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  • July 29, 2008 08:36 AM EDT by Elizabeth MacDonald

    Merrill's Latest Misfire

    The forecasters who thought investors should now pile into the financials, that the sector would start seeing an upward trend, now know the pain of betting on a false bottom.

    Merrill Lynch's shocking announcement after the market's close yesterday that it will book a huge pre-tax $5.7 bn writedown in its upcoming third quarter from its toxic securities and hedges with bond insurers, plus raise another $8.5 bn in new stock, should make investors who piled into the shares just last week at $31 thinking the worst was over after Merrill reported its disastrous second quarter results feel totally blindsided.

    It defies reason that Merrill did not know about this massive problem in its book of business, that it didn't see this freight train of a writedown coming when just last week it disclosed $4.9 bn in second quarter losses due to $9.4 bn in writedowns for the period. Wall Street had expected lesser sums here, $1.8 bn in losses due to $6 bn in writedowns.

    At minimum, do you really think it takes only about a week to convince foreigners to invest even more money at a time when the stakes they've already bought in Merrill earlier this year are now drastically under water?

    The second quarter losses marked Merrill's fourth straight quarterly loss. The tally of losses is ranging around $21 bn,  and writedowns amounting to more than $46 bn.

    Now more losses are on the way for the third quarter, the fifth straight quarter, at Merrill.

    Wall Street is now wondering whether Merrill's chief executive, John Thain, has a credibility problem. On the July 17 conference call about its bad second quarter results with analysts, analysts who were skeptical as they were expecting smaller losses and writedowns, Thain said: "Right now we believe we are in a very comfortable spot in terms of our capital."

    Really? And 10 days later you announce both a massive writedown and another eye-watering, dilutive capital raise? 

    Since he took over in December, Thain has repeatedly dismissed the notion that Merrill needs any more capital after the firm reported poor results, with the refrain being new capital would not be necessary. For a round up of Thain's comments that the firm does not need new capital, click on this link: http://in.reuters.com/article/governmentFilingsNews/idINN2824127720080729

    When did Merrill know it planned to unload this distressed debt and when did it know it had to do another $8.5 bn equity raise? Did it really come as a eureka moment just overnight?

    Investors who bought in last week when it was said the worst was over at Merrill, when it was trading at around $31, are getting hammered now. The stock is trending down toward $20. "Shareholders are seeing their positions diluted massively," says Dennis Gartman of the Gartman Letter.

    Gartman adds the blame should also be put squarely on Merrill's former chief executive Stanley O'Neal, ousted last fall due to his mismanagement, who walked away with $161.5 mn in compensation, compensation "that is not being written down even as the shareholders are having their positions massively corrupted," Gartman says.

    "If there is a crime on Wall Street it is this." That compensation effectively was paid out based on artificial profits made during the housing bubble. Merrill to date has laid off 5,200 people.

    Yes, I have raised the question of what some analysts were saying, whether we were seeing a bottom in the financials.

    I also warned you that thinking that way would be like trying to hold onto a piece of Styrofoam in a typhoon.

    Merrill's stock got pounded in after hours trading, closing down 12% to $24.33. Shares are down 54% this year, and are trading at their lowest levels in ten years.

    Meredith Whitney, a top analyst at Oppenheimer, says Merrill's pro forma book value per common share is more like $21 and that shares are still trading at levels that are "at a premium" and "expensive." Whitney does think Merrill is getting closer to being fairly valued and that "the hardest work" is behind the company. Whitney now expects Merrill to post a loss of $10.50 per share for the entire year, versus the $8.37 expected earlier.

    Don't be fooled by false bottoms in the financials. As economist Ed Yardeni points out, the financial sector of the S&P 500 jumped 31% "in a six-day short-covering rally that was interrupted by a 6.7% drop last Thursday, the biggest decline since a 7.7% decline on April 14, 2000."

    The jump came after Congress said it was close to signing the $300 bn housing bailout bill, which included the taxpayer backed rescue of publicly traded Fannie Mae (FNM) and Freddie Mac (FRE), and also turned these two as well as the Federal Housing Administration into a halfway house for severely delinquent, bombed out loans.

