securities owned by
customers collateralizing margin loans and other obligations. The market value
of securities owned by Merrill Lynch that have been loaned or pledged to
counterparties as collateral for obligations of Merrill Lynch, primarily related
to repurchase agreements, were $35,762 and $28,658 at December 25, 1998 and
December 26, 1997, respectively.
NOTE 4. INVESTMENTS AND OTHER NON-TRADING ASSETS
Investments
Merrill Lynch has several broad categories of investments on its
Consolidated Balance Sheets, including Marketable investment securities,
Investments of insurance subsidiaries, and Other investments.
Marketable investment securities consist of liquid debt and equity
securities, including those held (1) to manage cash flows related to certain
liabilities of Merrill Lynch's banking subsidiaries or (2) by a subsidiary for
credit rating agency purposes. Investments of insurance subsidiaries, primarily
debt securities, are used to fund policyholder liabilities. Other investments
consist of equity and debt securities, including those acquired in connection
with merchant banking activities. Certain merchant banking investments are
subject to restrictions that may limit Merrill Lynch's ability to realize its
investment until such restrictions expire.
Marketable investment securities and certain investments of insurance
subsidiaries and other investments are classified as held-to-maturity, trading,
or available-for-sale securities as described in Note 1. Investment securities
reported on the Consolidated Balance Sheets at December 25, 1998 and December
26, 1997 are as follows:
74
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
- --------------------------------------------------------------------------------
1998 1997
------- -------
MARKETABLE INVESTMENT SECURITIES
Available-for-sale $ 4,070 $ 2,392
Held-to-maturity 354 322
Trading 181 595
------- -------
Total $ 4,605 $ 3,309
======= =======
- --------------------------------------------------------------------------------
INVESTMENTS OF INSURANCE SUBSIDIARIES
Available-for-sale $ 2,917 $ 3,338
Trading 17 16
Non-qualifying(1)(2) 1,551 1,479
------- -------
Total $ 4,485 $ 4,833
======= =======
- --------------------------------------------------------------------------------
OTHER INVESTMENTS
Available-for-sale $ 435 $ 500
Held-to-maturity 290 233
Non-qualifying(1)(3) 1,865 1,096
------- -------
Total $ 2,590 $ 1,829
======= =======
- --------------------------------------------------------------------------------
(1) Non-qualifying for SFAS No. 115 purposes.
(2) Primarily consists of insurance policy loans.
(3) Includes merchant banking investments and investments hedging deferred
compensation liabilities.
Information regarding investment securities subject to SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities", follows:
- ----------------------------------------------------------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
----------------------------------------------- -----------------------------------------------
COST/ GROSS GROSS ESTIMATED COST/ GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
----------------------------------------------- -----------------------------------------------
AVAILABLE-FOR-SALE
Corporate debt $ 2,771 $ 61 $ (31) $ 2,801 $ 3,136 $ 78 $ (8) $ 3,206
U.S. Government and agencies 658 7 (1) 664 650 4 - 654
Municipals 1,721 15 (13) 1,723 936 2 (1) 937
Mortgage-backed securities 1,572 18 (2) 1,588 1,036 47 (1) 1,082
Other debt securities 183 1 (4) 180 109 1 (2) 108
------- ----- ----- ------- ------- ----- ----- -------
Total debt securities 6,905 102 (51) 6,956 5,867 132 (12) 5,987
Equity securities 447 26 (7) 466 247 1 (5) 243
------- ----- ----- ------- ------- ----- ----- -------
Total $ 7,352 $ 128 $ (58) $ 7,422 $ 6,114 $ 133 $ (17) $ 6,230
======= ===== ===== ======= ======= ===== ===== =======
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
----------------------------------------------- -----------------------------------------------
COST/ GROSS GROSS ESTIMATED COST/ GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
----------------------------------------------- -----------------------------------------------
HELD-TO-MATURITY
Corporate debt $ 38 $ 1 $ - $ 39 $ 189 $ 1 $ - $ 190
U.S. Government and agencies 263 29 - 292 211 - - 211
Municipals 144 64 (2) 206 35 44 (1) 78
Mortgage-backed securities 87 - - 87 119 2 - 121
Other debt securities 112 - (2) 110 1 - - 1
----- ---- ---- ----- ----- ---- ---- -----
Total $ 644 $ 94 $ (4) $ 734 $ 555 $ 47 $ (1) $ 601
===== ==== ==== ===== ===== ==== ==== =====
- ----------------------------------------------------------------------------------------------------------------------------------
75
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
The amortized cost and estimated fair value of debt securities at December
25, 1998, by contractual maturity, for available-for-sale and held-to-maturity
investments follow:
- --------------------------------------------------------------------------------
AVAILABLE-FOR-SALE HELD-TO-MATURITY
--------------------- ---------------------
ESTIMATED ESTIMATED
AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE
--------- --------- --------- ---------
Due in one year
or less $ 1,286 $ 1,285 $ 203 $ 203
Due after one year
through five years 1,565 1,591 254 297
Due after five years
through ten years 993 1,006 29 49
Due after ten years 1,489 1,486 71 98
------- ------- ----- -----
5,333 5,368 557 647
Mortgage-backed
securities 1,572 1,588 87 87
------- ------- ----- -----
Total(1) $ 6,905 $ 6,956 $ 644 $ 734
======= ======= ===== =====
- --------------------------------------------------------------------------------
(1) Expected maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without
prepayment penalties.
The proceeds and gross realized gains (losses) from the sale of
available-for-sale investments are as follows:
- --------------------------------------------------------------------------------
1998 1997 1996
------- ------- -------
Proceeds $ 3,426 $ 2,198 $ 1,341
Gross realized gains 74 27 41
Gross realized losses (27) (11) (12)
- --------------------------------------------------------------------------------
Net unrealized gains (losses) from investment securities classified as
trading included in the 1998, 1997, and 1996 Consolidated Statements of Earnings
were $6, $(21), and $(1), respectively.
Other Non-Trading Assets
The fair value of most other non-trading financial instrument assets
approximates their carrying value. Such assets include cash and cash
equivalents, cash and securities segregated for regulatory purposes or deposited
with clearing organizations, and other receivables. Other financial instrument
assets with carrying values that differ from their fair values follow:
- --------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
------------------- -------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
-------- ------- -------- -------
Loans, notes, and
mortgages(1) $ 7,471 $ 7,480 $ 4,197 $ 4,230
Merchant banking equity
investment and loan
portfolio(2) 241 355 275 403
- --------------------------------------------------------------------------------
(1) Excludes loans related to merchant banking activities.
(2) Merchant banking investments are non-qualifying for SFAS No. 115 purposes.
Fair value for merchant banking equity investments, including partnership
interests (both included in Other investments on the Consolidated Balance
Sheets), is estimated using a number of methods, including earnings multiples,
cash flow analysis, and review of underlying financial conditions and other
market factors. These instruments may be subject to restrictions (e.g., consent
of other investors) that may limit Merrill Lynch's ability to realize currently
the estimated fair value. Accordingly, Merrill Lynch's current estimate of fair
value and the ultimate realization on these instruments may differ.
Fair value for loans made in connection with merchant banking activities,
consisting primarily of senior and subordinated debt, is estimated using
discounted cash flows. Merrill Lynch's estimated fair value for other loans,
notes, and mortgages is determined based on loan characteristics. For certain
homogeneous categories of loans, including residential mortgages and home equity
loans, fair value is estimated using market price quotations or previously
executed transactions for securities backed by similar loans, adjusted for
credit risk and other individual loan characteristics. For Merrill Lynch's
variable-rate loan receivables, fair value approximates carrying value.
In addition to the merchant banking investments noted in the table above,
Merrill Lynch has made investments in Long Term Capital Portfolio L.P. ("LTCP")
and Bloomberg L.P. ("Bloomberg"), which are not readily marketable.
In 1998, in conjunction with 13 other financial institutions, Merrill
Lynch made a $300 capital infusion to LTCP, a hedge fund significantly affected
by the 1998 third quarter market turmoil. At December 25, 1998, the fair value
of this investment approximates its carrying value of $300.
Merrill Lynch holds a passive minority interest in Bloomberg, a privately
held limited partnership that provides information services to financial
institutions. In 1996, Merrill Lynch sold one-third of its interest to the
majority interest
76
[LOGO]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
holder, resulting in a pre-tax gain of $155. Due to the nature and terms of the
sale, the sale price is not necessarily indicative of the fair value of Merrill
Lynch's remaining investment. In addition, given the contractual restrictions on
disposition, the fair value of the remaining investment is not readily
determinable as of December 25, 1998. Management believes, however, that the
fair value of this investment may significantly exceed its carrying value of
$28.
Merrill Lynch enters into derivative hedges of interest rate risk on
various non-trading assets, including certain investments. At December 25, 1998
and December 26, 1997, the notional amounts of derivatives hedging these
positions were $10 billion and $4 billion, respectively. The combined fair value
of hedged non-trading assets and related hedges approximates their combined
carrying value at both dates.
Merrill Lynch uses currency derivatives to hedge certain exposures arising
from investments in and loans to non-U.S. subsidiaries. At December 25, 1998 and
December 26, 1997, the notional amounts of these currency derivatives were $4
billion and $2 billion, respectively.
NOTE 5. BORROWINGS AND OTHER NON-TRADING LIABILITIES
Borrowings
Merrill Lynch issues U.S. and non-U.S. dollar-denominated debt instruments
with both variable and fixed interest rates, primarily at the ML & Co. level.
These borrowing activities may create exposure to market risk, most notably
interest rate and currency risk. Merrill Lynch typically uses derivatives to
better match the interest rate and currency characteristics of assets and
liabilities, thereby reducing risk exposures. Derivatives used most frequently
include swap agreements that:
o convert fixed-rate interest payments into variable payments,
o change the underlying interest rate basis or reset frequency, or
o convert non-U.S. dollar payments into U.S. dollars.
Merrill Lynch also issues debt containing embedded options that link the
repayment of these obligations to the performance of an equity or other index
(e.g., S&P 500), an industry basket of stocks, or an individual stock. The
contingent components of these indexed debt obligations are hedged with
derivatives.
