Lancing the Boil at Merrill

We are coming up on the one-year anniversary of the credit crisis and despite the time that has elapsed, there is a sense that many financial institutions still are not sure exactly what the stuff on their balance sheets is worth. Evidently the pain has become more than Merrill Lynch can take, because this week, the firm announced that it would sell mortgage-backed securities with a face value of $30.6 billion in an effort to “lance the boil” once and for all, according to a person close to the matter.

The fire sale of the securities amounts to a haircut of 78 cents on the dollar, as the buyer, Texas private equity firm Lone Star, will pay $6.7 billion for the assets that Merrill had valued at $11.1 billion as of June 30. According the Financial Times, Merrill is actually providing the financing to Lone Star for 3/4 of the purchase, which means that “in effect, the money Lone Star is putting up itself to take the portfolio off Merrill’s books equates to just over five cents on the dollar of the gross value.” That kind of deal makes you wish you were an investor in Lone Star, not Merrill. The sale is in addition to the $46 billion that Merrill has already swallowed since last summer, giving pause to the notion that “the worst is behind us.”

To help shore up its balance sheet, Merrill also announced that it would sell $8.5 billion in new stock, in addition to the $15 billion it has already raised through common and preferred various common and preferred issues. This week’s move is even more painful for existing shareholders, because their positions will be diluted by approximately 38%. The new stock issuance will also require the firm to make additional payments to Temasek, the Singapore state-owned investment company that bought shares at a much higher price last December.

The problems at Merrill are endemic to many large investment banks. The greed of the last cycle allowed them to dive into ventures without properly assessing the risks involved. Just like the schmo who bought his Florida condo at the top of the market with an adjustable-rate loan, Merrill is now paying for its mishaps in spades. Of course one major difference is that investment bankers were supposed to smarter, more experienced and better prepared than the average schmo who dipped his toe in the real estate market. Merrill’s newly-minted chief, John Thain, continues to distance himself from the problems, but everyone should be asking why the firm did not make this announcement last week when it reported its fourth straight quarter loss.

These actions may lead the way for other financial institutions to purge their problems by slashing the value of similar holdings, although other firms may not have the wherewithal to withstand the process. On one hand, the past year has proved is that the credit and mortgage issues were far more toxic than most observers originally anticipated. But it is amazing that a company can write down billions and still be viable. Sure the stock has been spanked—it closed at decade-low levels this week, as it should, after this kind of dismal performance. Maybe lancing the boil at Merrill will allow the firm to move on, once and for all. Time will only tell.