    "The financials tend to rally following massive government programs to avert a financial meltdown," Yardeni says.  

    What you should be watching for are writedown announcements such as Merrill's, because it means the rest of Wall Street will start marking down their assets to potentially 22 cents on the dollar. Watch out, Lehman Bros. (LEH). Watch out Citigroup, which has $22.5 bn in subprime securities exposures here, and UBS, $15.6 bn, both ranked the highest in this category, Oppenheimer's Whitney says.

    A new report from Goldman Sachs on Merrill's 22 cents on the dollar pricing indicates it thinks there will be "a negative read-through to Citigroup given its exposure and the levels where these assets appear to be marked ($0.50)."

    Investors in Merrill should be notably concerned with what is happening at the country's largest brokerage. Merrill was a repackaging factory for some truly toxic subprime debt, including those pumped out by Countrywide Financial. Countrywide pointed its conveyor belt of nasty loan products at Wall Street, and Merrill was first in line to gin them up into asset-backed securities.

    Merrill's latest writedowns resulted from the sale of a huge $11.1 bn slug of its asset-backed securities, helping to create the latest $5.7 bn pre-tax writedown. It also pulled the plug on hedges with troubled bond insurers, the two white hot zones on many financials' balance sheets.

    Watch how this deal to unload a whopping slug of Merrill's distressed debt breaks down. Merrill said it sold $30.6 bn worth of distressed debt in the form of super senior asset-backed debt, once rated Triple A, for just $6.7 bn. Merrill had just said at the end of its second quarter these assets were worth $11.1 bn, or just 36 cents on the dollar.

    So, being that it has sold this distressed debt, called collateralized debt obligations, for just $6.7 bn to a unit of Lone Star Funds, a Dallas private equity firm, when you do the math, that's about 22 cents on the dollar. That's a writedown of 78%. Gasp. That created $4.4 bn of the writedown.

    Moreover, Lone Star only has to pony up $1.7 bn to seal the deal, borrowing the rest, or 75%, from Merrill. So Lone Star is effectively putting up just 25% of the deal, about six cents on the dollar, for the gross value of the deal. "That does not sound very good for the about-to-be diluted shareholders, now does it?," says Jill Schlesinger, executive vice president and chief investment officer for StrategicPoint Investment Advisors.

    One of the sharpest minds on Wall Street, Whitney Tilson, points out that Merrill's announcement said Lone Street " will not own any assets other than those pursuant to this transaction." Tilson says that means Lone Street is setting up a special unit to house Merrill's toxic CDOS, sheltered away from the pension, family trusts, endowment assets and insurance company portfolios Lone Star manages. That means if Lone Star defaults on its loan from Merrill, the only assets Merrill has recourse to are these CDO assets, Tilson notes.

    So Tilson asks whether Merrill got to book this deal as a $6.7 bn sale, or as a $1.7 bn deal, with an account receivable on its balance sheet of $5.0 bn.

    Does anyone at Merrill or on Wall Street know what these assets are really worth?

    The sale cuts Merrill Lynch's total CDO long exposures from $19.9 bn at June 27, 2008, supposedly to $8.8 bn. Most of what's left is made up of older vintage securities, dating back to 2005.

    Take a closer look through Merrill's books and you'll still see problems. As of June 27, it said it had exposures of $33.7 bn to U.S. prime mortgages, $1.01 bn to U.S. subprime mortgages, $1.54 bn to "Alt-A" mortgages and $7.45 bn to non- U.S. residential mortgages.

    It's also got a big $18 bn in exposures to subprime- and commercial-backed securities. Of that sum, its net exposure to subprime alone is $4.5 bn.

    Merrill has been in acute pain due to what it has had on its balance sheets, with 30 CDOs worth in the aggregate $32 bn for deals Merrill underwrote in just 2007 alone. Some 27 of these have seen their top triple-A ratings downgraded to "junk," Janet Tavakoli, a structured-finance consultant in Chicago, reportedly said. Their performance has been "dreadful," she says.

    Merrill has about $41 bn in net worth, or shareholder equity against about $34.4 bn in illiquid level three securities, those securities it has price tagged itself because no one wants them.

