Wednesday, July 30, 2008

Straight Down the Tubes at Merrill Lynch

30 July 2008

Here is a piece of financial detail you don't often see. On April 3, 2008, Merrill Lynch's CEO, John Thain, stated that the company's balance sheets were looking fine.

That means the company had sufficient capital to cover its operating costs.

"We have plenty of capital going forward and we don't need to come back into the equity market," Thain told the Nikkei in an interview published on the Japanese business daily's Web site and dated for Friday, April 4.

This statement followed a dilutive injection of $6.6 billion in new capital by Asian and Middle Eastern investors in 2007.

Unfortunately, a large piece of Merrill's capital ($30.6 billion) was marked to fantasy, not to market.

The soon-to-be-impaired asset consisted of U.S. super senior ABS CDOs (otherwise known as toxic waste - essentially unmarketable mortgage-backed securities). According to a Merrill press release on July 28, 2008, the supposed $30.6 billion asset was unloaded to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. The amount of the loss on the sale of this impaired asset was $23.9 billion.

Note too that this so-called "super senior " debt placed Merrill at or near the first-in-line position to get paid as cash payments worked their way through these mortgage-backed (collateralized debt) assets - with who knows who taking out hefty fees and commissions along the way at various stages of packaging and repackaging - one reason these so-called assets have so quickly become worthless or nearly so.

While no two repackaged CDOs are the same, Merrill's difficulties certainly raise the question as to how little - if anything at all - those holding securities further down the line will ever be reimbursed (in this case, for throwing their good money at irresponsible or hapless borrowers and being willing to pay inflated fees to financial gamesmen for the privilege of being taken for much if not all of their invested funds).

Now, here's the interesting part. As recently as June 30, 2008, this so-called asset was carried on Merrill's books at $11.1 billion, according to Merrill's second quarter report. That is, either the market - or Merrill's valuation methods - shifted so rapidly that the toxic asset degraded by a further 39.6% in only 28 days.

Moreover, during a conference call on July 17, Mr. Thain was bold enough to state, "Right now we believe that we are in a very comfortable spot in terms of our capital."

We now have this asset degrading over a period of only 11 days (from July 17 to July 28), not 28 days. That's a loss of roughly 3.6% per day over an 11-day period.

Merrill went on to declare a $5.7 billion total write-down as of July 28. The company now hopes to raise another $8.5 billion by selling stock... a dramatic turnaround from Mr. Thain's position as recently as July 17, 2008.

What? Again?

Here is the fundamental problem with bank assets:

The banks say that their assets are worth whatever they want to say they are worth. One only knows what the market will pay when they are unloaded at fire sale prices.

In this case, Merrill's asset was worth 78.1% less than its original book value. Merrill's market value has fallen by almost the same percentage (from the $100 range in January 2007 to the $25 range today.)

Supposedly the credit default crisis is winding down.

What then explains Merrill's 39.6% devaluation of an $11.1 billion asset over the past 11 days alone?

I read today that another analyst has said we are in the seventh inning stretch.
If so, then it's either a double header, or this is the world series of bank disclosures.

My call - this is the 7th inning stretch of nothing....

There are a lot more impaired assets out there, and we'll be hearing about them for a long time to come.

The truth is, we don't know the real asset value of any of the financial companies exposed to these low quality repackaged financial vehicles. Any number is a guess, and in my view, that is not good enough information on which to base an investment decision - any investment decision!.



  1. When John Thain became boss at Merrill he hired a new CFO (I forgot his name). My reaction is that the new CFO is doing a terrific job as he is determining the actual value of their capital in such a short time span. Also, you did not mention the fact that John sold their 20% stake in Bloomberg and, I think, he got a good price. Perhaps at the top price range.

  2. Darrell,

    Both great comments. You are putting forth evidence that Merrill may be responding well in a pinch.

    My concerns, however, are (1) what got Merrill into this pinch? (bad - very bad - investment decision-making in the midst of a herd phenomenon - the madness of crowds), (2) why the last-minute switch in guidance and need to raise capital? and (3) how much more price discovery will be needed before the process is done?

    I hope you're right. I take no delight in seeing a great company fail. However, I also like to see leaders acknowledge their mistakes and clarify their plan of remediation. On this count, I see far too much rationalization.

    Bad decision-making is just that, and needs to be called what it is.

    Nonetheless, thanks for your optimistic input. I hope you will be proven right!

  3. Merrill’s old, departed management stated categorically that they brought only assets that received top ratings from the debt rating services. My response was “what are the duties of risk officers, if not to evaluate the risk of loss of invested income.”

    During this time span there were numerous prophecies by informed investors about the consequences of these investment decisions. In short, they stated you are going to lose most of what you invested. I live in San Francisco and I know people who sold their homes and rented because they knew housing prices were not sustainable at these levels.

    The fact that the dollar is accepted as legal tender in most countries and the fact that our Federal Reserve is taking advantage of this fact by inundating the world with dollars and the fact that the dollar holders seeking a place to invest their surplus dollars trusted the rating agencies and invested their dollars in bad debt has created an economic environment where decision makers are almost compelled to act in a manner that is contrary to good investment principles.

    But this should not distract from the fact that Merrill’s new management is navigating these investment waters with the skill and foresight that allows them to see and understand the economic storms they encounter and take the appropriate action.

    Merrill Lynch will survive as a company.

    I still think the stock price is too high but, because of the currency surplus, I have not decided at what price value emerges.

  4. Darrell,

    Thanks again, very informative. I'd have to say there was plenty of evidence that the ratings agencies were playing to their audience rather than doing their job. You didn't need to be a MER top decision maker to know that the mortgage market had gone screwy by mid-decade.

    I continue to blame the Fed for its policies which devalued savings and inflated assets, which in my view is the primary problem. Clearly many of the smartest guys in the room got sucked into a herd phenomenon that was apparent to any small-scale investor with an independent mindset, as you point out in your San Francisco example.

    Hopefully the new guys at MER can save the game, but honestly, who would want to invest in their shaky bag of assets when there is a bull market in anti-dollar investments going on?

    Again, I'd rather be long a bull than speculating on a recovery play. It might be a decade or two before I would find MER interesting as an investment, though of course it will have up and down moves aplenty between now and then. It's just not the kind of asset that interests me as a major trend watcher.

    But your comments are great, very much appreciated.