Merrill Lynch’s stock price bounced nicely at the end of July, up 17% on the day following its sale to Lone Star of $30.6 billion in face value of US super-senior CDOs of ABS for just 22 cents on the dollar. Analysts applauded its bravery in taking this big hit to get out from under its most toxic asset problem rather than creeping along from one quarterly write-down to the next. Stock investors seemed relieved that a big uncertainty has been removed and the US market swallowed the biggest ever follow-on public equity offering of $8.55 billion of Merrill shares in just 15 hours.
Certainly this feels like a watershed deal that has big implications for the rest of the financial industry. But it’s hard to share the stock market’s first-day euphoria.
First of all, it raises an issue of credibility against John Thain and his newly assembled management team, including CFO Nelson Chai. Thain was brought in last December to clean up the mistakes of the previous incumbent and to improve risk management. He correctly concentrated on raising capital, bolstering liquidity and attracting senior hires.
This deal, however, marks a significant shift in his tenure at the top of Merrill. Rather than dealing with other people’s mistakes, he is now dealing with his own. How much credibility will investors attach in future to pronouncements of a senior management team that told them that problem assets were correctly marked at 33 cents on the dollar at the end of June, only to sell them for 22 cents on the dollar before the end of July?
Sure, Merrill can argue that this was a trail-blazing deal, the first one-off outright portfolio sale of super-senior tranches of US CDOs of ABS and, that in such a restricted market, a discount was required to complete it. But that only emphasizes the weakness of Merrill’s position, following the cashing in earlier in July of one of its hidden jewels, the equity stake in Bloomberg, to fill the hole already blown in the second-quarter earnings.
Remember that this management team has said before, following $15.5 billion of capital-raising in December last year, that Merrill was adequately capitalized for the uncertain and volatile markets it faced. Now it has had to raise more capital. The firm suggests that it is a sign of the continued confidence of investors that Temasek committed $3.5 billion to the new capital increase. But $2.5 billion of that came from Merrill itself, the Thain team having promised last December to compensate the Singaporean fund for any loss if it raised new capital at a lower price within a year. Temasek gets its market loss covered and ploughs a net $900 million into Merrill stock at what it hopes is a new low of $22.50.
Thain too must hope the stock has bottomed, being one of five senior managers to invest nearly $17 million in the latest equity offering. But it is getting to the point where the man brought in to fix Merrill is getting a reputation for doing great deals... for other firms.
Lone Star might well be another beneficiary. It will certainly expect to make a good trading profit on the distressed CDO assets it has bought and which it can now liquidate as they are unencumbered of the associated hedges with XL. Merrill allowed XL to terminate those underwater positions in exchange for a $500 million upfront payment, a fraction of what those hedges should have been worth to Merrill.
And like all truly canny traders, Lone Star has been careful in its financing of the $6.7 billion purchase price for the assets that Merrill had been carrying at $11.1 billion at the end of June. It has advanced just $1.675 billion of equity in the trade and Merrill has lent it the rest on undisclosed terms.
Is this a true sale? Is it more of a desperation trade?
If the value of the sold assets falls by 26%, Merrill is back on the hook. The associated loans have no recourse to any other Lone Star assets or earnings. It’s to be hoped the loan terms were generous to Merrill. According to its own marks, It is selling Lone Star an in-the-money call option on the assets and an out-of-the money put option. If the assets should fall to zero – yes, that is unlikely but we’re in financial markets where what seemed unlikely yesterday evening comes to pass tomorrow morning – that would be another $5 billion hit.
What more could go wrong at Merrill? Quite a lot. And Thain will no longer be able to point the finger at predecessor Stan O’Neal.