    The $8.5 bn capital raise will dilute existing investors by nearly 40%. Merrill has to compensate Temasek and the Kuwaiti Investment authority who both bought shares in Merrill earlier this year at a higher price.

    Last week, Merrill announced it would unload its stake in Bloomberg for $4.43 bn to raise capital. It had to unload this asset due to the fine print of an earlier $12 bn equity offering sold to Singapore's investment fund Temasek and the Kuwaiti investment authority, which forces Merrill to remunerate them in the event of any further dilutive equity raises.

    The new equity offering now forces Merrill to reset its earlier deals with Temasek and Kuwait, an issue I warned you would happen (see earlier blog, "Why Merrill May Cut Into its Muscle").

    Temasek had bought $5 bn at $48. As Merrill is now trending toward $20, Merrill has to pony up $2.5 bn to Temasek, and Temasek is expected to turn around and invest that remuneration into its new $3.4 bn investment in Merrill's latest equity raise.

    So in effect Merrill lent $5 bn to Lone Star to buy, gross value, $30 bn in securities, and at the same time it paid Singapore's Temasek $2.5 bn to buy its shares.

    Merrill also is in talks with the Kuwait Investment Authority to renegotiate the terms of its original investment. And Merrill's management will buy 750,000 shares in the new offering.

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WilliamBanzai7

Another example of blatant misleading conduct by a Wall Street bank. Meanwhile the SEC is still chasing the short sellers who seem to be the only ones who recognize just what a serious predicament these bloated CDO giants are in. Why is the SEC afraid to chase the senior executives of these financial innovators that are now innovating the truth?

July 29, 2008 at 10:17 am

Yuri Demidov

Why on earth would anyone allow Merrill Lynch financial advisers to manage their money if Merrill Lynch can not even manage itself.

July 29, 2008 at 10:20 am

Pat C

Great article - Thanks. What about Credit Default Swaps? It seems to not be on anyone's radar anymore? I don't think I will be comfortable investing in financials until this exposure gets sorted out and disclosed. I see these huge "netting's" being done in the footnotes to the major financial institution's regulatory filings. Do we have to wait until November when the new accounting kicks in to determine what is up? I have got to believe somebody is going to be left holding the bag on this insurance which will trigger additional massive write-downs for those that think they are hedged and are not.

July 29, 2008 at 10:41 am

Joseph Redding

I am a nobody when it comes to investing but all of the somebody types that we trusted to run things seem to have failed us. I say that we had it coming because we allowed all of the outlandish salary contracts. It defies common sense to promise to pay a person even if he leads the company into bankruptcy. My advice would be to find a modest salary based on experience and past performance and offer bonuses based on performance of the company. I dare say that under my plan we would be better off today. Anything else is just not good business.

July 29, 2008 at 10:43 am

Tracy

I would suggest everyone read today's (July 29, 2008) Wall Street Journal regarding MER recent developments. It's clear that EMAC is on a witch hunt when it comes to her blogs and reporting on the financials. "Fair & Balanced" certainly doesn't apply here and is definitely irresponsible reporting. Couldn't believe the blog regarding which banks are likely to fail.

July 29, 2008 at 2:50 pm

Lenny

Ms McDonald I have never seen you ever give a positive report on anything that has to do with financials,whether it's the Gov rescue of FANNIE,FREDDIE or any positive earning that comes out from any bank. I watch FBN always and till today I am still waiting for one single positive report.

July 29, 2008 at 6:32 pm

DrDetroit

from article: "When did Merrill know it planned to unload this distressed debt and when did it know it had to do another $8.5 bn equity raise? Did it really come as a eureka moment just overnight?" end paste I think this question indeed raises some questions, but I think LIKELY the answer is corporations involved in known write downs etc. surely keep it to themselves. If a corporation gets caught up in a rumor of debt even - they can face troubles. If it's flat out waving on a flag or t-shirt ? their expected write downs ? I'm not sure if their stock wouldn't reflect that news. I have a sense that these write downs are known about in many cases, and who in their right mind would go about blathering about it with interest in their company ? I don't know, but I wager they'll be dumped piece by piece - quarter by quarter. You don't want to spook the buyer or seller that's for sure. Oh well let's see who's up next. I bet Wachovia and WaMu both would fold quickly - some corporations can't even expend any more losses or writedowns it seems.

