For the time being I want to share with you a write up by HCM on Merrill Lynch deal to sell some of its assets. I am in disbelief that investors are still bidding their stock up or still holding a position in this company.
Merrill Lynch & Co. Inc.'s decision to dump $30.6 billion of mortgage securities at an average price of $0.22 on the dollar barely a week after its quarterly earnings announcement (which itself included a $10 billion write-down on such securities!) raises more questions than answers about the firm and the prospects for credit markets to recover from their current crisis. Merrill Lynch agreed to sell these securities to Lone Star Funds for $6.2 billion, yet barely two weeks earlier the sale the firm had valued those identical securities at $11.1 billion. Moreover, the sale is structured in such a way that Merrill Lynch is financing 75 percent of the transaction. This means that Lone Star is on the hook for the first $1.7 billion of losses, and then Merrill Lynch will eat any losses beyond that. In other words, another $0.05 drop in the value of these securities would leave Merrill Lynch back on the hook for more losses. Either this will prove to be one of the most desperate transactions done in the annals of the current credit crisis, or John Thain knows something the rest of us don't want to know about the real value of the toxic waste he just sold to Lone Star. At the same time, Mother Merrill announced the sale of 380 milion new shares of stock to raise $8.5 billion in new equity capital. The issuance of additional shares at current prices triggered a make-whole provision in an earlier share sale to Singapore's state investment agency, Temasek that cost Merrill Lynch $2.5 billion. Temasek, the firm's largest shareholder, turned around and reinvested this $2.5 billion in Merrill's new share offering along with an addition $900 million. These announcements not only left Merrill Lynch shareholders severely diluted but, if they had been paying attention to the quarterly earnings call, deluded.
This transaction may constitute one of the oddest corporate announcements in recent memory.6 First, it suggests that Merrill Lynch's quarterly earnings announcement was grossly inaccurate since, with respect to these assets alone, the firm's valuation was apparently off by a factor of 40 percent. Second, it raises serious questions about the values all financial firms are placing on their mortgage securities. Either Merrill is alone in mis-marking its book by 40 percent, or other firms are grossly over-valuing their holdings and will be forced to report large write-offs in the third quarter. What is particularly troubling (but gives the anti-quantitative HCM a wonderful dose of schadenfreude) is the enormous gap in valuations that different firms (i.e. Lone Star and Merrill Lynch) can apparently derive from securities that are allegedly valued according to mathematical models whose precision is such that they would have problems hitting the side of a barn.
And naturally Merrill Lynch's announcement, which included a highly dilutive share sale to compensate for the multi-billion capital loss suffered by the firm, led to a rally in the firm's stock price. Let us get this straight - the firm admits that it grossly mis-marked its book, reports a(nother) multi-billion dollar loss, announces a hugely dilutive stock offering, and the stock rallies? Makes perfect sense to us. And people wonder how and why the financial markets continually fall into crisis!