Merrill Makes Latest Mortgage Purging Attempt

So much for an April promise not to tap equity markets for more capital; Merrill Lynch CEO John Thain said then that the company “had plenty of capital going forward.” He must have meant until the end of July — on Monday evening, Merrill Lynch & Co. (MER) said it was heading back to the spigot for more capital, while also making the boldest attempt yet to purge itself of the toxic mortgage-related securities that have weighed so consistently on earnings for the past four quarters. Medicine for what ails? The Wall Street firm said it agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion, or 22 cents on the dollar. At the end of the second quarter of 2008, these CDOs were carried on Merrill’s books at $11.1 billion, suggesting that not only were existing write-downs not enough, but — much more ominously — that others still holding similar securities might now be forced to further mark down their own assets in a market already flooded with bad assets. “The sale of the substantial majority of our CDO positions represents a significant milestone in our risk reduction efforts,” said Thain in a press statement. The firm will take a $4.4 billion pre-tax hit in third quarter earnings tied to the sale, and will reduce its $19.9 billion super senior ABS CDO exposure at the end of Q2 to $8.8 billion, he said. But the sale wasn’t the only move made by Merrill to save its own hide — the financial giant also received $500 million to commute guarantees it bought from troubled bond insurer Security Capital Assurance (SCA), and said it would issue new common shares in a $8.5 billion public offering. Nobody said purging toxins was going to be easy, did they? Less bitter of a pill to swallow Any stock sale by Merrill was supposed to come with some bitter provisions tied to existing shareholders, designed to protect existing investors from future dilution — which will take place now, regardless. And investors largely capitulated on the issue, too, suggesting either their support for Merrill’s effort to purge or simple resignation in the face of a rising tide of losses. For one thing, Merrill said it will absorb a $2.5 billion reset payment to Temasek Holdings tied to provisions in the firm’s previous sale of securities; but Temasek, which invests on behalf of Singapore’s government, will invest all of the proceeds into Merrill’s latest stock offering. For another, investors owning $5.4 billion of the $6.6 billion of the firm’s outstanding convertible preferred shares agreed to exchange their stakes for roughly 195 million shares of common stock, plus accrued dividends. Another investor, who owns the remaining $1.2 billion, agreed to exchange their stake for new mandatory convertible preferred securities with a reference price of $33 per share. The additional dividends tied to the exchanges will cost Merrill another $2.4 billion, it said. Merrill has already raised more than $10 billion since the credit crisis began to cover credit costs tied to its ill-fated bet on residential mortgages and related derivative investments; it will nearly double that total with a stock offering that could reach as high as $9.8 billion, including the underwriters’ option. For Merrill, it’s a bold attempt to recapitalize, while simultaneously purging a good amount of the assets that have led to losses in the past few quarters. That said, the Wall Street firm held total exposure to U.S. mortgages of roughly $43.7 billion at the end of the second quarter, which stands distinct from any CDO holdings at the company. Shares in Merrill were at $24.24 in pre-market trading Tuesday morning, down .37 percent, when this story was published. Disclosure: The author held no positions in MER or other companies mentioned when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.