Monday, August 4, 2008

The Merrill Defense

The New York Times is out with an article entitled "Merrill's Chief Defends Recent Sale" which discusses Merrill CEO John Thain's reasons behind Merrill's recent CDO sale to Lone Star. According to the article:

A week after he stunned Wall Street by selling billions of dollars of toxic mortgage investments for pennies on the dollar, Mr. Thain defended his decision on Monday, saying he needed to take decisive action to shore up the Wall Street giant and morale among its employees.

“We have over 60,000 people working every day,” Mr. Thain said in an interview after eight tumultuous months as chief executive of Merrill. “All the efforts of these people were overwhelmed by the write-downs in the mortgage-related assets.”

Employee morale? That's touching, but it's a bit anticlimactic. This is an investment bank. I was expecting to hear something about maximizing shareholder value or improving risk-adjusted returns. If he wanted to boost employee morale he could have offered chair massages, personalized "We're #1" paperweights, or more stock options. Well, he could have offered the paperweights or massages.

The article adds:

At the end of Merrill’s whirlwind month, investors are still questioning its C.D.O. sale. Not only did Merrill sell $31 billion at a fire-sale price of $6.7 billion, but it also lent $5 billion to the buyer, Lone Star, a private equity firm in Dallas.

“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.

Let's take a closer looks at the deal. Merrill lent $5 billion of the $6.7 billion price tag, and that $5 billion loan is only secured by the CDOs that were "sold." Merrill is protected from the first $1.7 billion of losses on the securities, but they are still on the hook for that $5 billion loan. If Thain really thinks there's "very little chance that we ever get these CDOs back" then he must believe that no more than $1.7 billion of the securities will default. For the deal to also make sense for Merrill, Thain must believe that the CDOs will not be worth more than the $6.7 billion (I'm simplifying) sale price, otherwise he's leaving money on the table.

Lone Star basically wins if the net effect of any future defaults, any future appreciation, the interest expense on the $5 billion loan, and the income from the securities provides an adequate return on the $1.7 billion of equity at risk. But,
even if Lone Star doesn't default on this loan, Merrill will have taken a loss of 78% on these CDOs. That oughta boost morale.

Here's my favorite part of the article:
A broker in California said it just seemed to be more of the same. Customers, he said, still complain to him that “Merrill Lynch can’t control its money — why should I give you mine?”

Great question! I just can't believe that there are still any customers there to ask it. These Wall Street financial titans want to manage money, raise capital for firms, advise businesses on mergers and acquisitions, and use shareholder money for proprietary trading, but they thought it was a good idea to lend billions of dollars to people with bad credit, no money, and no verified income to buy assets at inflated prices with no equity. You can't make this stuff up.

Disclosure: The Rubbernecker is long chair massages and short investment bank CEOs.