Merrill Lynch Not Out of the Woods Yet

Merrill Lynch has taken drastic steps to rescue its ailing balance sheet – most notably, a fire sale of $30 billion of risky debts to Lonestar. Merrill also revealed another $6 billion of mortgage write-downs this quarter, right after last week’s report of a $5 billion loss. That is already $40-billion of write-downs, and we are still counting.

Fresh capital (about $9 billion ) is urgently sought to combat the escalating credit crisis and depreciating mortgage assets. And Temasek Holdings committed US$3.4b in the public offering… I do not know whether to laugh or cry over this matter.

Temasek managed to average down its investments, that is a positive, but when we are staring down the abyss at Merrill, it sounds more like a “throwing good money after bad” misadventure.

So far, more than US$15.3 billion in captial had been raised but Merrill is still hungry for more. Plans to dispose its crown jewels like Bloomberg, Financial Data Services and Blackrock are in the pipeline.

I hope Temasek considered all the risks because the devil is in the details of this fire sale. We know Lonestar purchased the $30b toxic assets for $6.7b (a steep discount discount of 22 cents on the dollar) but it is not a straightforward sale.

According to Merrill’s press release:

“They will provide financing to the purchaser (Lonestar) for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.”

Isn’t this creative accounting reminiscent of Enron? On paper, the $30.6 billion dollars of bad debts is moved off Merrill’s books and their CDO exposure reduces from $19.9b to $8.8b. However, Merrill is providing 75% of the 22 cents on the dollar, meaning Lonestar only has risks of slightly more than 5 cents.

And Merrill admitted that Lonestar has no other collateral which implies that the only recourse for the investment bank, in the event of default, is to repossess the CDOs from Lonestar.

Assuming favorable market conditions, Lonestar enjoys sky-high profits, but if the housing market deteriorates further, then wish good luck to Merrill.

This skewed transaction is merely window-dressing as Merrill (and indirectly, Temasek) bears virtually all the liability. I believe Merrill’s hands are tied as nobody wants to touch these CDOs and such desperate acts seem to be the only way to whittle down the exposure.

The monstrosity of write-downs is just beginning to unravel; with Merrill Lynch setting the example, other investment banks are now emboldened to report on their losses. Most of them may not have as much exposure to CDOs, except for Citigroup, which could “outdo” Merrill with a quarterly write-down of more than $8-billion.

Merrill Lynch is not out of the woods yet and so are the rest of the Wall Street giants. Even if you have spare cash to invest, it is better to wait on the sidelines before making any investment.

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