Borrowings at December 25, 1998 and December 26, 1997 are presented below:
- --------------------------------------------------------------------------------
1998 1997
-------- --------
COMMERCIAL PAPER AND OTHER
SHORT-TERM BORROWINGS
Commercial paper $ 16,758 $ 30,379
Other 1,921 3,961
-------- --------
Total $ 18,679 $ 34,340
======== ========
- ------------------------------------------------------------------------- ------
DEMAND AND TIME DEPOSITS
Demand $ 4,454 $ 3,537
Time 9,290 7,175
-------- --------
Total $ 13,744 $ 10,712
======== ========
- --------------------------------------------------------------------------------
LONG-TERM BORROWINGS
Fixed-rate obligations:(1)
U.S. dollar-denominated $ 12,595 $ 7,136
Non-U.S. dollar-denominated 1,189 1,878
Variable-rate obligations:(2)(3)
U.S. dollar-denominated 4,077 2,803
Non-U.S. dollar-denominated 1,303 1,276
Medium-term notes:(3)(4)
U.S. dollar-denominated 24,916 20,090
Non-U.S. dollar-denominated 13,483 9,960
-------- --------
Total $ 57,563 $ 43,143
======== ========
- --------------------------------------------------------------------------------
(1) At December 25, 1998, U.S. dollar-denominated fixed-rate obligations are
due 1999 to 2028 at interest rates ranging from 5.5% to 10.4%; non-U.S.
dollar-denominated fixed-rate obligations are due 1999 to 2002 at interest
rates ranging from 2.6% to 12.1%.
(2) Variable interest rates are generally based on rates such as LIBOR, the
U.S. Treasury Bill Rate, or the Federal Funds Rate.
(3) Included are various equity-linked or indexed instruments.
(4) The medium-term note program provides for issuances that may bear fixed or
variable interest rates and may have maturities that range from nine
months to 30 years from the date of issue.
Long-term borrowings at December 25, 1998, based on their contractual
terms, mature as follows:
- --------------------------------------------------------------------------------
1999 $ 13,714
2000 7,049
2001 7,985
2002 6,398
2003 6,154
2004 and thereafter 16,263
--------
Total $ 57,563
========
- --------------------------------------------------------------------------------
Certain long-term borrowing agreements contain provisions whereby the
borrowings are redeemable at the option of the holder at specified dates prior
to maturity. Management believes, however, that a significant portion of
77
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
such borrowings may remain outstanding beyond their earliest redemption date.
The notional or contractual amounts of derivatives used to hedge exposures
related to borrowings at December 25, 1998 and December 26, 1997 follow:
- --------------------------------------------------------------------------------
(in billions) 1998 1997
---- ----
Interest rate derivatives(1) $ 56 $ 44
Currency derivatives(1) 12 8
Equity derivatives 5 3
- --------------------------------------------------------------------------------
(1) Includes swap contracts totaling $2 billion in notional amounts that
contain embedded options hedging callable debt at both dates.
Most of these derivatives are entered into with Merrill Lynch's derivative
dealer subsidiaries, which intermediate interest rate, currency, and equity
risks with third parties in the normal course of their trading activities.
The effective weighted-average interest rates for borrowings, which
include the impact of hedges, at December 25, 1998 and December 26, 1997 were:
- --------------------------------------------------------------------------------
1998 1997
---- ----
COMMERCIAL PAPER AND OTHER
SHORT-TERM BORROWINGS 5.28% 5.43%
DEMAND AND TIME DEPOSITS 4.54 4.67
LONG-TERM BORROWINGS
Fixed-rate obligations 6.69 7.00
Variable-rate obligations 5.46 5.84
Medium-term notes 5.52 5.86
- --------------------------------------------------------------------------------
The fair value of borrowings and related hedges is estimated using current
market prices and pricing models. The carrying and fair values of these
instruments are summarized as follows:
- --------------------------------------------------------------------------------
DECEMBER 25, 1998 DECEMBER 26, 1997
-------------------- --------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
-------- -------- -------- --------
COMMERCIAL PAPER AND OTHER
SHORT-TERM BORROWINGS $ 18,679 $ 18,670 $ 34,340 $ 34,333
Related derivative:
Assets (15) (14) (21) (19)
Liabilities - 5 - 2
-------- -------- -------- --------
Total $ 18,664 $ 18,661 $ 34,319 $ 34,316
======== ======== ======== ========
- --------------------------------------------------------------------------------
DEMAND AND TIME DEPOSITS $ 13,744 $ 13,745 $ 10,712 $ 10,726
Related derivative:
Assets (27) (10) (7) (10)
Liabilities 4 21 3 2
-------- -------- -------- --------
Total $ 13,721 $ 13,756 $ 10,708 $ 10,718
======== ======== ======== ========
- --------------------------------------------------------------------------------
LONG-TERM BORROWINGS $ 57,563 $ 58,237 $ 43,143 $ 43,706
Related derivative:
Assets (1,387) (2,701) (811) (1,953)
Liabilities 790 1,243 921 1,032
-------- -------- -------- --------
Total $ 56,966 $ 56,779 $ 43,253 $ 42,785
======== ======== ======== ========
- --------------------------------------------------------------------------------
Subsequent to year-end 1998 and through February 19, 1999, long-term
borrowings, net of repayments and repurchases, increased approximately $3,301.
"Borrowing Facilities"
Merrill Lynch has obtained committed, unsecured revolving credit
facilities aggregating $6.9 billion under agreements with 67 banks. The
agreements contain covenants requiring, among other things, that Merrill Lynch
maintain specified levels of net worth, as defined in the agreements, on the
date of an advance. At December 25, 1998, none of these credit facilities had
been drawn upon.
The credit quality, amounts, and terms of the credit facilities are
continually monitored and modified as warranted by business conditions. Under
the existing agreements, the credit facilities mature as follows: $1.2 billion
in February 1999, $1.6 billion in April 1999, $2.1 billion in May 1999, and $2.0
billion in September 1999. At maturity, Merrill Lynch may convert amounts
borrowed, if any, into term loans that would mature in two years.
Other Non-Trading Liabilities
The fair value of other financial instrument liabilities approximate their
carrying value. Such liabilities include
78
[LOGO]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
payables to customers and brokers and dealers, and insurance and other
liabilities.
NOTE 6. PREFERRED SECURITIES ISSUED BY SUBSIDIARIES
Preferred securities issued by subsidiaries, which represent preferred
minority interests in consolidated subsidiaries, consist of perpetual
trust-issued preferred securities and other subsidiary-issued preferred
securities.
Trust Originated Preferred Securities(Service Mark) ("TOPrS"(Service
Mark)) are issued to investors by trusts created by Merrill Lynch. Using the
issuance proceeds, the trusts purchase Partnership Preferred Securities,
representing limited partnership interests. Using the purchase proceeds, the
limited partnerships extend loans to ML & Co. and one or more subsidiaries of ML
& Co. The trusts and partnerships are consolidated subsidiaries of Merrill
Lynch. ML & Co. has guaranteed, on a subordinated basis, the payment in full of
all distributions and other payments on the TOPrS to the extent that the trusts
have funds legally available. This guarantee and a similar partnership
distribution guarantee are subordinated to all other liabilities of ML & Co. and
rank equally with preferred stock of ML & Co.
The table below presents data related to the issuance of TOPrS by Merrill
Lynch Capital Trust I, II, III, IV, and V. All TOPrS issued have a liquidation
value of $25 per security, have a perpetual life, and can be redeemed at the
option of the trusts, in whole or in part, at the liquidation value on or after
their respective optional redemption dates. Distributions are payable from the
date of original issuance and are payable quarterly if, as, and when the trusts
have funds available for payment.
- --------------------------------------------------------------------------------
ANNUAL OPTIONAL
DISTRIBUTION ISSUE REDEMPTION LIQUIDATION
TOPrS RATE DATE DATE VALUE
- --------------------------------------------------------------------------------
I 7.75% Dec. 1996 Dec. 2006 $ 275
II 8.00 Feb. 1997 Mar. 2007 300
III 7.00 Jan. 1998 Mar. 2008 750
IV 7.12 Jun. 1998 Jun. 2008 400
V 7.28 Nov. 1998 Sep. 2008 850
-------
$ 2,575
=======
- --------------------------------------------------------------------------------
In addition, $52 of preferred securities of other subsidiaries were
outstanding at year-end 1998 and 1997.
NOTE 7. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE
Preferred Equity
ML & Co. is authorized to issue 25,000,000 shares of undesignated
preferred stock, $1.00 par value per share. All shares of currently outstanding
preferred stock constitute one and the same class that have equal rank and
priority over common stockholders as to dividends and in the event of
liquidation.
"9% Cumulative Preferred Stock, Series A"
ML & Co. has issued 17,000,000 Depositary Shares, each representing a
one-four-hundredth interest in a share of 9% Cumulative Preferred Stock, Series
A, liquidation preference value of $10,000 per share ("9% Preferred Stock"). The
9% Preferred Stock is a single series consisting of 42,500 shares with an
aggregate liquidation preference of $425, all of which was outstanding at
year-end 1998, 1997, and 1996.
Dividends on the 9% Preferred Stock are cumulative from the date of
original issue and are payable quarterly when declared by the authority of the
Board of Directors. The 9% Preferred Stock is perpetual and redeemable on or
after December 30, 2004 at the option of ML & Co., in whole or in part, at a
redemption price equal to $10,000 per share, plus accrued and unpaid dividends
(whether or not declared) to the date fixed for redemption.
"Remarketed Preferred (Service Mark) Stock, Series C"
During 1997, all outstanding shares of Remarketed Preferred Stock, Series
C were redeemed. Dividend rates in effect prior to redemption ranged from 3.80%
to 4.15% per annum.
Common Stock
In 1998, stockholders approved the proposal to amend ML & Co.'s
certificate of incorporation to increase the authorized number of shares of
common stock from 500 million to 1 billion.
In 1997, the Board of Directors declared a two-for-one common stock split
effected in the form of a 100% stock dividend. The par value of the common stock
remained at $1.33 1/3 per share. Accordingly, an adjustment from paid-in capital
to common stock of $315 was made to preserve the par value of the post-split
shares. All share and per share data have been restated for the effect of the
split. Dividends paid on common
79
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
stock were $.92, $.75, and $.58 per share in 1998, 1997, and 1996, respectively.
The following table summarizes the activity in outstanding common stock
for 1998, 1997, and 1996:
- --------------------------------------------------------------------------------
1998 1997 1996
----------- ----------- -----------
BEGINNING OF YEAR
Issued 472,660,324 472,660,324 472,660,324
Shares in treasury (133,400,971) (137,234,132) (117,681,492)
ESOP reversion shares - (3,077,556) (8,025,038)
----------- ----------- -----------
Outstanding 339,259,353 332,348,636 346,953,794
----------- ----------- -----------
ACTIVITY
Shares purchased - (13,301,100) (36,606,400)
Shares issued:
To employees(1) 16,291,477 20,211,817 22,001,242
Share exchanges 325,459 - -
Acquisition 407,776 - -
----------- ----------- -----------
Net activity 17,024,712 6,910,717 (14,605,158)
----------- ----------- -----------
END OF YEAR
Issued 472,660,324 472,660,324 472,660,324
Shares in treasury (116,376,259) (133,400,971) (137,234,132)
ESOP reversion shares - - (3,077,556)
----------- ----------- -----------
Outstanding 356,284,065 339,259,353 332,348,636
=========== =========== ===========
- --------------------------------------------------------------------------------
(1) Net of reacquisitions.
