Thursday, July 31, 2008

Merrill's Capital Squeeze

Yesterday, I wrote about Merrill Lynch's recent writedowns/sale of some CDO assets.

Today's (and yesterdays, in the Lone Star article) Wall Street Journal divulged some more details about the transactions. Details so tortured as to give me even less confidence that Merrill can ever return to anything approaching 'normal.'

To begin with, just consider what the firm is really doing. Sure, Thain is asking investors to buy $8.5B in new equity. But Merrill has, according to the Journal, written off $46B in losses since June of last year.

Good money after bad? You bet. "Bet" being the operative word!

We do not know at that price investors will answer Thain's call.

We do, however, know that Merrill sold $30B of mortgage-related securities for $6.7B, to Lone Star. That's 22 cents on the dollar.

But Merrill also financed 75% of the purchase as the recourse holder for losses. Meaning it's not clear of losses yet. And didn't really flush the assets off of its balance sheet, so much as lend the money to Lone Star to take title, at a 78% discount, to $30B of untradeable securities.

Thus, we see that Thain isn't so much raising capital externally, as being forced to raise it internally by selling assets. And even dodgy assets at that, the removal of which trigger horrendous losses. And perhaps even further losses in the future, should 22 cents be too high a value per dollar sold.

But wait...there's more.

Lone Star received financing and a recourse condition for the $6.7B purchase. Doesn't that, in reality, mean the plain vanilla value of the $30B of securities, absent the special financing conditions, is, in truth, even lower than 22% of face value?

Could it be as low as, say, 18%?

Isn't Merrill really already clouding the true losses on this $30B chunk of assets?

What will other investment and commercial banks with similar assets now do to value theirs? Shouldn't Wachovia, Chase, Citi, BofA, Morgan Stanley and Lehman all be observing this 'market pricing' of some 18% of face value of these assets?

Or is this not even a 'market price?' Does its arranged nature make it not a basis on which other financial institutions should price their similar assets?

One thing is sure, though. John Thain's Merrill Lynch is now so crippled that it can't even tap capital markets reliably anymore. It must begin disgorging badly damaged assets just to free up internal capital, in lieu of having confidence that any sane investor would touch a share of Merrill common equity for years to come.

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