How bad were the terms of the capital-raising transactions Merrill (MER) announced yesterday? Awful. The firm will be stronger after the deals than before, but the price and terms at which the firm unloaded $30.6 billion of CDOs should strike fear in the hearts of financial-services investors everywhere.
First, there was the sale of $30.6 billion of toxic crap for 22 cents on the dollar ($6.7 billion). Merrill had already written this down to $11.1 billion, so that’s only another $4.4 billion loss, but it comes only 10 days after the firm said it had written everything on the balance sheet down to “market.” It also comes about six months after Merrill CEO John Thain said the firm had written the value of its CDOs down so far that it was essentially carrying them at nothing.
Implication: The CDOs on other financial services firm’s books (Lehman, et al) are almost certainly worth far less than their carrying value. Which means more sales and capital raises to go.
Second, Merrill is lending the buyer of the CDOs 75% of the money to buy them, and the only collateral for the loan is the CDOs. This means that although the CDOs are off the firm’s balance sheet, it still has 75% of its original exposure to them. So that’s another $5 billion the firm could still lose.
Implication: Even at 22 cents on the dollar, you have to pay people to cart this stuff away. And you still own it while it rots in the junkyard.
(Here’s another way of thinking about this transaction. Imagine you have a house you want to unload that was once worth $100,000. The highest bidder you can find is only willing pay $22,000, and then only if you lend him $16,500 of this (he’ll borrow the rest somewhere else). The buyer doesn’t want to risk his own skin, however, so your loan is only backed up by the value of the house, which could still go to zero.)
Third, there is the horrifically dilutive equity deal. Eighteen months ago, Merrill’s stock was close to $100. Three months ago, it was at $50. Merrill will sell this equity at about $25. That will leave existing shareholders (including me) owning about 75% of the firm.
Merrill has now taken $46 billion of writedowns (and counting). It has sold a stake of Bloomberg worth $4.4 billion. And it has been forced to sell about a third of itself at firesale prices. That was some expensive mortgage gambling the firm did a couple of years ago.