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Merrill Lynch: Is It Taking the Right Steps?

The giant American investment bank is giving up on credit markets and diluting the interests of current shareholders. Is that the best course of action?

Ryan Lentell 30 July, 2008 | 4:55AM
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Merrill Lynch (link will open in a new window) announced a series of dramatic steps to put the stream of continuous quarterly write-downs behind it and allow its core earnings power to begin to shine through. However, the transactions may not be the most friendly for existing shareholders. Merrill is selling new shares at an extremely dilutive price and selling assets at significant discount to the price at which they were marked at the end of the second quarter. We expect to materially lower our fair value estimate. It appears Merrill has effectively given up waiting for the credit markets to stabilize and is punishing existing shareholders for mistakes of the previous manag

ement team. On a positive note, we believe Merrill retains significant earnings power in its private client group and investment bank, and these transactions help to ensure the firm's earnings will be the main story going forward.

Merrill is selling $30.6 billion gross notional value (equivalent to par value) of super senior collateralized debt obligations for $6.7 billion to an affiliate of Lone Star Funds. This is a significant discount to the $11.1 billion value these CDOs were marked to on its balance sheet only a few weeks ago, at the end of the second quarter; therefore, the transaction will produce a $4.4 billion loss in the third quarter. Merrill is providing financing to Lone Star to support the transaction. The sale appears to be in contrast to the strategy voiced on the second-quarter conference call only a week and a half ago, when management indicated it did not want to liquidate assets at just any price.

Merrill also announced it is working to terminate its hedges with monoline financial guarantors. In total, Merrill believes the termination of these hedges could produce another $1.3 billion of losses in the third quarter. Merrill announced it executed an agreement with XL Capital XL in which Merrill will receive a $500 million cash payment for the termination of hedges valued at about $1 billion on Merrill's balance sheet. Merrill is essentially taking guaranteed cash payments up front to eliminate the risk that it may not be able to collect from the guarantors if they become insolvent. It appears the firm is essentially throwing in the towel on these hedges too. If the sale price of Merrill's CDOs to Lone Star is indicative of the value of these securities, and if the monolines were able to pay out the majority of what was owed on the hedges over time (a big if), Merrill might have been better off maintaining the agreements with the monolines.

Finally, Merrill is planning to raise $6 billion of fresh capital in order to offset the expected losses. The firm is selling $8.5 billion of common stock but will be required to pay Temasek Holdings $2.5 billion because of a price reset agreement included in Temasek's previous capital infusion. Temasek has agreed to invest the entire $2.5 billion and another $900 million in equity in Merrill's planned common stock offering.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ryan Lentell  Ryan Lentell is a stock analyst with Morningstar.

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