Dumbest Bubble Deals

As rotten mortgages continue to cripple the balance sheets of large companies, beleaguered executives face yet another looming risk to their stock prices.

Massive writedowns related to past M&A deals, where companies bought up en masse bad mortgage mills and finance companies during the go-go bubble years.

Many of these M&A deals were made at the worst possible time, epic bad bets made right around the peak of the housing bubble in the summer of 2006--or right when the bubble burst a year later.

The looming writedowns are a sobering comeuppance for executives who went on a spectacular, speculative merger bender during the housing and credit bubble.

Lured by the glitz and glamour of dramatic newspaper headlines, the rampant dealmaking tossed pixie dust in the eyes of top executives, blinding them to the impenetrable foolishness of their deals and to the danger they put their companies, shareholders and eventually taxpayers, in.

In fact, some of the bad deals have helped cause companies to be nationalized by their governments.

A Merger Wave Ends

As the record five-year merger wave ended last year, with deal volumes down a crushing 33%, many large banks and companies, including Merrill Lynch, Royal Bank of Scotland, Bank of America and General Electric are estimated to have overpaid for other companies during the bubble years. Their profits are now getting slammed, in many instances largely because of their haphazard acquisitions.

A surprising slug of the overpayments arose from rotten mortgage and finance companies that the buyers tossed around among themselves like hot potatoes.

Beyond Bad Bets

The merger problem goes beyond dumb market bets, like Countrywide setting up IndyMac in 1985, the third largest bank to fail in the history of the US, or Bear Stearns' longstanding relationship in financing New Century's mortgage operation, a reckless lender which subsequently collapsed in April 2007, along with 100 mother mortgage lenders at the time.

Or Citigroup's disastrous bet on liquidity puts sold along with its collateralized debt obligations, which gave purchasers the right to hand back to Citigroup the CDOs at the original sales price if the market for them soured. Citigroup initially made money on the puts, but when the market for them collapsed, Citi had to put $25 bn of them back on the balance sheet.

Overpayments Could Be Massive

The merger overpayments could be massive, overpayments flushed out as the subprime crisis has gone viral.

Subprime loans are just $1.3 tn, or 11% to 13% of the $11.5 tn U.S. residential market, but now they are the most lethal of loans, having helped trigger the credit crisis and economic meltdown.

But the merger overpayments could veer towards $200 bn, a Goldman Sachs report suggests.

The overpayments are found in the line item called "goodwill," a folksy, backslapping anachronism of a term that came to prominence during the heyday of mergers in the '70s, a term that has wreaked lots of bad blood among acquirers and their targets.

Goodwill sums are the extra amounts in cash or stock a corporate buyer pays to acquire a company, to pay for things like the brains in a target company's R&D operation, its brand name or its corporate reputation.

The sums are loaded onto the buying company's balance sheet and are thought to add to a company's net worth.

The S&P 500 companies have about $2.6 tn, or 10% of their total assets, in goodwill and other intangibles on their books, says Goldman Sachs.

But when companies later write off these merger overpayments, the writedowns slam stock prices, slash a companies' book value and jack up their leverage ratios, which can force them to borrow at higher interest rates because they may be deemed too risky by corporate lenders.

Royal Bank of Scotland's Colossal Mistake

Royal Bank of Scotland's shares recently plunged, causing the British government to increase its ownership in the troubled bank and triggeirng its plan to bail out the country's financial system with tens of billions of dollars.

What triggered RBS's stock plunge, besides bad lending?

The worst deal of all.

RBS reported it would book a record loss, Britain's largest ever, ranging from $31.8 bn to $40.5 bn, due to a whopping impairment charge from its participation in a $98.5 bn takeover of ABN AMRO Holding NV, a Dutch bank in April 2007, right when the bubble was about to burst.

RBS spent about $36 bn to complete its share of the costly deal, which it did along with Banco Santander and Fortis, a Belgian banking group that has since been nationalized by Belgium after it was on the brink of collapse.