Shares Exchangeable into Common Stock
In 1998, Merrill Lynch & Co., Canada Ltd. issued 4,831,224 Exchangeable
Shares in connection with Merrill Lynch's merger with Midland (see Note 2).
Holders of Exchangeable Shares have dividend, voting, and other rights
equivalent to those of ML & Co. common stockholders. Exchangeable Shares may be
exchanged at any time, at the option of the holder, on a one-for-one basis for
ML & Co. common stock. Merrill Lynch may redeem all outstanding Exchangeable
Shares for ML & Co. common stock after January 31, 2011, or earlier under
certain circumstances.
During 1998, 325,459 Exchangeable Shares were converted to ML & Co. common
stock. At year-end 1998, 4,505,765 Exchangeable Shares were outstanding.
Accumulated Other Comprehensive Income
Accumulated other comprehensive income represents cumulative gains and
losses on items that are not reflected in earnings. The balances at December 25,
1998 and December 26, 1997 are as follows:
- --------------------------------------------------------------------------------
1998 1997
----- -----
FOREIGN CURRENCY TRANSLATION ADJUSTMENT
Unrealized losses, net of gains $(241) $(110)
Deferred income taxes 103 25
----- -----
Total (138) (85)
----- -----
UNREALIZED GAINS ON INVESTMENT SECURITIES
AVAILABLE-FOR-SALE
Unrealized gains, net of losses 56 116
Adjustments for:
Policyholder liabilities (38) (54)
Deferred policy acquisition costs - (4)
Deferred income taxes (2) (20)
----- -----
Total 16 38
----- -----
TOTAL ACCUMULATED OTHER COMPREHENSIVE LOSS $(122) $ (47)
===== =====
- --------------------------------------------------------------------------------
Stockholder Rights Plan
In 1997, the Board of Directors approved and adopted the amended and
restated Stockholder Rights Plan. The amended and restated Stockholder Rights
Plan provides for the distribution of preferred purchase rights ("Rights") to
common stockholders. The Rights separate from the common stock ten days
following the earlier of: (a) an announcement of an acquisition by a person or
group ("acquiring party") of 15% or more of the outstanding common shares of ML
& Co., or (b) the commencement of a tender or exchange offer for 15% or more of
the common shares outstanding. One Right is attached to each outstanding share
of common stock and will attach to all subsequently issued shares. Each Right
entitles the holder to purchase 1/100 of a share (a "Unit") of Series A Junior
Preferred Stock, par value $1.00 per share, at an exercise price of $300 per
Unit at any time after the distribution of the Rights. The Units are
nonredeemable and have voting privileges and certain preferential dividend
rights. The exercise price and the number of Units issuable are subject to
adjustment to prevent dilution.
If, after the Rights have been distributed, either the acquiring party
holds 15% or more of ML & Co.'s outstanding shares or ML & Co. is a party to a
business combination or other specifically defined transaction, each Right
(other than those held by the acquiring party) will entitle the holder to
receive, upon exercise, a Unit of preferred stock or shares of common stock of
the surviving company with a value equal to two times the exercise price of the
Right. The Rights expire in 2007, and are redeemable at the option of a majority
of the directors of ML & Co. at $.01 per Right at any time until the
80
[LOGO]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
tenth day following an announcement of the acquisition of 15% or more of ML &
Co.'s common stock.
Earnings Per Share
Basic earnings per share ("EPS") is calculated by dividing earnings
available to common stockholders by the weighted-average number of common shares
outstanding. Diluted EPS is similar to basic EPS, but adjusts for the effect of
the potential issuance of common shares. The following table presents the
computations of basic and diluted EPS:
- --------------------------------------------------------------------------------
1998 1997 1996
-------- -------- --------
Net earnings $ 1,259 $ 1,935 $ 1,648
Preferred stock dividends 39 39 46
-------- -------- --------
Net earnings applicable to
common stockholders 1,220 1,896 1,602
Interest on convertible debt - - 1
-------- -------- --------
$ 1,220 $ 1,896 $ 1,603
======== ======== ========
- --------------------------------------------------------------------------------
(shares in thousands)
Weighted-average shares
outstanding (basic shares)(1) 355,589 340,096 346,043
------- ------- -------
Effect of dilutive instruments(2)
Employee stock options 29,184 29,748 21,934
FCCAAP shares 16,548 20,574 19,570
Restricted units 4,895 5,258 4,727
ESPP shares 46 45 56
Convertible debt - 134 660
------- ------- -------
Dilutive potential common shares 50,673 55,759 46,947
------- ------- -------
Diluted shares(3) 406,262 395,855 392,990
======= ======= =======
- --------------------------------------------------------------------------------
Basic EPS $ 3.43 $ 5.57 $ 4.63
Diluted EPS 3.00 4.79 4.08
- --------------------------------------------------------------------------------
(1) Includes shares exchangeable into common stock.
(2) See Note 10 for a description of these instruments and issuances
subsequent to December 25, 1998.
(3) At year-end 1998, 1997, and 1996, there were 486, 7, and 58 instruments,
respectively, that were considered antidilutive and thus were not included
in the above calculations.
NOTE 8. COMMITMENTS AND CONTINGENCIES
Litigation
There are civil actions, arbitration proceedings, and claims pending
against Merrill Lynch as of December 25, 1998, some of which involve claims for
substantial amounts. Included among these matters is an action (the "Orange
County Action") that is pending in the United States District Court for the
Central District of California, commenced on January 12, 1995 by Orange County,
California ("Orange County") and the Orange County Investment Pools, both of
which filed bankruptcy petitions in the United States Bankruptcy Court for the
Central District of California (the "Bankruptcy Court") on December 6, 1994. ML
& Co. and certain of its subsidiaries are named as defendants in connection with
Merrill Lynch's business activities with the Orange County Treasurer-Tax
Collector. On May 17, 1996, the Bankruptcy Court confirmed a plan pursuant to
which Orange County emerged from bankruptcy.
In June 1998, the Orange County Action and a related action brought by the
Irvine Ranch Water District were settled. Under the settlement terms, ML & Co.
undertook to pay $400 to Orange County and $17 to the Irvine Ranch Water
District and to return approximately $20 of excess collateral. On November 30,
1998, the District Court found that the settlement of the Orange County Action
was in good faith, thereby barring any potential claims for contribution,
indemnity or similar relief by non-settling parties. Payment by ML & Co. to
Orange County will be due approximately five business days after expiration of
the time for any party to appeal from this District Court finding of good faith,
which expiration will occur 60 days after entry of final judgment incorporating
the bar order.
In addition, other actions are pending against or on behalf of ML & Co.,
and/or against certain of its officers, directors, and employees and certain of
its subsidiaries. These include class actions and stockholder derivative actions
brought by persons alleging harm to themselves or to Merrill Lynch arising out
of Merrill Lynch's business activities.
Although the ultimate outcome of these actions cannot be ascertained at
this time and the results of legal proceedings cannot be predicted with
certainty, it is the opinion of management that the resolution of these matters
will not have a material adverse effect on the financial condition or results of
operations of Merrill Lynch as set forth in the Consolidated Financial
Statements contained herein.
Lending and Guarantees
Merrill Lynch enters into commitments to extend credit, predominantly at
variable interest rates, in connection with certain merchant banking and loan
syndication transactions. Customers 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. Merrill Lynch also issues
various guarantees to counterparties in connection
81
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
with certain leasing, agency securities lending, securitization, and other
transactions. These commitments and guarantees 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 or
guarantees are issued, Merrill Lynch may require the counterparty to post
collateral depending upon creditworthiness and market conditions.
The contractual amounts of these commitments and guarantees represent the
amounts at risk should the contract be fully drawn upon, the client default, and
the value of the existing collateral become worthless. The total amount of
outstanding commitments and guarantees may not represent future cash
requirements, as commitments and guarantees may expire without being drawn upon.
At December 25, 1998 and December 26, 1997, Merrill Lynch had the
following commitments and guarantees:
- --------------------------------------------------------------------------------
1998 1997
-------- -------
Commitments to extend credit $ 10,388 $ 5,839
Third party guarantees 17,842 5,251
- --------------------------------------------------------------------------------
The fair value of the outstanding guarantees was $18 and $25 at December
25, 1998 and December 26, 1997, respectively.
Leases
Merrill Lynch has entered into various noncancelable long-term lease
agreements for premises that expire through 2025. During 1996, Merrill Lynch
incurred a pre-tax charge of $40 related to the resolution of Olympia & York's
bankruptcy that affected Merrill Lynch's long-term sublease agreements in the
World Financial Center Headquarters ("WFC"). Merrill Lynch has also entered into
various noncancelable short-term lease agreements, which are primarily
commitments of less than one year under equipment leases.
At December 25, 1998, future noncancelable minimum rental commitments
under leases with remaining terms exceeding one year are as follows:
- --------------------------------------------------------------------------------
WFC OTHER TOTAL
------- ------- -------
1999 $ 140 $ 313 $ 453
2000 143 270 413
2001 145 250 395
2002 151 207 358
2003 158 168 326
2004 and thereafter 1,747 658 2,405
------- ------- -------
Total $ 2,484 $ 1,866 $ 4,350
======= ======= =======
- --------------------------------------------------------------------------------
The minimum rental commitments shown above have not been reduced by $753
of minimum sublease rentals to be received in the future under noncancelable
subleases. Certain leases contain renewal or purchase options or escalation
clauses providing for increased rental payments based upon maintenance, utility,
and tax increases.
Net rent expense for each of the last three years is presented below:
- --------------------------------------------------------------------------------
1998 1997 1996
----- ----- -----
Rent expense $ 537 $ 468 $ 438
Sublease revenue (112) (104) (48)
----- ----- -----
Net rent expense $ 425 $ 364 $ 390
===== ===== =====
- --------------------------------------------------------------------------------
Other Commitments
In the normal course of business, Merrill Lynch enters into commitments
for underwriting transactions. Settlement of these transactions as of December
25, 1998 would not have a material effect on the consolidated financial
condition of Merrill Lynch.
In connection with trading activities, Merrill Lynch had commitments at
December 25, 1998 and December 26, 1997 to enter into resale and repurchase
agreements as follows:
- --------------------------------------------------------------------------------
1998 1997
------- -------
Resale agreements $ 5,392 $ 3,440
Repurchase agreements 4,456 4,469
- --------------------------------------------------------------------------------
Merrill Lynch also obtains letters of credit from issuing banks to satisfy
various counterparty collateral requirements in lieu of depositing cash or
securities collateral. Letters of credit aggregated $2,222 and $1,063 at
December 25, 1998 and December 26, 1997, respectively.
