Monday, July 28, 2008
Merrill Lynch 'Lance the Boil'
Firm Dumps Mortgage Assets as Crisis Drags On; Another Big Write-Down Merrill Lynch & Co., trying to purge its balance sheet of some of its worst remaining problems, said it is selling more than $30 billion in mortgage assets at a steep loss. Merrill also said it plans to raise about $8.5 billion in new common stock despite terms of an earlier stock sale in December that required it to make extra payments to investors who bought shares at a much higher price. Common-stock issues are typically unpopular because they dilute current shareholders. A Singapore company that has purchased a big slug of Merrill stock in the past year will put in $3.4 billion of the new capital. The announcement came as a surprise to Wall Street. Merrill Chief Executive John Thain, who just 12 days ago had resisted calls by Wall Street analysts for a fire sale to pare down the firm's holdings of mortgage debt, said the firm expects to take a new $5.7 billion write-down in the third quarter, after racking up $41 billion in write-downs since June 2007. Merrill's announcement came after a tumultuous day in stock and bond markets. The Dow Jones Industrial Average fell 239.61 points, or 2.1%, to 11131.08, bringing it down 16% on the year. All the blue-chip average's financial components traded lower, stung by the collapse late Friday of two small banks, First National Bank of Nevada and First Heritage Bank of Newport Beach, Calif. State and federal officials took new steps to address the market's woes Monday. The Treasury Department said that four of the nation's largest banks -- Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. -- agreed to begin issuing a type of debt called covered bonds, which the Bush administration has been pushing as a way to help reinvigorate the housing market. Meanwhile, New York's top insurance regulator, Eric Dinallo, helped broker a deal between bond insurer Security Capital Assurance Ltd. and Merrill that would allow the troubled insurer to cancel $3.74 billion of bond-insurance policies it has written in return for a payment of $500 million. (See related article.) Merrill's decision to sell the mortgage assets was described by one person close to the company as an attempt to "lance the boil" and put the mortgage debacle behind it once and for all. The decision signals Merrill sees no immediate turnaround in the sharp decline of assets backed by mortgages. Before the latest announcement, Merrill had raised more than $15 billion through various common and preferred share issues. It also sold a number of key assets, including unloading its 20% stake in Bloomberg LP for almost $4.5 billion. Financial shares shot up in mid-July after the federal government offered help for mortgage giants Fannie Mae and Freddie Mac and announced steps to crack down on short-selling, in which investors seek to profit from a decline in shares. But many obstacles remain to a resolution of the credit crisis that has gripped the market since last year. Bank and brokerage shares fell sharply Monday as investors worried anew about losses on mortgage-related assets and the weak economy and housing market. "This is a financial crisis in slow motion," said Nicholas Bohnsack of Strategas Research Partners. Merrill shares fell nearly 12% in regular-hours trading, before its announcement. In after-hours trading, the shares recovered slightly. Merrill Lynch has been hit hard by the mortgage crisis, largely owing to big bets on mortgage-backed securities not long before the market for those securities collapsed. Late last year, Stan O'Neal, the chief executive who oversaw those bets, was forced out. He was replaced in December by Mr. Thain, a former Goldman Sachs Group Inc. mortgage trader who later ran the New York Stock Exchange. Despite installing new risk controls and a new management team, Mr. Thain has been unable to steer Merrill out of trouble. This month it reported its fourth straight quarterly loss. Sitting on CDOs Merrill has been sitting on collateralized debt obligations, securities backed by pools of mortgages or other assets. The biggest single action Merrill took Monday was the sale of mortgage assets to an affiliate of Lone Star Funds. Those assets had a face value of $30.6 billion, and Merrill was carrying them on its books at $11.1 billion as of the end of June. Lone Star paid just $6.7 billion for the assets, or 22 cents for every dollar of face value. The sale reduced Merrill's holding of such assets by more than half, to $8.8 billion from $19.9 billion. Merrill said it would finance about 75% of the value of the deal. Other banks with toxic assets have taken similar action, in their quest to find someone to take the assets off their hands. Despite the steep discount, Merrill's sale may bode well for other firms on Wall Street such as Lehman Brothers Holdings Inc. that are also sitting on hard-to-sell assets. The new stock sale by Merrill is doubly painful because the firm offered price protection to some investors including Temasek Holdings Pte. Ltd., a Singapore state-owned investment company, on earlier sales in December and March of $6.2 billion in stock at $48 a share. Merrill said at the time that if it sold stock at a lower price within 12 months, it would compensate the $48-a-share investors. With Merrill's stock at a closing price of $24.33 a share, that price protection would cost Merrill $2.5 billion, though Temasek agreed to plow that money into its $3.4 billion investment in the new stock. The price of the shares wasn't specified. Also Monday, Merrill announced management plans to buy 750,000 shares of common stock in the coming public offering. Shaky Guarantors Another issue for Merrill has been the shaky standing of financial guarantors such as Security Capital Assurance, the company that was part of Monday's deal announced by New York state regulators. These guarantors wrote insurance against losses on bonds held by Merrill, but with so many bonds going bad, the guarantors were looking less likely to make good on their promises. Merrill had already written down $8.5 billion of its exposure to financial guarantors such as SCA during the past nine months, leaving it with just $2.9 billion in remaining exposure. Last month Merrill won a summary judgment in federal court in New York upholding its right to collect on SCA's insurance. Merrill said Monday the deal involving SCA -- in which it will give up the insurance in exchange for the $500 million payment -- would cause it to write down another $500 million in the third quarter. The agreement is likely to set a precedent for other insurers and financial institutions that are facing steep losses from problematic subprime-mortgage securities created over the past few years. Other bond insurers have also written billions of dollars of guarantees on mortgage bonds and might not have the capital to make payments on those guarantees. This could set the stage for a resolution of their problems. The bond insurers also have hundreds of billions of dollars of guarantees written on municipal bonds, and a resolution of their mortgage troubles could help relieve uncertainty in the municipal arena.