Merrill Moves To Cut Risk, But Pays a Hefty Price

Merrill Lynch took steps to limit their future risk, but it is doing so at a cost, analysts said.

Merrill Lynch
Merrill Lynch

Merrill Lynch shares fell after the bank announced plans to raise capital to offset losses from selling $30 billion of repackaged debt at a deep discount.

Merrill sold $8.55 billion of common shares at $22.50 apiece, or about 7.5 percent below Monday's closing share price of $24.33.

The sales consisted of 380 million shares with an over-allotment option for an additional 57 million shares.

The capital raised came as Merrill said it would take a $5.7 billion third-quarter writedown.

This news comes less than two weeks after it posted a $4.9 billion second-quarter loss, which was hit by $9 billion of writedowns in that period.

"You've done more damage to the balance sheet, you've diluted shareholders, and what happens during these times is they're so inwardly focused, so how can they focus on building their business profitably?" said Ralph Cole, portfolio manager at Ferguson Wellman Capital Management in Portland, Oregon, which does not own Merrill shares.

In a sign of how toxic Merrill's debt holdings have become, it has agreed to sell $30.6 billion of collateralized debt obligations (CDOs), a kind of repackaged debt, to an affiliate of private equity fund Lone Star Funds, for just $6.7 billion, or about 22 cents on the dollar.

The fire sale nature of that deal will add to concerns that the global credit crisis, which has already led to more than $400 billion of write-downs and losses at major banks, still has a long way to run.

"What is happening to Merrill and others is death by a thousand cuts. It's painful to see it happen over and over again," said Daniel Alpert, managing director at investment bank Westwood Capital.

Analysts Widen Estimated Losses

Several analysts, including Oppenheimer's Meredith Whitney, widened their loss view on Merrill Lynch following the company's announcement.

Whitney, who "applauded" Merrill's efforts to cut its losses, said, "we believe the stock is getting closer to fairly valued levels as now the hardest work is behind the company." Whitney sees a 2008 loss of $10.50 a share for Merrill, up from her prior loss view of $8.37.

Merrill shares were recently trading down 2.4 percent, or 59 cents, at $23.74.

Commenting on Merrill's plans, UBS, Banc of America and Credit Suisse said though Merrill's risk exposure has reduced significantly, the company has had to pay a price for it.

Widening its loss view by 80 percent, Credit Suisse said, "Merrill has now substantially reduced its ABS CDO exposure. But the exit was expensive, coming at a price below marks."

The company has lost $19.2 billion in the past year and suffered more than $40 billion of write-downs. Its shares have lost half their value since January.

Citigroup, which increased its loss view by $1.29, said it expects the sale of highly illiquid mortgage related assets to be a catalyst to refocus on the earnings power of the Merrill franchise.

Analysts on average see 2008 loss in the range of $5.47 to $12.70, the biggest loss being forecast by Credit Suisse.

Merrill's stock sale includes a $3.4 billion purchase by Singapore's state-run Temasek Holdings, and may grow to $9.8 billion. Management also plans to buy 750,000 shares, it said.

Raises Questions About Thain

Monday's writedown and plans to raise capital may raise further questions about the ability of John Thain, who only became Merrill's CEO in December following the ouster of Stanley O'Neal, to turn around the firm.

"Are things that much worse than we were led to believe?" said James Ellman, president of Seacliff Capital in San Francisco. "If people were going to believe Thain when he said Merrill raised more capital than it needed to and had taken conservative marks on its securities book, I'm not sure they're going to believe him tomorrow morning."

On a July 17 conference call, Thain said: "Right now we believe we are in a very comfortable spot in terms of our capital." He has made a series of similar comments over the past seven months.

The most recent round of capital raising was particularly bruising because of provisions Merrill agreed to when it raised money in December and January. Essentially, the investment bank said it would give the investors in those raisings extra compensation if it later issued equity at a lower price.

That meant that in this offering, more than half the shares or share proceeds will go to prior investors, with $2.5 billion paid to compensate Temasek, and another $2.4 billion paid as additional dividends to investors in convertible securities.

Temasek agreed to invest the $2.5 billion in the new offering, as a large part of its purchase of $3.4 billion of common stock in this deal.

Prior Sales

The Lone Star deal will result in a $4.4 billion write-down for Merrill and it will finance about 75 percent of the purchase price, Merrill said.

Merrill also said it agreed to help bail out bond insurer Security Capital Assurance by agreeing to accept a $500 million cash payment in
exchange for canceling some credit default swaps and ending related litigation.

Merrill said the settlement, together with the potential settlement of other CDO hedges, will result in a $1.3 billion write-down.

Earlier this month, Merrill completed the sale of its 20 percent stake in Bloomberg to the news and financial data company for $4.43 billion. Merrill also said then it was in talks to sell a controlling interest in a unit that provides services to mutual funds, in a deal that values the entire unit at $3.5 billion.