Merrill Lynch latest victim of mortgage meltdown

One of the world’s biggest investment banks, Merrill Lynch, said it was writing off almost six-billion dollars in bad debts associated with the US mortgage meltdown.

It’s also sought a new injection of capital to prop up its ailing balance sheet.

Presenter: Michael Rowland

Speakers: Jim Awad, The Chairman Of WP Stewart Asset Management; Michael Nix Of Greenwood Capital

MICHAEL ROWLAND: Under mounting pressure from the imploding mortgage market Merrill Lynch has been forced into a spectacular corporate fire sale. The bank has unloaded more than $30-billion of risky debt at a very deep discount. In fact the buyers of the tainted loans are getting for them for just 22 cents on the dollar.

Such is the desperation of one of the world’s biggest banks to get its house in order ahead of what could be an extended period of financial market instability. Merrill Lynch has also revealed it expects to make another $6-billion in mortgage-related write-downs in the current financial quarter.

It will take to more than $40-billion the bank’s total write-downs over the last year. Jim Awad, the chairman of WP Stewart Asset Management, is among those stunned by the move.

JIM AWAD: Now what it says is that this thing is worse than most people expect, that we have further to go, that there’s more work to do and that we don’t know the bottom yet. And that’s affecting confidence in the financials and its impact on the economy and the ability of the financial system to operate efficiently.

MICHAEL ROWLAND: Attention is already turning to the other big investment banks. Some analysts expect financial colossus Citigroup to post quarterly write-downs of more than $8-billion. Michael Nix of Greenwood Capital says more bad news from the Wall Street giants is inevitable.

MICHAEL NIX: I don’t think that we’ve seen the end of the write-downs. Again I think with this news with Merrill Lynch there’s going to be a reassessment from a lot of financials going forward. And we can see from additional write-downs and some additional capital raises, unfortunately which really are needed when you’re writing down these assets.

MICHAEL ROWLAND: Fresh capital is something Merrill Lynch sorely needs and it’s got it in the form of a $9-billion cash injection, a large part of it from the Singapore Government-owned fund Temasek Holdings.

Just three months ago, Merrill’s chief executive John Thain was assuring investors the bank didn’t need any new capital. It’s now looking for all the help it can get to weather the credit crisis.

The average American homeowner isn’t so lucky. Just as Merrill Lynch was making market shock waves a closely watched index had us house prices plunging 16 per cent in May, that’s the steepest decline ever. No city in the Standard and Poor’s Case-Shiller survey experienced price gains.

While the figures are undeniably bleak, Mickey Levy, the chief economist at Bank of America believes the US housing market may be about to bottom.

MICKEY LEVY: I would say it’s painful but we’re making progress and widdling down the undesired inventories and we’ll eventually see the light at the end of the tunnel.

MICHAEL ROWLAND: But Mr Levy says this won’t be until next year at the earliest.

HEARD ON THE STREET

Merrill Bites Credit Bullet

Thain’s CDO Sale

Could Inspire Peers

To Join Bloodletting

By DAVID REILLY

July 30, 2008; Page C16

John Thain’s move to clear the decks at Merrill Lynch sends a message to other financial chiefs: Those losses you have been hoping will go away? Well, they are real.

Even though the financial crisis is about a year old, plenty of executives have resisted that notion. Losses sparked by the credit crunch, they rationalize, are a temporary aberration fed by the supposed excesses of marking assets to market prices. T

hat view has led many firms to dig themselves deeper into the proverbial hole by refusing to free their balance sheets by selling hard-hit assets at a loss. The result is that many will end up taking a worse hit when they finally try to repair the damage.

Now, Mr. Thain has injected some realism into the debate. While belated, the Merrill chief sold $30 billion of collateralized debt obligations -- among the most toxic of complex debt products -- for an average price of 22 cents on the dollar.

Merrill’s CDO pile had already been marked down to an average value of about 36 cents. But the asset sale didn’t just lower this price for balance-sheet purposes, it turned it into a real loss.

That is tough medicine. Lots of other financial firms need a dose.

Unfortunately for investors, it isn’t crystal clear just who should swallow hard. CDOs aren’t standardized products, and their values can differ based on a host of factors. That means investors can’t cut and paste Merrill’s prices into the values other institutions assign their CDOs.

Still, investors should question whether executives are basing valuations on realistic market prices, rather than a rosy "Trust us -- these will be money good" view.

Consider Citigroup. At the end of the second quarter, Citigroup had about $28 billion in gross CDO holdings, of which $9.8 billion was hedged.

A portion of the bank’s net holdings are valued in line with Merrill’s sale price. But the bulk -- about $14.4 billion -- are asset-backed commercial-paper CDOs valued at about 62 cents on the dollar.

Citigroup has defended this higher value. The bank says that it hasn’t suffered cash-flow losses on these holdings and that they are of better quality because they were mainly issued between 2003 and 2005.

Not all investors agree. In a report Tuesday, Morgan Stanley analyst Betsy Graseck argued that Citigroup may need to reduce their value by an additional 21%. While that may seem pessimistic, Merrill’s sale argues for a glass half-empty view.

A bigger question hangs over Bank of America. Of its about $11 billion in CDOs backed by subprime mortgages, $5.1 billion are CDOs made up of other CDOs. These so-called CDOs-squared are considered the most toxic of these products.

Yet Bank of America is valuing these CDOs-squared at about 35 cents on the dollar. That is well above the average 22 cents Merrill fetched for its high-grade and mezzanine holdings, considered less toxic. That makes no sense.

A spokesman said Bank of America doesn’t disclose intraquarter valuations of holdings. He added that values assigned to a type of CDO by one firm can’t simply be read across to holdings of another.

Other big banks also may need to reassess their CDO holdings in light of Merrill’s sale. In Europe, UBS, Royal Bank of Scotland and Barclays all have large exposures to CDOs, as well as to bond insurers, that may need to be re-examined.

Investors may also want to use Merrill’s acknowledgment that credit-crunch losses are real to ask tougher questions about values being assigned to commercial-real-estate holdings at firms such as Lehman Brothers Holdings and to the still-skimpy allowances for loan losses taken by many regional banks.

Of course, while giving Merrill and Mr. Thain their due, investors shouldn’t shower them with rose petals. He dithered for months before finally biting the bullet.

Also, the CDO sale didn’t actually remove all the risk from Merrill’s shoulders. By financing 75% of the $6.7 billion sale price, it could still be exposed to loss if the CDO values fall by an additional 25%. That would be extreme, but anything is possible these days. A Merrill spokeswoman declined to comment on terms of the financing.

That said, Merrill has taken its lumps and moved on. If enough financial firms do the same, moribund markets could awaken from their stupor.