In connection with merchant banking activities, Merrill Lynch has
committed to purchase $369 and $88 of partner-
82
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
ship interests at December 25, 1998 and December 26, 1997, respectively.
Merrill Lynch has entered into agreements with providers of market data,
communications, and systems consulting services. At December 25, 1998 and
December 26, 1997, minimum fee commitments over the life of these agreements
aggregated $300 and $348, respectively.
NOTE 9. EMPLOYEE BENEFIT PLANS
Merrill Lynch provides retirement and other postemployment benefits to its
employees worldwide through defined contribution and defined benefit pension
plans and other postretirement benefit plans. Merrill Lynch reserves the right
to amend or terminate these plans at any time.
Defined Contribution Pension Plans
The U.S. defined contribution plans consist of the Retirement Accumulation
Plan ("RAP"), the Employee Stock Ownership Plan ("ESOP"), and the 401(k) Savings
& Investment Plan ("401K"). The RAP, ESOP, and 401K cover substantially all U.S.
employees who have met service requirements.
Merrill Lynch established the RAP and the ESOP, collectively known as the
"Retirement Program," for the benefit of employees with one year of service. A
separate retirement account is maintained for each participant.
In 1989, the ESOP trust purchased from Merrill Lynch 47,851,236 shares of
ML & Co. common stock with residual funds from a terminated defined benefit
pension plan ("Reversion Shares") and loan proceeds from a subsidiary of Merrill
Lynch ("Leveraged Shares").
Merrill Lynch credits a participant's account and records pension expense
under the Retirement Program based on years of service and eligible
compensation. This expense is funded by quarterly allocations of Leveraged and
Reversion Shares and, if necessary, cash, to participants' accounts based on a
specified formula. Leveraged and Reversion Shares are released in accordance
with the terms of the ESOP. If the fair market value of the shares released is
less than the formula allocation to participants' accounts, cash contributions
are made to the RAP. Reversion Shares were allocated to participants' accounts
over a period of eight years, ending in 1997. Leveraged Shares are allocated to
participants' accounts as principal is repaid on the loan to the ESOP, which
matures in 1999. Principal and interest on the loan are payable quarterly upon
receipt of dividends on certain shares of common stock or other cash
contributions.
ESOP shares are considered to be either allocated (contributed to
participants' accounts), committed (scheduled to be contributed at a specified
future date but not yet released), or unallocated (not committed or allocated).
Share information at December 25, 1998 is as follows:
- --------------------------------------------------------------------------------
REVERSION LEVERAGED
SHARES SHARES
---------- ----------
Allocated 38,962,348 7,748,048
Committed - 163,101
Unallocated - 977,739
- --------------------------------------------------------------------------------
The remaining cost of the unallocated Leveraged Shares of $6 at December
25, 1998 is recorded as a reduction of stockholders' equity and represents the
remaining ESOP loan balance.
Additional information on ESOP activity follows:
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
Dividends used for debt service(1) $ 7 $ 7 $ 8
Compensation costs funded
with ESOP shares 49 193 190
- --------------------------------------------------------------------------------
(1) Dividends on all Leveraged Shares are used for debt service on the ESOP
loan.
Employees can participate in the 401K by contributing, on a tax-deferred
basis, up to 15% of their eligible compensation, but not more than the maximum
annual amount allowed by law. Merrill Lynch's contributions are equal to
one-half of the first 4% of each participant's eligible compensation contributed
to the 401K, up to a maximum of fifteen hundred dollars annually. No corporate
contributions are made for participants who are also Employee Stock Purchase
Plan participants (see Note 10).
Merrill Lynch also sponsors various non-U.S. defined contribution plans.
The costs of benefits under the RAP, 401K, and non-U.S. plans are expensed
during the related service period.
83
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
Defined Benefit Pension Plans
Merrill Lynch has purchased a group annuity contract that guarantees the
payment of benefits vested under a U.S. defined benefit plan that was terminated
in accordance with the applicable provisions of the Employee Retirement Income
Security Act of 1974 ("ERISA"). At year-end 1998 and 1997, a substantial portion
of the assets supporting the annuity contract was invested in U.S. Government
and agencies securities. Merrill Lynch, under a supplemental agreement, may be
responsible for, or benefit from, actuarial experience and investment
performance of the annuity assets. Merrill Lynch also maintains supplemental
defined benefit plans for certain U.S. employees.
Employees of certain non-U.S. subsidiaries participate in various local
defined benefit plans. These plans provide benefits that are generally based on
years of credited service and a percentage of the employee's eligible
compensation during the final years of employment. Merrill Lynch's funding
policy has been to contribute annually the amount necessary to satisfy local
funding standards.
The following table provides a summary of the changes in the plans'
benefit obligations and assets for 1998 and 1997, a statement of the funded
status of the plans as of year-end 1998 and 1997, and the amounts recognized in
the Consolidated Balance Sheets:
- --------------------------------------------------------------------------------
1998 1997
------- -------
PROJECTED BENEFIT OBLIGATIONS
Balance, beginning of year $ 1,928 $ 1,639
Service cost 54 32
Interest cost 122 109
Net actuarial loss 55 69
Benefits paid (77) (61)
Acquisitions - 171
Other 8 (31)
------- -------
Balance, end of year 2,090 1,928
------- -------
FAIR VALUE OF PLAN ASSETS
Balance, beginning of year 2,151 1,768
Actual return on plan assets 282 314
Contributions 46 34
Benefits paid (77) (61)
Acquisitions - 121
Other 8 (25)
------- -------
Balance, end of year 2,410 2,151
------- -------
FUNDED STATUS 320 223
Unrecognized net actuarial gains (215) (120)
Unrecognized prior service cost 3 4
Unrecognized net transition obligation 2 3
------- -------
NET AMOUNT RECOGNIZED $ 110 $ 110
======= =======
Assets 234 209
Liabilities (124) (99)
------- -------
NET AMOUNT RECOGNIZED $ 110 $ 110
======= =======
- --------------------------------------------------------------------------------
The projected benefit obligation, accumulated benefit obligation, and fair
value of plan assets for pension plans with accumulated benefit obligations in
excess of plan assets were $111, $96, and $50, respectively, as of December 25,
1998, and $97, $80, and $45, respectively, as of December 26, 1997. These plans
primarily represent U.S. supplemental plans not subject to ERISA or non-U.S.
plans where funding strategies vary due to legal requirements and local
practices.
84
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
Pension cost included the following components:
- --------------------------------------------------------------------------------
1998 1997 1996
----- ----- -----
DEFINED CONTRIBUTION PLAN COST $ 177 $ 218 $ 224
----- ----- -----
DEFINED BENEFIT PLANS(1)
Service cost for benefits earned
during the year 54 32 25
Interest cost on projected
benefit obligation 122 109 104
Expected return on plan assets (141) (121) (122)
Deferral and amortization
of unrecognized items 7 - 7
----- ----- -----
Total defined benefit plan cost 42 20 14
----- ----- -----
TOTAL PENSION COST $ 219 $ 238 $ 238
===== ===== =====
- --------------------------------------------------------------------------------
(1) The following actuarial assumptions were used in calculating the defined
benefit cost and benefit obligations. Weighted-average rates as of the
beginning of the year are:
1999 1998 1997
----- ----- -----
Discount rate 5.5% 6.3% 6.7%
Rate of compensation increase 5.7 5.6 5.4
Expected rate of return on plan assets 6.2 6.6 6.9
- --------------------------------------------------------------------------------
Postretirement Benefits Other Than Pensions
Merrill Lynch provides health and life insurance benefits to retired
employees under a plan that covers substantially all U.S. employees who have met
age and service requirements. The health care component is contributory, with
certain retiree contributions adjusted periodically; the life insurance
component of the plan is noncontributory. The accounting for costs of health
care benefits anticipates future changes in cost-sharing provisions. Merrill
Lynch pays claims as incurred. Full-time employees of Merrill Lynch become
eligible for these benefits upon attainment of age 55 and completion of ten
years of service. Merrill Lynch also sponsors similar plans that provide health
care benefits to retired employees of certain non-U.S. subsidiaries. As of
December 25, 1998, none of these plans had been funded.
The following table provides a summary of the changes in the plans'
benefit obligations and assets for 1998 and 1997, and a statement of the funded
status of the plans as of year-end 1998 and 1997:
- --------------------------------------------------------------------------------
1998 1997
----- -----
ACCUMULATED BENEFIT OBLIGATIONS
Balance, beginning of year $ 211 $ 173
Service cost 8 6
Interest cost 13 11
Net actuarial (gain) loss (12) 15
Benefits paid (7) (6)
Acquisitions - 15
Other 1 (3)
----- -----
Balance, end of year 214 211
----- -----
FAIR VALUE OF PLAN ASSETS
Balance, beginning of year - -
Contributions 7 6
Benefits paid (7) (6)
----- -----
Balance, end of year - -
----- -----
FUNDED STATUS OF THE PLANS (214) (211)
Unrecognized net actuarial (gain) loss (3) 8
Unrecognized prior service cost (1) (1)
----- -----
ACCRUED BENEFIT LIABILITIES $(218) $(204)
===== =====
- --------------------------------------------------------------------------------
Other postretirement benefit cost included the following components:
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
Service cost $ 8 $ 6 $ 6
Interest cost 13 11 11
Amortization of unrecognized (gain) loss - - -
---- ---- ----
Total other postretirement benefit cost $ 21 $ 17 $ 17
==== ==== ====
- --------------------------------------------------------------------------------
The following actuarial assumptions were used in calculating the
postretirement benefit cost and obligations. Weighted-average rates as of the
beginning of the year are:
- --------------------------------------------------------------------------------
1999 1998 1997
---- ---- ----
Discount rate 6.3% 6.4% 6.8%
Health care cost trend rates(1)
Initial 7.0 7.5 8.0
2012 and thereafter 5.5 5.5 5.5
- --------------------------------------------------------------------------------
(1) Assumed to decrease gradually until 2012 and remain constant thereafter.
The assumed health care cost trend rate has a significant effect on the
amounts reported for the health care plans. A one percent change in the assumed
health care cost trend rate would have the following effects:
85
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
- --------------------------------------------------------------------------------
1% INCREASE 1% DECREASE
------------- --------------
1998 1997 1998 1997
---- ---- ---- ----
Effect on:
Other postretirement
benefit cost $ 4 $ 3 $ (4) $ (3)
Accumulated
benefit obligation 35 26 (30) (22)
- --------------------------------------------------------------------------------
Postemployment Benefits
Merrill Lynch provides certain postemployment benefits for employees on
extended leave due to injury or illness and for terminated employees. Employees
who are disabled due to non-work-related illness or injury are entitled to
disability income, medical coverage, and life insurance. Merrill Lynch also
provides severance benefits to terminated employees. In addition, Merrill Lynch
is mandated by U.S. state and federal regulations to provide certain other
postemployment benefits. Merrill Lynch funds these benefits through a
combination of self-insured and insured plans.
