Merrill Lynch (NYSE: MER ) reported today that their Level III assets - those that are the hardest to value - jumped to $68.9 billion from $41.4 billion reported at the end of 2007. An increase of this magnitude signals that the end of the financial crisis may not be as near as many have thought. Level III assets, by definition, cannot be valued based on the market because there is no market to peg them to. Instead, Level III assets are valued based on the asset owners' own judgment. In other words, Level III assets are not marked-to-market, they're marked-to-whatever the company feels like marking them to. This term has been dubbed "mark-to-myth" because in the end, it's simply a guess. We can derive, however, that Merrill will mark these assets higher than their actual value, because there is incentive to do so. Strong disincentives exist for marking them lower than their actual value, including credit downgrades, shareholder anger, and stock price punishment. Just look at what happened to Bear Stearns when trust in them was lost. Merrill is now marking more of their assets Level III, from the Level II, or even Level I, asset pools. If Merrill feels the need to do this, there must be a good reason. The only reason I can think of is that they don't like the actual market values that must be used on Level I and Level II assets, and would rather just make up the value of their assets. If the credit markets return to normal, this might be a solid play to regain investor confidence. If the markets don't return to normal in the next few quarters, Merrill shareholders will be in for a big surprise when their Level III books are accurately valued. This is not just a Merrill problem, this is an investment bank problem. Goldman Sachs, Morgan Stanley, and Lehman Brothers all face similar issues. In fact, Merrill is one of the strongest with regards to Level III assets compared to their tangible equity capital of $78 billion, coming in at around 90%. The others are all above 200%. But this does leave one pondering if Merill will continue to move assets to its Level III portfolio at such a rapid pace. At the beginning of today, their Level III assets comprised of 53% and with today's announcement it's up to 90%. A few more of these and it'll be well over the 200% mark that seems to be the norm in the industry.
Citing "deteriorating conditions in the mortgage market" and the potential for another $6 billion in write-downs, Moody’s Investors Service said it may cut Merrill’s credit rating, which would be the second time in six months. In October, Merrill’s rating was lowered one level to A1, the fifth highest of 10 investment ratings.
Over the first quarter, the company recorded more than $9.5 billion in write-downs and losses on subprime mortgages and other risky assets. It also posted $2.9 billion in net revenues (a 69% drop) and $805 million in investment-banking fees (a 40% drop) in "this challenging market environment, which continued to deteriorate during the quarter," according to the company’s earnings release. The third-largest U.S. securities firm lost $1.96 billion, or $2.19 a share, compared to a $2.16 billion gain, or $2.26 a share, a year earlier.
Merrill Lynch took a beating for the third quarter 2007 as it posted the biggest subprime related write-down on Wall Street. The $8.4 billion write-down of Collateralized Debt Obligations led Merrill to post a $2.3 billion loss and resulted in the ousting of its Chairman and CEO Stan O’Neal. As of the third quarter 2007, Merrill still faces an exposure to $20.9 billion in subprime mortgages and Collateralized Debt Obligations
It is really bad isn’t it? Even as we are being told that all is okay on Wall Street, the banks and brokers are so full of disease it can easily be compared to necrotizing fasciitis. You know, that awful flesh eating disease.
The latest shenanigans by Merrill Lynch (MER) are almost too much to Bear (pun intended) and now we are going to surely continue with a crisis of confidence as it seems impossible for this group to allow the truth to come out when it speaks. Now Merrill is in a jam and it is trying everything to make it seem that all is just fine.
Bill Fleckstein had a few observations on this that just cannot be ignored:
So the question is: What changed in the past couple of weeks to cause a CDO — a package of loans known as a collateralized debt obligation — valued at 36 cents on the dollar to be “sold” last week at 22 cents? What did Thain know about this at the last conference call, and why was it not made clear to folks?
Of course, this is more a consignment sale than a true sale. Merrill is providing 75% financing on a non-recourse basis. That means it’s really receiving about 5 cents on the dollar. It may get the other 17 cents later, or it may get the securities back. In essence, Merrill wrote a put option “down 5 cents on the dollar” and gets a call option to get the other 17 cents.
Essentially, Merrill is putting up the funds to sell of the assets. Does that mean that the super-senior-debt they put up was sold for almost nothing? Why the payoff? What did Lone Star, Temasek or others have on them or even better, why did they unload the debt and lose the potential upside? Are they out of options?
The ugly factor is at an all time high. If Merrill goes down, it will not be because it was murdered, it will be because it kicked the chair out and hung itself.
Shrinking by selling its " crown Jewels " - can not build a great future or postpone more write downs.
As rumoured through the media, Merrill has agreed to sell its 20% stake in
private news and data provider Bloomberg for an expected $4.5 billion. Bloomberg is the buyer after having sold the stake to it
Merrill was previously believed to be selling its 49% interest in BlackRock but is now said to not be. It is a part of core
operations and would be akin to selling its soul when this messy market finally turns around. Their share of BlackRock is said to be worth $10 billion.
Sanford Bernstein analyst Brad Hintz on Thursday told TheStreet.com that " it would not be unexpected" to see "hedging breakdowns" at Merrill, much as occurred with Lehman. Additionally, Hintz says Merrill has limited options as far as raising new capital goes.
"Remember, Thain has nailed his flag to the mast as far as saying they're not going to raise any more common stock," Hintz says.
Additionally, Hintz points out that Merrill's agreements with sovereign wealth funds that have invested in it preclude it from issuing new equity without giving those funds more equity to prevent their holding being diluted.
Lehman Brothers analyst Roger Freeman, who had been calling for a loss of 53 cents per share, is now estimating losses will be $2.99 a share. Citing a "deeper review of Merrill's monoline exposures," he increased his writedown estimate from $3 billion and lowered his price target to $44 from $47.
CNBC, citing sources close to the firm, reported Friday afternoon that Merrill is in preliminary discussions about selling its passive minority stake in Bloomberg.
Lehman joins Goldman Sachs and Sanford Bernstein in ratcheting up its pessimism. Analysts at those firms lowered their estimates for Merrill on Thursday.
Merrill is set to report results July 17, making it the last of the big four U.S. brokers to do so.
Merrill's Lynch's growth has been largely driven by acquisitions and joint ventures over the last 5 years. There is some concern that Merrill may be significantly overpaying for some of its most recent acquisitions. It paid a 40% premium for First Republic for instance. In the near term the M&A environment will make finding affordable acquisitions extremely difficult.
Though inorganic growth such as acquisitions is a key part of Merrill's overall growth strategy and could potentially open many new doors for the firm, Merrill's been making some less-than-stellar choices about which companies to acquire and when to acquire them. The acquisition of subprime lender First Franklin in late 2006 came at the worst possible time: just before the collapse of the subprime mortgage market. Merrill paid $1.3 billion for Franklin just before the bottom fell out; this was obviously a significant misstep. A few months later, Merrill bought First Republic for $1.8 billion, its largest acquisition in 10 years. First Republic, thankfully, isn't a subprime lender, but a private bank aimed at ultra-high-new-worth individuals. And these are just the two largest of Merrill's recent acquisitions. These weren't necessarily bad investments; Merrill simply overpaid. Depending on who's discussing the First Franklin acquisition, the amount Merrill overpaid can run as high as $600 million (nearly half of the $1.3 billion it shelled out), while it bought First Republic at a 40% premium over the per-share price. Within two quarters, the combined overpayment for these two acquisitions alone totaled anywhere from $500 million to $1 billion. While it's true that Merrill is a large firm with the resources to afford these types of acquisitions, a few hundred million in lost profit is hardly trivial.