Thain takes the pain

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Jul 31st 2008 | NEW YORK
From The Economist print edition

An unexpected fire-sale could mark a turning-point


“I GREW up in a relatively small town in the Midwest, and I am a very straightforward kind of person,” John Thain told a group of Merrill Lynch bond traders last December, not long after taking over as chief executive. The struggling investment bank’s shareholders may beg to differ. On July 17th, after Merrill announced its fourth quarterly loss in a row and the sale of its cherished stake in Bloomberg, a financial-information firm, Mr Thain said he believed the bank was in a “very comfortable spot” in terms of capital. Eleven days later Merrill unveiled another whopping write-down of mortgage-linked assets and further steps to shore up its finances with an $8.5 billion share offering.

Merrill’s news doubtless helped confirm the Federal Reserve in its decision, announced on July 30th, to extend its emergency lending facility for Wall Street firms until January (it also lengthened loan periods for commercial banks). But amid the red ink and the flip-flopping, there is also a hint of hope. The write-down stems mainly from a deal to sell collateralised-debt obligations (CDOs) with a face value of $30.6 billion to Lone Star, a vulture investor with a track record of buying distressed financial assets (see article), for a mere 22 cents on the dollar. A market-clearing price may finally be being established for the most toxic assets on banks’ books, albeit at a very low level. And after several false dawns (see chart) Merrill may be able to start looking past its immediate woes.

In another hopeful sign, the bank also said it had settled a dispute with XL Capital over CDO hedges it had taken out with the troubled bond insurer. In return for cancelling $3.7 billion-worth of policies it wrote but was having difficulty honouring, XL will pay Merrill $500m. This could prove a template for other banks that have become entangled with “monoline” guarantors.

If the CDO sale is Merrill’s long-hoped-for “kitchen sink” moment, it comes at a cost. The bank was able to complete the sale only by agreeing to finance 75% of the purchase price. And by raising more capital—bringing the total since December to more than $30 billion—it triggered a “reset provision” that requires it to pay $2.5 billion to Temasek, a Singaporean fund that invested in an earlier offering at a higher price (and is ploughing $3.4 billion into this one). That bodes ill for others, such as Washington Mutual, that agreed to similar terms and may need to raise more capital.

With Merrill’s net exposure to CDOs now down to $1.6 billion (the rest is hedged with “highly rated”, non-monoline counterparties), the worst of the pain is surely over—especially since most of the securities that remain date from 2005 and earlier, before underwriting became really sloppy. It has also halved to $7 billion its exposure to leveraged loans. The question now is whether the bank has enough profit-making oomph in other areas to return to full health. Its big wealth-management business is still doing well, and its international operations are growing. But the combination of a sickly share price and a purged balance-sheet may make it a tempting takeover target.

Because it sets a new benchmark for duff assets, the Lone Star deal has sent ripples through the banking industry. An Australian lender that co-invested with Merrill has reportedly already had to slash the value of its CDOs to ten cents on the dollar, because it held lower-rated tranches.

All eyes will now be on Citigroup and UBS, which vied with Merrill for top spot in the CDO league tables during the boom. UBS’s holdings are valued at between 30 and 40 cents on the dollar. Citi’s exposure of $18 billion is marked higher, at an average of 45 cents. Mike Mayo, an analyst at Deutsche Bank, thinks it could face a further $7 billion hit. Not all securitised assets are the same, of course, and Citi argues that its CDO holdings are less noxious, and of an older vintage, than the stuff Lone Star picked up from Merrill. Still, in this era of fair-value accounting, securities are only worth what someone is willing to pay for them. And, as Merrill’s bullet-biting deal shows, that seems to be very little.