Merrill Lynch recognized $439, $30, and $31 in 1998, 1997, and 1996,
respectively, of postemployment benefits expense, which included severance costs
for terminated employees of $424, $18, and $14 in 1998, 1997, and 1996,
respectively. The severance costs for 1998 include amounts related to the staff
reduction provision (see Note 2). Although all full-time employees are eligible
for severance benefits, no additional amounts were accrued as of December 25,
1998 since future severance costs are not estimable.
NOTE 10. EMPLOYEE INCENTIVE PLANS
To align the interests of employees with those of stockholders, Merrill
Lynch sponsors several employee compensation plans that provide eligible
employees with stock or options to purchase shares. The total compensation cost
recognized in earnings for stock-based compensation plans for 1998, 1997, and
1996 was $453, $318, and $269, respectively. Merrill Lynch also sponsors
deferred cash compensation plans for eligible employees.
Long-Term Incentive Compensation Plans ("LTIC Plans")
and Equity Capital Accumulation Plan ("ECAP")
LTIC Plans and ECAP provide for grants of equity and equity-related
instruments to certain employees. LTIC Plans provide for the issuance of
Restricted Shares, Restricted Units, and Nonqualified Stock Options, as well as
Incentive Stock Options, Performance Shares, Performance Units, Performance
Options, Stock Appreciation Rights, and other securities of Merrill Lynch. ECAP
provides for the issuance of Restricted Shares, as well as Performance Shares.
As of December 25, 1998, no instruments other than Restricted Shares, Restricted
Units, and Nonqualified Stock Options had been granted.
"Restricted Shares and Units"
Restricted Shares are shares of ML & Co. common stock carrying voting and
dividend rights. A Restricted Unit is deemed equivalent in fair market value to
one share of common stock, is payable in cash or shares of common stock, and
receives cash payments equivalent to dividends. Under these plans, such shares
and units are restricted from sale, transfer, or assignment until the end of the
restricted period, and such shares and units are subject to forfeiture during
the vesting period for grants under LTIC Plans or the restricted period for
grants under ECAP.
The activity for Restricted Shares and Units under these plans during 1998
and 1997 follows:
- --------------------------------------------------------------------------------
LTIC PLANS ECAP
---------------------------- ----------
RESTRICTED RESTRICTED RESTRICTED
SHARES UNITS SHARES
----------- ---------- ----------
AUTHORIZED FOR ISSUANCE AT:
December 25, 1998 240,000,000 N/A 52,400,000
December 26, 1997 200,000,000 N/A 52,400,000
- --------------------------------------------------------------------------------
AVAILABLE FOR ISSUANCE AT:(1)
December 25, 1998 69,342,410 N/A 2,985,313
December 26, 1997 44,703,329 N/A 2,935,408
- --------------------------------------------------------------------------------
OUTSTANDING, END OF 1996 8,962,962 9,274,900 4,131,744
Granted - 1997 3,662,390 3,819,904 48,747
Paid, forfeited, or released
from contingencies (2,779,206) (3,197,062) (299,926)
---------- ---------- ---------
OUTSTANDING, END OF 1997 9,846,146 9,897,742 3,880,565
Granted - 1998 4,265,945 4,641,545 6,443
Paid, forfeited, or released
from contingencies (519,246) (3,680,398) (68,398)
---------- ---------- ---------
OUTSTANDING, END OF 1998(2) 13,592,845 10,858,889 3,818,610
========== ========== =========
- --------------------------------------------------------------------------------
(1) Includes shares reserved for issuance upon the exercise of stock options.
(2) In February 1999, 33,766 and 3,235,932 Restricted Shares and Units under
LTIC Plans, respectively, and 1,450 ECAP Restricted Shares were granted to
eligible employees.
86
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
The weighted-average fair value per share or unit for 1998, 1997, and 1996
grants follows:
- --------------------------------------------------------------------------------
1998 1997 1996
------- ------- -------
LTIC Plans
Restricted Shares $ 66.20 $ 46.31 $ 28.97
Restricted Units 64.77 44.47 28.69
ECAP Restricted Shares 81.78 66.99 28.76
- --------------------------------------------------------------------------------
Merrill Lynch sponsors other plans similar to LTIC Plans in which
restricted shares and units are granted to employees and non-employee directors.
The table below summarizes information related to restricted shares and units
for these other plans:
- --------------------------------------------------------------------------------
RESTRICTED RESTRICTED
SHARES UNITS
---------- ----------
AUTHORIZED FOR ISSUANCE AT:
December 25, 1998 6,300,000 400,000
December 26, 1997 6,300,000 400,000
OUTSTANDING AT:
December 25, 1998 316,823 40,051
December 26, 1997 258,929 31,862
- --------------------------------------------------------------------------------
"Nonqualified Stock Options"
Nonqualified Stock Options granted under LTIC Plans in 1989 through 1995
generally become exercisable over four years in equal installments commencing
one year after the date of grant. Options granted in 1996 and thereafter
generally are exercisable over five years. The exercise price of these options
is equal to 100% of the fair market value (as defined in LTIC Plans) of a share
of ML & Co. common stock on the date of grant. Nonqualified Stock Options expire
ten years after their grant date.
The activity for Nonqualified Stock Options under LTIC Plans for 1998,
1997, and 1996 follows:
- --------------------------------------------------------------------------------
WEIGHTED-
OPTIONS AVERAGE
OUTSTANDING EXERCISE PRICE
------------ --------------
OUTSTANDING, BEGINNING OF 1996 60,146,634 $ 13.65
Granted - 1996 13,633,940 27.28
Exercised (8,481,030) 10.45
Forfeited (1,486,888) 25.43
----------
OUTSTANDING, END OF 1996 63,812,656 16.72
Granted - 1997 15,323,524 42.18
Exercised (9,065,189) 12.24
Forfeited (1,363,699) 31.27
----------
OUTSTANDING, END OF 1997 68,707,292 22.69
Granted - 1998 11,971,105 62.74
Exercised (7,732,322) 15.41
Forfeited (694,661) 44.88
----------
OUTSTANDING, END OF 1998(1) 72,251,414 29.89
==========
- --------------------------------------------------------------------------------
(1) In January 1999, eligible participants were granted Nonqualified Stock
Options and Performance Options for 9,893,225 and 19,959,423 shares,
respectively. Performance options vest based on Merrill Lynch's
achievement of performance criteria over a period not exceeding 9 years.
At year-end 1998, 1997, and 1996, options exercisable under LTIC Plans
were 38,518,400, 36,380,942, and 35,532,334, respectively.
The table below summarizes information related to outstanding and
exercisable options at year-end 1998.
- ---------------------------------------------------------------------------------------------
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------- ------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE NUMBER EXERCISE REMAINING NUMBER EXERCISE
PRICE OUTSTANDING PRICE LIFE (YEARS)(1) EXERCISABLE PRICE
- --------------- ----------- -------- --------------- ----------- ---------
$ 5.00 - $21.99 33,947,586 $ 14.34 3.99 31,658,066 $ 14.10
$22.00 - $38.99 12,637,203 27.53 7.15 4,562,973 27.55
$39.00 - $55.99 12,848,038 40.59 8.21 2,205,990 40.59
$56.00 - $72.99 12,496,607 62.03 9.17 91,371 67.86
$73.00 - $89.99 321,980 89.53 9.58 - -
- ---------------------------------------------------------------------------------------------
(1) Based on original contractual life of ten years.
87
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
At consummation of Merrill Lynch's merger with Midland (see Note 2), each
Midland optionholder received 0.24 options on ML & Co. common stock, with the
vesting period and contractual life identical to the terms of the original
grant. Information at year-end 1998, 1997, and 1996 related to these options
follows:
- --------------------------------------------------------------------------------
OPTIONS WEIGHTED-AVERAGE
OUTSTANDING EXERCISE PRICE
----------- ----------------
1998 642,370 $ 36.16
1997 743,634 31.04
1996 688,146 28.08
- --------------------------------------------------------------------------------
At year-end 1998, 1997, and 1996, such options exercisable were 292,215,
284,578, and 243,404, respectively.
The weighted-average fair value of options granted in 1998, 1997, and 1996
was $21.52, $14.62, and $7.58 per option, respectively. Fair value is estimated
as of the grant date based on a Black-Scholes option pricing model using the
following weighted-average assumptions:
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
Risk-free interest rate 5.81% 6.74% 5.68%
Expected life 6 yrs. 6 yrs. 5 yrs.
Expected volatility 28.10% 26.86% 26.35%
Dividend yield 1.28% 1.47% 1.91%
- --------------------------------------------------------------------------------
The weighted-average fair value of options granted by Midland in 1998,
1997, and 1996 was $14.07, $15.01, and $15.28 respectively.
See Pro Forma Compensation Expense in the following Employee Stock
Purchase Plans section for additional information.
Employee Stock Purchase Plans ("ESPP")
ESPP plans allow eligible employees to invest from 1% to 10% of their
eligible compensation to purchase ML & Co. common stock at a price generally
equal to 85% of its fair market value. These purchases are made on four
quarterly investment dates through payroll deductions. Up to 50,300,000 shares
of common stock have been authorized for issuance under ESPP. The activity in
ESPP during 1998, 1997, and 1996 follows:
- --------------------------------------------------------------------------------
1998 1997 1996
---------- ---------- ----------
Available, beginning of year 7,251,343 8,267,360 9,992,526
Authorized during year - 300,000 -
Purchased through plan (1,261,248) (1,316,017) (1,725,166)
--------- --------- ---------
Available, end of year 5,990,095 7,251,343 8,267,360
========= ========= =========
- --------------------------------------------------------------------------------
The weighted-average fair value of ESPP stock purchase rights exercised by
employees in 1998, 1997, and 1996 was $11.31, $7.66, and $4.38 per right,
respectively.
"Pro Forma Compensation Expense"
No compensation expense has been recognized for Merrill Lynch's grants of
stock options under LTIC Plans or ESPP purchase rights (see Note 1 for
accounting policy). Based on the fair value of stock options and purchase
rights, Merrill Lynch would have recognized compensation expense, net of taxes,
of $95, $56, and $27 for 1998, 1997, and 1996, respectively, resulting in pro
forma net earnings and earnings per share as follows:
- --------------------------------------------------------------------------------
1998 1997 1996
----- ----- -----
NET EARNINGS
As reported $ 1,259 $ 1,935 $ 1,648
Pro forma 1,164 1,879 1,621
EARNINGS PER SHARE
As reported:
Basic $ 3.43 $ 5.57 $ 4.63
Diluted 3.00 4.79 4.08
Pro forma:
Basic 3.16 5.41 4.55
Diluted 2.77 4.65 4.01
- --------------------------------------------------------------------------------
In the table above, pro forma compensation expense associated with option
grants is recognized over the vesting period. The impact of applying SFAS No.
