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Merrill Lynch's Zigzag Is Making Investors Uncomfortably Numb

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By MARK GILBERT

Bloomberg News

Published: August 1, 2008

To be comfortable is to be "in a state of tranquil enjoyment and content; free from pain and trouble; at ease," the Oxford English Dictionary says. It's hard to think of a less appropriate description of the situation at Merrill Lynch & Co. after the bank's latest pirouette.

Two weeks ago, Chief Executive Officer John Thain told the world Merrill was "in a very comfortable spot in terms of our capital," after reporting a $4.65 billion second-quarter net loss. This week, he decided he needed to raise an additional $8.55 billion to get truly comfy. If financial markets were courts of law, Thain would risk perjury.

Merrill's balance-sheet flip-flop came with two more bombshells. First, those collateralized-debt obligations that used to trade at 100 percent of face value? Well, Merrill now values $31 billion of them at just 22 percent, meaning the rest of Wall Street has some catching-up to do on its writedowns.

And that $4.4 billion that Temasek Holdings Pte, Singapore's sovereign wealth fund, invested in Merrill at Christmas? That backing turns out to be somewhat less than wholehearted, because Merrill is now paying Temasek $2.5 billion in restitution for the stock losing half of its value this year.

"Call me naive, but if these investors take an ownership stake by buying Merrill shares, why do they get compensated if the price falls?" Bill Blain, who produces a daily market report for bond broker KNG Securities LLP in London, wrote this week. "I thought providing equity capital to banks meant I shared in their upside and downside. Can I have the same, please?"
Strange Twist
That "heads we win, tails we don't lose" twist somewhat tarnishes the ringing endorsement from Manish Kejriwal, Temasek's senior managing director for investments. He said on Dec. 26 that the deal was "a vote of confidence for the management team and the underlying strengths of Merrill Lynch's franchise."

Votes of confidence don't typically come with just-in-case side agreements. I'm starting to think that when I die, I'd like to come back as a sovereign wealth fund.

Even Merrill's decision to throw in the towel on its collateralized-debt adventure has a zigzag. The bank is selling almost $31 billion of CDOs to an affiliate of Dallas-based investment manager Lone Star Funds. The securities are priced at 22 percent of face value. Merrill, though, says it is lending the cash to fund 75 percent of the purchase.

That loan, moreover, is secured on the CDOs themselves. And Jeffrey Rosenberg, an analyst at Bank of America Corp. in New York, said in a report Wednesday that a further 5 cent decline in the value of those securities would leave Merrill "on the hook" for any additional losses.

"If you got the opportunity to buy something at a whopping discount of 22 cents on the buck, would you jump at it or would you demand that the seller provide the financing?" Joan McCullough, a strategist at brokerage East Shore Partners in Hauppauge, N.Y., said in a commentary this week. "That depends if you thought that what you were buying was a true rock-bottom steal at 22 cents or if the 22 cents, despite its rock-bottom appearance, had room to roam lower."

Remember when telecom companies got suckered into laying miles of so-called dark fiber, paying over the odds for licenses to control bits of the airwaves and prostrating themselves for sacrifice on the altar of the debt markets? Phone-equipment makers got themselves entangled in something called vendor financing, where they effectively paid the telecom companies to buy their bits and pieces. That movie didn't end so well.

Thain's derivatives clearance sale - Merrill will take a third-quarter pretax writedown of $4.4 billion, in addition to the second-quarter $3.5 billion CDO writedown it took two weeks ago - reprices the market for asset-backed securities.

Questionable Prices

"The announcement reminds us that the market-clearing prices of many illiquid ABS products are probably lower than where they are marked on bank books," says Jim Reid, a credit strategist at Deutsche Bank AG in London. "The danger is that these financial institutions are forced to sell at fire-sale prices in order to preserve capital. The news doesn't give us any confidence that this risk will subside anytime soon."

Citigroup Inc., for example, may have to write off a further $8 billion on its CDOs, according to Mike Mayo, Deutsche Bank's New York-based banking analyst. Moody's Investors Service said Wednesday it expects further writedowns by European lenders.

Every time an investment bank takes a big writedown, analysts start using the words "kitchen sink" and investors start bidding the stock higher. Merrill shares, for example, popped almost 8 percent higher after its writedown and capital-raising announcements.

The strategy, though, has proved disastrous. The S&P 500 Financials Index is down about 27 percent this year after a 21 percent drop in 2007.

Merrill's belated recognition that the toxic waste in its CDO business has lost almost 80 percent of its value should be a reminder that the finance industry is still in a world of pain.

Equity investors, in the words of Pink Floyd, have become "comfortably numb." It's time they woke up to the dangers still lurking in bank balance sheets.

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