The British government recently hiked its stake in RBS to 70% from 58%, effectively nationlizing RBS.

Wells Fargo's Wachovia Indigestion

Wells Fargo figured it had outsmarted Citigroup when it bought Charlotte, North Carolina-based Wachovia Corp. in a $15.1 bn all-stock deal, nixing Citigroup's pursuit of Wachovia's banking deposit operations.

The value of the all-stock merger had fallen to $14 bn by the time of the deal, which didn't require any government TARP money to complete, Wells Fargo said.

Wells Fargo may have wanted to think twice about not taking TARP money. Wachovia reported on its balance sheet as of Sept. 30 that a huge slug of its net worth, $18.4 bn, was for that intangible ephemeral asset known as goodwill. That's $3.3 bn more than what Wells Fargo paid for the entire company.

What was the stinker on Wachovia's books?

Perhaps the silliest deal of all--its $25.5 bn acquisition in May of 2006 of Golden West Financial, a mom and pop shop that went berserk rubberstamping reckless loans for the worst of borrowers. Herbert and Marion Sandler, who built Golden West into a mortgage mill, made off with $2.4 bn.

The Golden West deal caused the collapse of Wachovia Corp., causing it to report a huge third-quarter loss 2008 of $23.9 bn--$18.7 bn of which was a writedown of goodwill. Wachovia had already lost $33 bn in the last two quarters. Its loan losses could reach a total of $74 bn.

Merrill Lynch's Dud Deals

 

Under E. Stanley O'Neal, Merrill Lynch "went hog wild," says a Merrill insider, buying up right and left mortgage finance companies.

First Franklin Financial Corp. was one such hot potato.

In September 2006 Merrill Lynch bought the high-risk First Franklin Financial Corp., a San Jose, Calif. subprime mortgage lender, from National City Corp. for $1.3 bn, which would later flop (see below).

National City bought California-based First Franklin from--get this--a subsidiary of Bank of America for $266 mn in 1999.

Bank of America has since purchased Merrill Lynch for $24 bn in a highly controversial deal, in which BofA chief executive Ken Lewis threatened to walk away unless the government helped it buy the brokerage (the government gave BofA a subsequent $20 bn capital injection to do so, on top of the $25 bn the two companies had already received).

Lewis himself is now under fire for not doing enough due diligence on the Merrill Lynch deal, and an acquisition spree in which BofA has spent $129 bn to buy other companies is now under scrutiny. BofA bought Countrywide Financial for $4.1 bn, a mortgage lender that is now under regulatory investigation and is now the subject of numerous shareholder lawsuits. BofA invested $2 bn in Countrywide in August 2007, right when the bubble blew.

Market expert Janet Tavakoli, president of Tavakoli Structured Finance, says BofA's potential "overpayment is stunning" in its Merrill acquisition, as Merrill reported $15.3 bn in losses in the fourth quarter, and more than $41 bn in losses and writedowns in prior quarters.

First Franklin specialized in mortgages for people with lousy credit ratings who could only qualify for mortgages at nosebleed interest rates.

But at about the same time it bought First Franklin, Merrill Lynch bought three other mortgage-related companies. Merrill Lynch then booked $999 mn in the goodwill line item on its balance sheet, primarily from its First Franklin acquisition.

Two years later, in March 2008, as the market for risky mortgages evaporated nationwide, First Franklin became worthless and Merrill shut its doors for good. A month later, in April 2008, Merrill Lynch accused National City of misrepresenting its losses.

Merrill Lynch also partly owned California based Ownit Mortgage Solutions, a mortgage lender that collapsed in December 2006 after issuing bad loans such as 45-year ARMs and massive amounts of no income, no documentation loans. Michael Blum, Merrill Lynch's head of global asset backed finance, sat on the board of Ownit Mortgage.

Ownit's founder and chief executive William D. Dallas was quoted as saying: "The market is paying me to do a no-income verification loan more than it is paying me to do the full documentation loan."

