Rethinking Merrill's Purge Cycle
Maybe the good news on Merrill Lynch & Co. (MER) yesterday wasn't really all that good, after all. That's the consensus that seems to be creeping into the Street's collective psyche Wednesday morning, as analysts scrutinize the details of the deal to sell $30.6 billion in gross notational amount of ABS CDOs to an affiliate of Lone Star Funds. Merrill suggested in its press statement that it sold the securities for roughly 22 cents on the dollar, a figure that major financial press immediately hooked onto as establishing a price point in the battered secondary market. That figure, however, has quickly come under fire, as details of the sale have been digested by market participants. In particular, the fact that 75 percent of the deal is financed by Merrill itself -- meaning Merrill only received $1.7 billion in cash for the deal -- had more than a few market pundits, including the Financial Times' Lex, suggesting that the implied sale price was actually much lower. "In putting up three-quarters of Lone Star’s funding, secured only on the assets it is shedding, Merrill gets about $1.7bn in cash, and effectively swaps $5bn of direct exposure to CDOs for credit exposure to the buyer," according to the Lex column. "A fall of 25 per cent could see this risk return to Merrill, hardly a comfort when the assets have apparently dropped 40 per cent since the end of June." For the record, a 25 percent drop translates into a drop of just another 5 cents or so. Analysts at Bank of America reversed course Wednesday morning after calling the deal "the endgame" for CDO risk on Tuesday; Bloomberg News reported that the same BofA analysts said they had originally "overstated the positive implications" of the CDO deal. "Merrill must be hurting worse than we thought," one analyst told HW via email yesterday afternoon. Citi's woes, speculation grows All of the analysis over Merrill's deal is proving to be rather problematic for firms like Citigroup Inc. (C), which holds a lot of these sort of securities -- none of which are really marked anywhere close to the implied value here of 5.5 cents. Or even 22 cents, for that matter. Mike Mayo, an analyst at Deutche Bank, was among the first to sharpen his pencil and said Tuesday that Citigroup could face a write-down of $8 billion on its ABS CDO portfolio, cutting his earnings estimates for the bank, as a result. Mayo suggested that Citigroup has its CDOs valued at 53 cents on the dollar in his report. William Tanona at Goldman Sachs & Co. (GS) went even further, suggesting a $16 billion write-down. Rating agency DBRS downgraded long-term ratings for Merrill, suggesting that the deal limited Merrill's future prospects for capital. "While successful in lowering the company’s risk profile, this combination of actions continues to draw down the company’s potential resources," the agency said in a press statement. And, of course, there's the not-so-little issue of Merrill CEO John Thain's credibility on Wall Street and among investors -- or, more appropriately, what's left of it. The fact that Thain had so recently said fresh capital wouldn't be needed, and that the company recently reported earnings on July 17 without so much as a peep about the asset sale or its terms, left more than a few market commentators and HW sources either scratching their heads, or incensed. "Existing shareholders have been diluted 38 percent by this," said one source, who asked not to be named. "And that's after Thain swore up and down no more capital would be needed." There are those that have said the market's malaise is as much about investor sentiment as it is about market fundamentals. If true, it's clear that Merrill Lynch did little yesterday to clear up the picture on either front. Disclosure: The author held no positions in MER, C, or GS when this story was published; other indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.