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Tuesday, July 29, 2008

Merrill: Finally Marks to Market, Raises Capital

Dilution. Massive dilution.

Merrill to Sell $8.5 Billion of Stock, Unload CDOs (Update3): “Merrill Lynch & Co., the third- biggest U.S. securities firm, will sell $8.5 billion of stock and liquidate $30.6 billion of bonds at a fifth of their face value to shore up credit ratings imperiled by mortgage losses.

Temasek Holdings Pte., the Singapore-owned fund that became Merrill's biggest investor by acquiring shares in December, will buy $3.4 billion of the new stock, Merrill said yesterday in a statement. The New York-based company is paying Temasek $2.5 billion to offset losses on its earlier investment. Merrill will also book $5.7 billion of writedowns in the third quarter.

Almost $19 billion of net losses in the past year forced Chief Executive Officer John Thain to backtrack from assurances that the firm had enough capital to weather the credit crisis. Since taking the post in December, Thain has raised $30 billion in an effort to keep pace with mounting charges on mortgage bonds amassed by his predecessor, Stan O'Neal. Standard & Poor's cut the firm's debt rating last month and signaled that more downgrades were possible.”

Thain swore up and down that Merril didn’t have to raise anymore capital…

Expect massive share offerings from all major banks and brokerages. Expect massive dilution. Expect more forced balance sheet de-leveraging. $30.6 billion is no small amount… and finding a bid for all that selling isn’t going to be easy. Therefore Merril is dumping them at one fifth of face value. That’s $6.12 billion. More specifically, rumors are that it was 22 cents on the dollar.

But far more interesting is this little gold nugget:

“Merrill will provide financing for about 75 percent of the purchase price, according to the statement. The financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion.”

So in order to get ANYBODY to buy this $30.6 billion pile of crappy bonds, Merrill had to provide the financing and promise to eat any losses greater than $1.68 billion. So because of a neat accounting trick, $30.6 billion is removed from the balance sheet, making it look leaner and cleaner. Really, the ultimate risk is still with Merrill. So, the question then is: Did Merrill really SELL the bonds? Or just shuffle everything around a bit?

Other food for thought:

“Why these assets are written down when you're selling them and weren't written down in your earnings is a question. This kind of announcement is surprising and a little disheartening.” -Ralph Cole, Ferguson Wellman Capital Management Inc.

This also creates another bigger headache. The sale sets a precedent. Now there is a ‘mark’ for these bonds and other institutions now have to move them out from their level 3 asset bucket (where they are being valued at some fantasy level) and back into the ‘mark to market’ asset bucket at about 22 cents on the dollar.

Merril (MER) is the 20th largest weighting in the DOW Jones Financial Index at just over 1%. SKF, the Proshares Ultra Short Financials is x2 the inverse of that index.


Anonymous said...


(1) MER is off 3% or so pre-market . . . it should be much higher when they're talking about 30% dilution, right?

(2) Guess there is still easy money to be made on the short side of financials!

(3) SKF daily return is double inverse daily return of DJ Financial Index which, technically, is not the same as double inverse the DJ Financial Index. Fundamentally, there's a different risk characteristic to it than had you gone balls-to-the-wall short the DJ Financial Index in a margin account -- at least, that's how I interpret the prospectus from ProShares. YMMV.

-Mike J

Ben Bittrolff said...

During a conference call on July 17, Thain said: "Right now we believe that we are in a very comfortable spot in terms of our capital."

Hahahaha. Reuters has a good article on it here.

Anonymous said...

The mark to market of CDOs, long in coming, is still a chillig prospect. This is the beginning of a wave of disaster for financial companies. I'm still confounded by how any sort of rescue can be performed on the economy as a whole at this juncture of events.

Ben, if you got any ideas, let us know.

I'm just sitting here at my computer watching the nonreaction of the markets so far to the latest Boom of Doom being lowered on us all.


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