123 on pro forma disclosure is not representative of the potential impact on pro
forma net earnings for future years, which will include the cumulative effect of
expense related to vesting of 1995 and subsequent grants.
Financial Consultant Capital Accumulation Award Plans ("FCCAAP")
Under FCCAAP, eligible employees in Merrill Lynch's Private Client groups
are granted awards generally based upon their prior year's performance. Payment
for an award is contingent upon continued employment for a period of time and
88
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
is subject to forfeiture during that period. The award is generally payable ten
years from the date of grant in a fixed number of shares of ML & Co. common
stock unless the fair market value of such shares is less than a specified
minimum value plus interest, in which case the minimum value is paid in cash.
Eligible participants may defer awards beyond the scheduled payment date. FCCAAP
may also provide for the issuance of Restricted Shares that vest ten years from
the date of the original award and carry voting and dividend rights. Only shares
of common stock held as treasury stock may be issued under FCCAAP.
At December 25, 1998, shares subject to outstanding awards totaled
31,375,873, while 18,154,644 shares were available for issuance through future
awards. The fair value of awards granted under FCCAAP during 1998, 1997, and
1996 was $67.94, $42.09, and $25.34 per award, respectively.
Incentive Equity Purchase Plan ("IEPP")
IEPP allowed selected employees to purchase shares of ML & Co. common
stock ("Book Value Shares") at a price equal to book value per common share.
Book Value Shares, which otherwise may not be resold, may be sold back to
Merrill Lynch at book value or exchanged at any time for a specified number of
freely transferable common shares. Book Value Shares outstanding under IEPP were
1,814,000 at December 25, 1998. In 1995, IEPP was amended to reduce the
authorized shares to zero and prohibit the reuse of any surrendered shares. No
further offerings will be made under this plan.
Merrill Lynch Investment Certificate Program ("MLICP")
Under MLICP, eligible employees in Merrill Lynch's Private Client groups
are issued investment certificates based on their performance. The certificates
mature ten years from the date issued and are payable in cash if certain
performance criteria are achieved and the employee is continuously employed for
the ten-year period, with certain exceptions. The certificates bear interest
commencing with the date on which the performance requirements are achieved. As
of year-end 1998 and 1997, $353 and $292, respectively, were accrued under this
plan.
Other Deferred Compensation Plans
Merrill Lynch sponsors other deferred compensation plans in which eligible
employees may participate. Generally, contributions to the plans are made on a
tax-deferred basis by participants. Contributions are invested by Merrill Lynch
in mutual funds and other funds sponsored by Merrill Lynch, and the plans may
include a leverage feature. The plans' investments and the amounts accrued by
Merrill Lynch under the plans are both included in the Consolidated Balance
Sheets. Plan investments totaled $648 and $554, respectively, at December 25,
1998 and December 26, 1997. Accrued liabilities at those dates were $532 and
$441, respectively.
NOTE 11. INCOME TAXES
Income tax provisions (benefits) on earnings consisted of:
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
U.S. FEDERAL
Current $ 673 $ 856 $ 515
Deferred (180) (94) (119)
U.S. STATE AND LOCAL
Current 105 (15) 198
Deferred 10 7 (54)
NON-U.S
Current 412 400 496
Deferred (307) (25) (56)
----- ------- ------
Total $ 713 $ 1,129 $ 980
===== ======= ======
- --------------------------------------------------------------------------------
The corporate statutory tax rate was 35.0% for the three years presented.
A reconciliation of statutory U.S. federal income taxes to Merrill Lynch's
income tax provisions for earnings follows:
- -------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
U.S. federal income tax at statutory rate $ 734 $ 1,089 $ 920
U.S. state and local income taxes, net 74 (5) 94
Pension plan transaction (3) 6 12
Non-U.S. operations (33) 41 3
Tax-exempt interest (51) (26) (21)
Dividends received deduction (30) (33) (34)
Other, net 22 57 6
----- ------- -----
Income tax expense $ 713 $ 1,129 $ 980
===== ======= =====
- -------------------------------------------------------------------------------
89
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
Deferred income taxes are provided for the effects of temporary
differences between the tax basis of an asset or liability and its reported
amount in the Consolidated Balance Sheets. These temporary differences result in
taxable or deductible amounts in future years. Details of Merrill Lynch's
deferred tax assets and liabilities follow:
- --------------------------------------------------------------------------------
1998 1997 1996
------- ------- -------
DEFERRED TAX ASSETS
Valuation and other reserves(1) $ 1,225 $ 940 $ 895
Deferred compensation 679 478 351
Employee benefits 120 109 115
Other 375 116 285
------- ------- -------
Gross deferred tax assets 2,399 1,643 1,646
Valuation allowances(2) (42) (26) (30)
------- ------- -------
Total deferred tax assets 2,357 1,617 1,616
------- ------- -------
DEFERRED TAX LIABILITIES
Lease transactions 148 116 114
Employee benefits 64 58 54
Accelerated tax depreciation 17 26 44
Other 190 178 88
------- ------- -------
Total deferred tax liabilities 419 378 300
------- ------- -------
NET DEFERRED TAX ASSET $ 1,938 $ 1,239 $ 1,316
======= ======= =======
- --------------------------------------------------------------------------------
(1) Primarily related to Trading assets and Other payables.
(2) Related to net operating loss carryforwards not expected to be realized.
At December 25, 1998, Merrill Lynch had net operating loss carryforwards
as follows: $48 in U.S. federal (expiring 2009), $261 in U.S. states (expiring
2005), $76 in Hong Kong (no expiration), $63 in Germany (no expiration), $59 in
Japan (expiring 2003), and $42 in Canada (expiring 2005).
Income tax benefits of $336, $173, and $30 were allocated to stockholders'
equity related to employee compensation transactions for 1998, 1997, and 1996,
respectively.
Earnings before income taxes included approximately $44, $805, and $800 of
earnings attributable to non-U.S. subsidiaries for 1998, 1997, and 1996,
respectively. Cumulative undistributed earnings of non-U.S. subsidiaries not
previously taxed in the U.S. were approximately $2,230 at December 25, 1998. No
deferred U.S. federal income taxes have been provided for the undistributed
earnings to the extent that they have been permanently reinvested in Merrill
Lynch's non-U.S. operations. Assuming utilization of non-U.S. tax credits,
Merrill Lynch estimates that approximately $240 of U.S. federal income taxes and
$110 of non-U.S. withholding taxes would be incurred on the repatriation of such
earnings.
NOTE 12. REGULATORY REQUIREMENTS AND DIVIDEND RESTRICTIONS
MLPF&S, a U.S. registered broker-dealer, is subject to the net capital
requirements of Rule 15c3-1 under the Securities Exchange Act of 1934. Under the
alternative method permitted by this rule, the minimum required net capital, as
defined, shall not be less than 2% of aggregate debit items arising from
customer transactions. At December 25, 1998, MLPF&S's regulatory net capital of
$3,224 was 14% of aggregate debit items, and its regulatory net capital in
excess of the minimum required was $2,761.
MLI, a U.K. registered broker-dealer, is subject to capital requirements
of the Financial Services Authority ("FSA"). Financial resources, as defined,
must exceed the total financial resources requirement of the FSA. In 1997, MLI
became Merrill Lynch's primary global equity derivatives dealer (previously
Merrill Lynch Capital Markets PLC). At December 25, 1998, MLI's financial
resources were $3,711, exceeding the minimum requirement by $1,124.
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 December 25,
1998, MLGSI's liquid capital of $1,441 was 261% of its total market and credit
risk, and liquid capital in excess of the minimum required was $778.
Merrill Lynch's insurance subsidiaries are subject to various regulatory
restrictions that limit the amount available for distribution as dividends. As
of December 25, 1998, $483, representing 89% of the insurance subsidiaries' net
assets, was unavailable for distribution to Merrill Lynch.
Over 80 other subsidiaries are subject to regulatory requirements
promulgated by the regulatory and exchange authorities of the jurisdictions in
which they operate. These regulatory restrictions may limit the amounts that
these subsidiaries can pay in dividends or advance to Merrill Lynch. At December
25, 1998, restricted net assets of these subsidiaries were $3,555.
90
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
In addition, to satisfy rating agency standards, a credit intermediary
subsidiary of Merrill Lynch must also meet certain minimum capital requirements.
At December 25, 1998, this minimum capital requirement was $490.
With the exception of regulatory restrictions on subsidiaries' abilities
to pay dividends, there are no restrictions on ML & Co.'s present ability to pay
dividends on common stock, other than (1) ML & Co.'s obligation to make payments
on its preferred stock and subsidiaries' TOPrS, and (2) the governing provisions
of the Delaware General Corporation Law.
NOTE 13. SEGMENT, PRODUCT, AND GEOGRAPHIC INFORMATION
Segment Information
In reporting to management, Merrill Lynch's operating results are
categorized into two business segments: Wealth Management and CICG. For
information on each segment's activities, see Management's Discussion and
Analysis (unaudited) - Business Segments.
The principal methodology used in preparing the segment results in the
table that follows is:
o Revenues and expenses are assigned to segments where directly
attributable.
o A portion of CICG principal transactions and investment banking revenues
are allocated to Wealth Management based on production credits generated
by Financial Consultants and other investment professionals.
o Interest is allocated based on management's assessment of the relative
risk of segment assets and liabilities.
o Goodwill amortization, Mercury financing costs, and the staff reduction
provision are not attributed to segments because management excludes these
items from segment operating results in evaluating segment performance.
o Residual revenues and expenses (i.e., those related to overhead and
support units) are attributed to segments based on specific methodologies
(e.g., headcount, square footage, intersegment agreements).
o Income taxes are attributed based on tax rates in the tax jurisdictions in
which the segment activity takes place.