Copycat Deals

Both Merrill Lynch and Morgan Stanley were copycatting Lehman Brothers Holdings' modus operandi of acquiring mortgage originators.

Lehman collapsed last September due to a variety of dangerous investments in commercial and consumer real estate and derivatives. Prior to going bankrupt, Lehman shuttered its subprime lending unit, BNC Mortgage, triggering $42 mn in charges, including a goodwill writedown of $27 mn.

Similarly, Morgan Stanley had paid $706 mn for subprime lender Saxon Mortgage, and had booked $348 mn of goodwill on its balance sheet related to the purchase of Saxon as well as Moscow-based lender CityMortgage, its financial statements show. Watch out here.

PNC Financial's National City Headache

In October 2008, Pittsburgh-based PNC Financial Services Group then bought troubled National City Corp. in a $5.2 bn all-stock deal, at the time thought to be a bargain price because National City was supposedly worth $25 bn in 2007. Cleveland-based National City had lost more than $3 bn during the previous five quarters, and its stock plummeted about 90% over the prior year.

However, PNC only did the acquisition after the US Treasury gave it $7.7 bn in TARP funding to do this deal, which "put this transaction on a very solid footing,'' PNC said.

What was National City really worth? On its balance sheet, National City recorded $4.3 bn of goodwill for, well, your guess is as good as mine. That sum nearly equals what PNC paid for the troubled lender, which once numbered among the country's top 10 subprime lenders.

General Electric's Soured Acquisitions?

As of September 2008, the latest data available, General Electric had $26 bn in goodwill balances, an increase of $1.2 bn, from its new acquisitions.

The troubled conglomerate--whose market cap is now less than that of AT&T (T) or Wal-Mart (WMT)--says its most significant increases stemmed from its acquisitions of Merrill Lynch Capital ($608 mn), Bank BPH ($399 mn) and CDM Resource Management ($229 mn as).

In fact, GE's potential overpayments for its acquisitions have steadily risen since 2007. Last year, it booked an increase of $485 mn in goodwill, largely stemming from its 2007 acquisitions of even more finance companies. It bought Sanyo Electric Credit and Dundee REIT in 2008.

GE's Scary Balance Sheet

GE's deal making, and its other bad market bets, has put its cherished Triple A rating at risk, a rating just nine companies in this country sport. Its balance sheet is close to being under water. While the credit rating agencies have backed off for now, GE has notified the SEC it faces a potential downgrade, which would slam its operations.

GE has $523.8 bn in borrowings, $514.6 bn of which sit at its finance unit, GE Capital.  

GE's net worth, its assets minus its liabilities, has dropped in value, to $104.7 bn, down from $112 bn in the third quarter and from $118 bn in the second quarter, and $116 bn at year-end 2007. 

However, a whopping $96.7 bn of that $104.7 bn is in the form of goodwill and intangible assets, hard-to-pin-down ephemera that GE says is the premium (or potential overpayments) it paid in acquisitions as well as things like the value of its patents, among other items.

So GE's net worth based on its hard assets, what's called its tangible book value, is just $8 bn. On that basis, GE is levered up 65 to one.

GE also has $53.2 bn in receivables and assets squirreled away in off-balance sheet vehicles, which market regulators may force it to put back on its balance sheet, a move all companies would have to make, by the end of the year.

These vehicles get to sport GE's gold-plated triple-A rating, even though these assets are backstopped by a weak $2.7 bn in credit support.

Factor in its $53.2 bn in off-balance sheet items, and GE's debt picture blows out to $577 bn. In turn, its leverage ratio balloons to 72 to one.

GE also has more than $33 bn in illiquid securities and derivatives it's having trouble selling in a frozen over market, securities troubling many companies as they remain, for now, priced for the ice age.

Is GE really a triple-A company?

Regions Financial Gets Slammed

Regions Financial recently lost about 25% of its market after reporting a $6 bn goodwill charge due to its $10.5 bn purchase of troubled AmSouth Bancorp.