July 29, 2008 at 7:24 pm

DrDetroit

Yeah, When did who know what they were unloading and even who knew what was loaded and who knows what they still have to unload ?

July 29, 2008 at 7:26 pm

DrDetroit

from a post: Comment by Tracy Jul 29th, 2008 at 2:50 pm I would suggest everyone read today’s (July 29, 2008) Wall Street Journal regarding MER recent developments. It’s clear that EMAC is on a witch hunt when it comes to her blogs and reporting on the financials. “Fair & Balanced” certainly doesn’t apply here and is definitely irresponsible reporting. Couldn’t believe the blog regarding which banks are likely to fail. end paste Tracy, Witch Hunt ? If you did read the offerings from MacDonald, yes, one article is titled using 'Witch Hunt' indeed, but I think you're going to far towards a generalization, I'd say broad generalization, but I stopped overstating that one ! Tracy, aside from all of this, I went to type in Hunt oil to get to learn more about the report out where Hunt oil had transparency with Iraqi Ministry of Oil. Guess who's on page one from news.google ? The Witch Hunt article. Either way Tracy, I too posted a list of institutions I borrowed from innercitypress - I think they are a .net - odd, many were shared, the list I posted was in regard to a New York Federal Reserve Bank private meetings/arrangements highly questionable and at the same time ? was not being made available let's just say as public as possible. Zooming in on one or many institutions doesn't fit with Witch Hunt, all in all Tracy, I didn't find your allegory, analogy or metaphor to fit well with my experience of oh - a variety of subjects I've found on this outlet/web page. Tracy, if it helps, imagine Liz MacDonald detached from FBN ? I really don't even pick up favoritism towards the institution paying her salary etc. Which would be good, considering - oh nm, no time or place to rant on 2nd floor and up at Fox/FBN. I don't see how it's irresponsible though to flaunt a list of items of interest to anyone probably with some meager intellectual facultites. For example Tracy, I openly 'speculate' - somewhere there is intended humor there on 'speculate' - that Whacovia and WaMu are going to just go poof at some point - JUST insight you know ? that's a list, of two heh. I started formation on BOTH studying their product changes/offerings, even their 'bonus' token toaster. I LATELY wonder about this Whacovia auto transfer of $1 from checking to savings on every card use. I SURE hope there is an immunity to the Insufficient Funds Fee that could hit someone by surprise... Friday, thinking, okay, I have $89 in checking, making 11 purchases, forgets about the $11 in transfers as per purchase Whacovia has $1 go from checking to savings. That would simply ROCK if Whacovia ? did 1 NSF charge ($30 to $40) PER $1 transfer ! 'Yes Mrs. Smith, that's right, because your balance was negative $11 last evening ? each $1 transfer cost you $1 + the NSF fee of $38 That's right Mrs. Smith - 11 x 38 - or you account is $-391 today Mrs Smith hello ? mrs smith ? are you still on the line ? Let's hope not. Tracy, your thoughts ? on Wachovia ? or Washington Mutual ? as of late ? even with fed pipelines - I would say Tracy ? irresponsible is when you have a situation such as with that senator who mentioned a comment on IndyMac - which in turn went dead shortly after as a result of a run on the bank. THAT was irresponsible. confidence seems key. If I recall though, post IndyMac, there now exists a safety net with the pipeline to treasury access for any institution I believe in banking, not sure if any, certainly the list at NY FRB revealed well- it's tricky Tracy - because just being on the list doesn't imply you're in dire straits - but at the same time it doesn't look too good that you'd have to be. I mean, if you have capital to balance it all ? hey, what's the prob. Tracy, did you observe WaMu's push to encourage deposits ? oh what was it ? free checking, free checks - and something else. I swear - WaMu will probably visit some other country just to help - or hey - SWF all the way baby. Worked for Citi. I just pictured someone from Abu Dhabi looking over, instead of a car lot of luxury cars- instead, US financial institutions willing to take SWF's, about to go out on the lot and buy a few, or certainly heavily buy into. Perhaps this man from Abu Dhabi shopping on a lot full of US financial institutions will bump into Paulson - trying to find the Freddie Mac building to go buy shares. Hmm - uh oh Tracy, you don't think Paulson would do any naked shorting at some point, I mean, if the Treasury is going to get into buying stock into Freddie Mac and Fannie Mae ? Gee Why stop there, short, short some more, and naked short. I do wonder, putting naked shorting aside, if Paulson at the Treasury would even entertain shorting Freddie and Fannie at some interval - just because it would be profitable. THEN, you'd have a whole new ball game. Oh, what the heck - mandate all monies collected through taxes go right into the market - and the gov. can collect what it needs for projects etc from SOME of the profits from the taxes - the rest kick back to the citizens. Hmm - maybe I need more sleep - or more coffee- strange idea though. I just feel Treasury buying stock into Fannie Mae is like one foot on thin ice, if and when it goes through, where does it stop ? I still like the humor intended in there regarding the Treasury shorting Freddie at one time or another.