Management believes that the following information by business segment
provides a reasonable representation of each segment's contribution to the
consolidated amounts:
- --------------------------------------------------------------------------------
WEALTH CORPORATE
MANAGEMENT CICG ITEMS TOTAL
---------- --------- --------- ---------
1998
Net interest revenue(a) $ 1,015 $ 299 $ (306)(b) $ 1,008
All other revenues 10,316 6,223 - 16,539
-------- --------- ------- ---------
Net revenues 11,331 6,522 (306) 17,547
Non-interest expenses,
excluding staff reduction
provision 9,260 5,535 226(c) 15,021
Provision for costs related
to staff reductions - - 430(d) 430
-------- --------- ------- ---------
Earnings before income taxes 2,071 987 (962) 2,096
Income tax expense (benefit) 725 105 (117) 713
Dividends on preferred
securities issued
by subsidiaries - - 124 124
-------- --------- ------- ---------
Net earnings $ 1,346 $ 882 $ (969) $ 1,259
======== ========= ======= =========
Year-end total assets $ 45,726 $ 248,714 $ 5,364 $ 299,804
======== ========= ======= =========
- --------------------------------------------------------------------------------
1997
Net interest revenue(a) $ 860 $ 196 $ - $ 1,056
All other revenues 8,645 6,555 - 15,200
-------- --------- ------- ---------
Net revenues 9,505 6,751 - 16,256
Non-interest expenses 7,872 5,208 65(c) 13,145
-------- --------- ------- ---------
Earnings before income taxes 1,633 1,543 (65) 3,111
Income tax expense 577 398 154 1,129
Dividends on preferred
securities issued
by subsidiaries - - 47 47
-------- --------- ------- ---------
Net earnings $ 1,056 $ 1,145 $ (266) $ 1,935
======== ========= ======= =========
Year-end total assets $ 38,781 $ 252,732 $ 5,467 $ 296,980
======== ========= ======= =========
- --------------------------------------------------------------------------------
1996
Net interest revenue(a) $ 751 $ 282 $ - $ 1,033
All other revenues 7,233 5,355 - 12,588
-------- --------- ------- ---------
Net revenues 7,984 5,637 - 13,621
Non-interest expenses 6,602 4,341 50(c) 10,993
-------- --------- ------- ---------
Earnings before income taxes 1,382 1,296 (50) 2,628
Income tax expense 527 366 87 980
-------- --------- ------- ---------
Net earnings $ 855 $ 930 $ (137) $ 1,648
======== ========= ======= =========
Year-end total assets $ 31,553 $ 185,080 $ 633 $ 217,266
======== ========= ======= =========
- --------------------------------------------------------------------------------
(a) Management views interest income net of interest expense in evaluating
results.
(b) Represents Mercury financing costs.
(c) Represents goodwill amortization.
(d) Had this amount been allocated to segments, $163 and $267 would have been
allocated to Wealth Management and CICG, respectively.
91
[LOGO]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
Product Information
Merrill Lynch delivers a wide variety of products to clients:
o Brokerage: Executing or facilitating security and commodity trades for
retail clients and assisting clients in allocating their assets. (Includes
commissions and net interest.)
o Asset management and portfolio services: Offering customers access to a
wide array of asset management services and other fee-based products.
o Lending: Serving investors' liability management needs by providing margin
lending, mortgage and other consumer loans, and commercial financing.
o Trading: Satisfying institutional customer demand for securities,
currencies, and other products by maintaining securities inventories and
writing over-the-counter derivatives. Through structured notes and
derivatives, investors are provided with opportunities to diversify their
portfolios, manage risk, and enhance returns. (Includes commissions,
principal transactions revenues, and net interest.)
o Origination: Raising capital for clients through securities underwritings,
private placements, and loan syndications.
o Strategic services: Providing advice on mergers and acquisitions, sales,
divestitures, and joint ventures.
The following table summarizes Merrill Lynch's net revenues by product.
- --------------------------------------------------------------------------------
1998 1997 1996
-------- -------- --------
WEALTH MANAGEMENT
Brokerage $ 6,412 $ 5,851 $ 5,057
-------- -------- --------
Asset management and portfolio services:
Asset management fees 2,075 1,232 1,010
Portfolio service fees 1,150 826 608
Other fees 977 944 813
-------- -------- --------
Total 4,202 3,002 2,431
-------- -------- --------
Lending 577 477 378
Other 140 175 118
-------- -------- --------
Total Wealth Management 11,331 9,505 7,984
-------- -------- --------
CICG
Trading:
Debt 847 2,242 2,072
Equity 2,761 2,024 1,658
-------- -------- --------
Total 3,608 4,266 3,730
-------- -------- --------
Origination:
Debt 488 593 489
Equity 841 770 587
-------- -------- --------
Total 1,329 1,363 1,076
-------- -------- --------
Strategic services 1,102 797 430
Other 483 325 401
-------- -------- --------
Total CICG 6,522 6,751 5,637
-------- -------- --------
TOTAL WEALTH MANAGEMENT AND CICG 17,853 16,256 13,621
Corporate (306) - -
-------- -------- --------
TOTAL $ 17,547 $ 16,256 $ 13,621
======== ======== ========
- --------------------------------------------------------------------------------
92
[LOGO]
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
Geographic Information
Merrill Lynch operates in both U.S. and non-U.S. markets. Merrill Lynch's
non-U.S. business activities are conducted through offices in six regions:
o Europe, Middle East, and Africa,
o Asia Pacific,
o Australia and New Zealand,
o Japan,
o Canada, and
o Latin America.
For further information on activities in these regions, see Management's
Discussion and Analysis (unaudited) - Global Operations.
The principal methodology used in preparing the geographic data in the
table that follows is:
o Commissions revenues are recorded based on the location of the sales
force,
o Trading revenues are principally recorded based on the location of the
trader,
o Investment banking revenues are recorded based on the location of the
client,
o Asset management and portfolio service fees are recorded based on the
location of the fund manager,
o Earnings before income taxes include the allocation of certain shared
expenses among regions, and
o 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
amounts.
- --------------------------------------------------------------------------------
1998 1997 1996
--------- --------- ---------
NET REVENUES
Europe, Middle East, and Africa $ 2,808 $ 1,982 $ 1,563
Asia Pacific 338 489 361
Australia and New Zealand 224 177 60
Japan 574 416 408
Canada 625 702 615
Latin America 392 524 435
--------- --------- ---------
Total Non-U.S 4,961 4,290 3,442
U.S. 12,892 11,966 10,179
Corporate (306) - -
--------- --------- ---------
Total $ 17,547 $ 16,256 $ 13,621
========= ========= =========
- --------------------------------------------------------------------------------
EARNINGS BEFORE INCOME TAXES
Europe, Middle East, and Africa $ 307 $ 360 $ 301
Asia Pacific (165) (34) 36
Australia and New Zealand 36 25 7
Japan (11) 74 109
Canada 46 134 118
Latin America (67) 141 146
--------- --------- ---------
Total Non-U.S 146 700 717
U.S. 2,912 2,476 1,961
Corporate (962) (65) (50)
--------- --------- ---------
Total $ 2,096 $ 3,111 $ 2,628
========= ========= =========
- --------------------------------------------------------------------------------
AVERAGE ASSETS
Europe, Middle East, and Africa $ 134,664 $ 73,251 $ 59,935
Asia Pacific 6,562 4,707 6,513
Australia and New Zealand 2,789 2,939 1,103
Japan 10,224 7,910 5,007
Canada 11,612 11,869 8,469
Latin America 11,874 10,629 5,968
--------- --------- ---------
Total Non-U.S 177,725 111,305 86,995
U.S. 196,710 176,835 132,829
Corporate 5,573 680 519
--------- --------- ---------
Total $ 380,008 $ 288,820 $ 220,343
========= ========= =========
- --------------------------------------------------------------------------------
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SUPPLEMENTAL FINANCIAL INFORMATION
- --------------------------------------------------------------------------------
QUARTERLY INFORMATION
The unaudited quarterly results of operations of Merrill Lynch for 1998
and 1997 are prepared in conformity with generally accepted accounting
principles and reflect all adjustments (which consist of normal recurring
accruals and a provision for costs related to staff reductions) that are, in the
opinion of management, necessary for a fair presentation of the results of
operations for the periods presented. Results of any interim period are not
necessarily indicative of results for a full year.
- -------------------------------------------------------------------------------------------------------------------------------
(dollars in millions, except per share amounts)
For the Quarter Ended
-----------------------------------------------------------------------------------
DEC. 25, SEPT. 25, JUNE 26, MAR. 27, DEC. 26, SEPT. 26, JUNE 27, MAR. 28,
1998 1998 1998(1) 1998(1) 1997(1) 1997(1) 1997(1) 1997(1)
------- ------- ------- ------- ------- ------- ------- -------
Total Revenues $ 8,172 $ 8,712 $ 9,581 $ 9,388 $ 8,311 $ 8,338 $ 8,200 $ 7,650
Interest Expense 4,091 4,863 4,726 4,626 4,301 4,196 4,090 3,656
------- ------- ------- ------- ------- ------- ------- -------
Net Revenues 4,081 3,849 4,855 4,762 4,010 4,142 4,110 3,994
Non-Interest Expenses 3,562 4,054(2) 3,940 3,895 3,275 3,353 3,306 3,211
------- ------- ------- ------- ------- ------- ------- -------
Earnings (Loss) Before Income Taxes
and Dividends on Preferred
Securities Issued by Subsidiaries 519 (205) 915 867 735 789 804 783
Income Tax Expense (Benefit) 119 (75) 339 330 254 275 300 300
Dividends on Preferred Securities
Issued by Subsidiaries 41 33 27 23 12 12 13 10
------- ------- ------- ------- ------- ------- ------- -------
Net Earnings (Loss) $ 359 $ (163) $ 549 $ 514 $ 469 $ 502 $ 491 $ 473
======= ======= ======= ======= ======= ======= ======= =======
Earnings (Loss) Per Common Share(3)
Basic $ .97 $ (.48) $ 1.52 $ 1.44 $ 1.34 $ 1.45 $ 1.42 $ 1.36
Diluted .86 (.48) 1.31 1.26 1.15 1.24 1.24 1.16
- -------------------------------------------------------------------------------------------------------------------------------
(1) Amounts have been restated from that originally reported on Form 10-Q to
reflect the Midland Walwyn merger as required under pooling-of-interests
accounting.
(2) Includes a $430 million provision for costs related to staff reductions.
(3) Restated for the 1997 two-for-one common stock split.
DIVIDENDS PER COMMON SHARE
- --------------------------------------------------------------------------------
(Declared and paid)
1ST QTR. 2ND QTR. 3RD QTR. 4TH QTR.
------- ------- ------- -------
1998 $ .20 $ .24 $ .24 $ .24
1997 .15 .20 .20 .20
- --------------------------------------------------------------------------------
Dividends per common share amounts give effect to the 1997 two-for-one
common stock split. With the exception of regulatory restrictions on
subsidiaries' abilities to pay dividends, there are no restrictions on ML &
Co.'s present ability to pay dividends on common stock, other than (a) ML &
Co.'s obligation to make payments on its preferred stock and subsidiaries'
preferred securities, and (b) the governing provisions of the Delaware General
Corporation Law. Certain subsidiaries' ability to declare dividends may also be
limited (see Note 12 to the Consolidated Financial Statements).