July 30, 2008 at 2:20 am

DrDetroit

I like upstream observations such as The USD in some way can be viewed as part of a 'credit rating' the US has around the world with all of the current currencies. So, doesn't matter if the Treasury offers life lines, if the 'paying interest only' loan the US CURRENTLY rids on gets any tighter - that means even the Treasury wouldn't have the funds to back all it wants to during any up and coming collapses. Certainly will be interesting. Just hit me - 300 billion in housing assistance -is about 10 Katrina's. hmm Now, food post Katrina did it's first major shift to oh ? what ? 15 to 20 % up ? my obervation at least. And to hear the oil company CEO's on c-span sensibly say post Katrina, actually, the price went up due to global price shifts, and supply wasn't issue. Go figure. At least there won't be a food jump like Katrina just because the US Fed just dumped 300 Billion into hmm - who ? Don't tell me it's ALL to the BoA? heh It can't be Now, BoA DID craft the original housing assistance bill - go figure. of COURSE it was renamed - anyone know how much BoA takes from this 300 billion ? if it's all to BoA - sheesh- what a bonus ride

July 30, 2008 at 2:32 am

DrDetroit

Indeed, I'd like to know where the 30 Katrina's are - e.g. the 300 Billion for housing. Where did it all go ? or will it ? if it's a fund for trouble. Just wait, some no bid contract from Halliburton will show up from Halli-Financial to handle it all - oh wait, GS probably.

July 30, 2008 at 2:33 am

Tracy

To DrDetriot.......WHAT?!?!?!?!? Elizabeth's articles (when it comes to financials) are very biased and BARELY touch the whole truth. This article takes the cake. To call the recent moves by Merrill a "misfire" is unbelievable. What should they have done? Hold the CDOs until they're worthless? The value of these assets is determined only by what someone is willing to pay for them - that's called a MARKET. And a market changes day to day, hour by hour and minute by minute. The CEO of Merrill took action based on what is happening in the market. With regard to Elizabeth's article about which banks are next to fail. She has no knowledge of which institutions are in trouble. It's irresponsible to throw out names of banks in a BLOG in order to create fear and panic among depositors. EMAC is acting like an expert when she is merely entertainment....but people think she's expert and will act on what she's written. I know most people are smart enough to do their own research and I hope that's what they are doing before pulling all their business from an institution she's decided to bash on any given day.

July 30, 2008 at 6:59 pm

Greedom

To Malik on your, reply: MER isn't going to go about saying the ship is sinking now is it ?

July 31, 2008 at 9:34 am

Jonathan

Great article! I know a lot of shareholders got burned bad on this one, but this is no surprise. As a trader, many of us saw this coming long ago. As far as the remaining financials are concerned, there will be more losses to come. Thanks and great reporting Liz!

August 3, 2008 at 4:20 am

about this blog

  • Elizabeth MacDonald is the stocks editor for Fox Business Network. She is recognized as one of the top prize-winning business journalists in the country, and has received 14 awards, including the top prize in business journalism, the Gerald Loeb Award for Distinguished Business Journalism, and the Newswomen's Club of New York Front Page Award for Excellence in Investigative Journalism.

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