STOCKHOLDER INFORMATION
Consolidated Transaction Reporting System prices for the specified
calendar quarters are noted below. Prices have been restated for the 1997
two-for-one common stock split.
- ---------------------------------------------------------------------------------------------------
(At calendar period-end)
1ST QTR. 2ND QTR. 3RD QTR. 4TH QTR.
--------------------- --------------------- --------------------- -------------------
HIGH LOW HIGH LOW HIGH LOW HIGH LOW
-------- --------- --------- --------- --------- --------- --------- --------
1998 $ 87 1/2 $ 60 7/16 $ 100 $ 82 1/4 $ 109 1/8 $ 45 5/8 $ 80 $ 35 3/4
1997 52 39 1/4 63 7/8 42 1/16 75 1/8 59 1/16 78 3/16 61 1/4
- ---------------------------------------------------------------------------------------------------
The approximate number of record holders of ML & Co. common stock as of
February 12, 1999 was 19,400. As of February 19, 1999, the closing price of ML &
Co. common stock as reported on the Consolidated Transaction Reporting System
was $72 3/8.
94
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BOARD OF DIRECTORS
- --------------------------------------------------------------------------------
HERBERT M. ALLISON, JR.
President and Chief Operating Officer of Merrill Lynch...55 years old...joined
Merrill Lynch in 1971.
W.H. CLARK
Corporate Director...former Chairman and Chief Executive Officer of Nalco
Chemical Company, a producer of specialty chemicals...66 years old...elected a
Director of Merrill Lynch in 1995.
JILL K. CONWAY
Visiting Scholar, Massachusetts Institute of Technology...President of Smith
College from 1975 to 1985...64 years old...elected a Director of Merrill Lynch
in 1978.
STEPHEN L. HAMMERMAN
Vice Chairman of the Board and General Counsel of Merrill Lynch...61 years
old...joined Merrill Lynch in 1978.
EARLE H. HARBISON, JR.
Chairman of the Board of Harbison Corporation, a manufacturer of molded plastic
products...former Chairman of the Executive Committee and former President and
Chief Operating Officer of Monsanto Company...70 years old...elected a Director
of Merrill Lynch in 1987.
GEORGE B. HARVEY
Corporate Director...former Chairman of the Board, President and Chief Operating
Officer of Pitney Bowes Inc., a provider of mailing, office and logistics
systems and management and financial services...67 years old...elected a
Director of Merrill Lynch in 1993.
WILLIAM R. HOOVER
Chairman of the Executive Committee of, Consultant to, and former Chairman of
the Board, Chief Executive Officer and President of, Computer Sciences
Corporation, a provider of information technology consulting, systems
integration and outsourcing to industry and government...69 years old...elected
a Director of Merrill Lynch in 1995.
DAVID H. KOMANSKY
Chairman of the Board and Chief Executive Officer of Merrill Lynch...59 years
old...joined Merrill Lynch in 1968.
ROBERT P. LUCIANO
Corporate Director...Director and former Chairman of the Board and Chief
Executive Officer of Schering-Plough Corporation, a health and personal care
products company...65 years old...elected a Director of Merrill Lynch in 1989.
DAVID K. NEWBIGGING
Chairman of the Board of Friends' Provident Life Office, a United Kingdom-based
life assurance company...former Chairman of the Board of Equitas Holdings
Limited...former Chairman and Senior Managing Director of Jardine, Matheson &
Co. Limited...65 years old...elected a Director of Merrill Lynch in 1996.
AULANA L. PETERS
Partner in the law firm of Gibson, Dunn & Crutcher...former Commissioner of the
U.S. Securities and Exchange Commission...57 years old...elected a Director of
Merrill Lynch in 1994.
JOHN J. PHELAN, JR.
Corporate Director...former Chairman and Chief Executive Officer of the New York
Stock Exchange, Inc....Senior Adviser, Boston Consulting Group...member of the
Council on Foreign Relations...former President of the International Federation
of Stock Exchanges ...67 years old...elected a Director of Merrill Lynch in
1991.
JOHN L. STEFFENS
Vice Chairman of the Board and Head of U.S. Private Client Group of Merrill
Lynch...57 years old...joined Merrill Lynch in 1963.
WILLIAM L. WEISS
Corporate Director...Chairman Emeritus and former Chairman of the Board and
Chief Executive Officer of Ameritech Corporation, a provider of communications
products and services...69 years old...elected a Director of Merrill Lynch in
1993.
95
[LOGO]
EXECUTIVE MANAGEMENT
- --------------------------------------------------------------------------------
[PHOTO]
DAVID H. KOMANSKY
Chairman of the Board
and Chief Executive Officer
[PHOTO]
PAUL W. CRITCHLOW
Senior Vice President
Marketing and Communications
[PHOTO]
CAROL GALLEY
Senior Vice President and
Co-Head of Merrill Lynch
Mercury Asset Management
[PHOTO]
HERBERT M. ALLISON, JR.
President and
Chief Operating Officer
[PHOTO]
THOMAS W. DAVIS
Executive Vice President and
Head of Corporate and
Institutional Client Group
[PHOTO]
EDWARD L. GOLDBERG
Executive Vice President
Operations Services Group
[PHOTO]
JOHN L. STEFFENS
Vice Chairman of the Board and Head of U.S.
Private Client Group
[PHOTO]
RICHARD A. DUNN
Senior Vice President
Global Risk and
Credit Management
[PHOTO]
JEROME P. KENNEY
Executive Vice President
Corporate Strategy and Research
[PHOTO]
STEPHEN L. HAMMERMAN
Vice Chairman of the Board
and General Counsel
[PHOTO]
BARRY S. FRIEDBERG
Executive Vice President and
Chairman of Corporate and
Institutional Client Group
[PHOTO]
Michael J.P. Marks
Executive Chairman
of Merrill Lynch Europe,
Middle East & Africa
96
[PHOTO]
JOHN A. MCKINLEY, JR.
Senior Vice President
Chief Technology Officer and
Head of Technology Group
[PHOTO]
WINTHROP H. SMITH, JR.
Executive Vice President and
Head of International Private
Client Group and Chairman,
Merrill Lynch International Inc.
[PHOTO]
JOHN G. HEIMANN
[PHOTO]
E. STANLEY O'NEAL
Executive Vice President and
Chief Financial Officer
[PHOTO]
MARY E. TAYLOR
Senior Vice President
Human Resources
[PHOTO]
ARTHUR ZEIKEL
[PHOTO]
THOMAS H. PATRICK
Executive Vice President
and Chairman
Special Advisory Services
[PHOTO]
STEPHEN A. ZIMMERMAN
Senior Vice President and
Co-Head of Merrill Lynch
Mercury Asset Management
[PHOTO]
JEFFREY M. PEEK
Executive Vice President
and Head of Asset
Management Group
TWO VALUED MEMBERS of Merrill Lynch Executive Management -- John G. Heimann,
Chairman of Merrill Lynch Global Financial Institutions, and Arthur Zeikel,
Chairman of Merrill Lynch Asset Management -- retired in 1999. Mr. Heimann, who
came to Merrill Lynch in 1984, was instrumental in the firm's expansion in
Europe and the Middle East and served ably as the senior relationship manager
with financial institutions around the world. Mr. Zeikel, a 23-year Merrill
Lynch veteran, was President of MLAM since its inception in 1977, building one
of the largest asset management businesses in the world and introducing mutual
funds to literally millions of investors. Each has contributed in strong and
lasting ways to our firm, and their legacies will live on at Merrill Lynch for
many years to come.
97
[LOGO]
MERRILL LYNCH & CO., INC.
- --------------------------------------------------------------------------------
EXECUTIVE OFFICES
Merrill Lynch & Co., Inc.
World Financial Center
North Tower
New York, New York 10281-1332
COMMON STOCK
EXCHANGE LISTINGS
The common stock of Merrill Lynch (trading symbol MER) is listed on the New York
Stock Exchange, Chicago Stock Exchange, Pacific Exchange, Paris Bourse, London
Stock Exchange and Tokyo Stock Exchange.
TRANSFER AGENT AND REGISTRAR
Merrill Lynch & Co., Inc. is the principal transfer agent for its own common
stock. Questions from registered stockholders on dividends, lost and stolen
certificates, changes of legal or dividend addresses, and other matters relating
to registered stockholder status should be sent to:
Merrill Lynch & Co., Inc.
P.O. Box 20, Church Street Station
New York, NY 10277-1004
Attn: Andrea L. Dulberg, Secretary
However, registered stockholders wishing to transfer their stock should continue
to do so through the following transfer agent and registrar:
ChaseMellon Shareholder Services
P.O. Box 3310
South Hackensack, NJ 07606-1910
1-800-851-9677
PREFERRED STOCK
EXCHANGE LISTING
Depositary Shares representing 1/400 of a share of 9% Cumulative Preferred
Stock, Series A, are listed on the New York Stock Exchange.
TRANSFER AGENT AND REGISTRAR
Citibank, N.A.
111 Wall Street, Fifth Floor
New York, NY 10043
Attn: Corporate Trust Department
FORM 10-K ANNUAL REPORT FOR 1998
This Annual Report of Merrill Lynch & Co., Inc. contains much of the financial
information that will be included in the 1998 Annual Report on Form 10-K to be
filed with the Securities and Exchange Commission. Merrill Lynch will furnish a
copy of its 1998 Annual Report on Form 10-K (including financial statements and
financial schedules but excluding other exhibits), without charge, to any person
upon request addressed to Andrea L. Dulberg, Secretary, Merrill Lynch & Co.,
Inc., P.O. Box 20, Church Street Station, New York, NY 10277-1004.
EQUAL EMPLOYMENT OPPORTUNITY
Merrill Lynch is committed to Equal Employment Opportunity and to attracting and
retaining the most qualified employees, regardless of race, national origin,
religion, gender, age, or disability. For more information, write to Westina
Matthews, Senior Director, First Vice President, Corporate Responsibility,
Merrill Lynch & Co., Inc., World Financial Center, North Tower, New York, NY
10281-1331.
CHARITABLE CONTRIBUTIONS
A summary of the Corporation's charitable contributions is available upon
written request to the Secretary.
ANNUAL MEETING
The 1999 Annual Meeting of Merrill Lynch & Co., Inc. stockholders will take
place at the Merrill Lynch Conference and Training Center, 800 Scudders Mill
Road, Plainsboro, New Jersey. The meeting is scheduled for Wednesday, April 14,
1999, beginning at 10:00 a.m. (local time).
Designed by DeSola Group, Inc.
Executive portrait photography by Chris Jones
VISIT OUR WEBSITE AT WWW.ML.COM
98