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Merrill Lynch is mostly responsible for the damage done to its business and its balance sheet as the company continued to create mortgage backed security derivative vehicles even as the market for them was falling apart, says the Wall Street Journal quoting an unnamed source with inside knowledge.
Merrill Lynch is expected to report yet another multi-billion dollar quarterly loss in the next few days, and the overall subprime mortgage crisis related damage for the company could be as much as $30 billion by the time it's all said and done. In fact, The Wall Street Journal reports that Merrill is about to report its third straight quarterly loss, its worst quarterly losing streak ever.
And to make matters more difficult, he company, reportedly, is about to embark on a turn around plan that will include a 10-15% reduction of its work force, among other cost cutting and other tactical measures, said the Journal.
So how did Merrill get into such deep water? According to the Journal "Merrill aggressively continued to create new mortgage securities after doing so became riskier," a fact that is raising questions at the SEC, which wonders why "Merrill and other firms should have told investors sooner about the stumbling mortgage business last year."
In other words, as with Watergate and other "gates" the coverup is likely to be more incriminating than the act itself, although it would seem that both the act and any potential coverup in this case are likely to be legendary.
According to the Journal's report, three key steps led Merrill to its current situation:
1. "When housing boomed earlier this decade, Merrill profited by turning mortgage-backed bonds into complex securities. Initially, it was well protected from credit risk in this underwriting. The protection frayed at the start of 2006. But Merrill kept playing the game."
2. "By early 2007, as cracks in the housing and mortgage markets widened, Merrill again missed a chance to scale back. In fact, it revved up its production of complex debt securities -- despite a shortage of buyers for them -- in what turned out to be a misguided effort to limit its losses."
3. " Its torrid underwriting loaded Merrill with exposure to mortgage securities, whose top credit rating provided scant protection when investors fled. Then Merrill made another fateful move: trying to hedge some of its massive mortgage risk through bond insurers whose strength was questionable."
To be sure, new Merrill CEO John Thain seems to be taking steps to improve the company's fortunes, but as the Journal notes, the firm is still highly leveraged with a 31.9 to 1 asset to equity ratio. That means that Merrill has 31.9 times the number of obligations compared to its equity, which is as if a homeowner held nearly 32 mortgages on his homestead.
As far back as 2005, according to the Journal, AIG Group was involved with Merrill in its mortgage backed securities deals, but AIG got out of the business after auditing its own risk/reward ratio, leaving Merrill holding lots of its own risk. Yet, instead of following AIG's lead, Merrill actually jumped into the mortgage backed securities derivative market further. Some of this outrageous risk taking seems to have been related to Merrill's bonus structure, which according to the Journal has now been changed.
In the past, those who took the biggest risks were rewarded more aggressively if they were successful. New CEO Thain has tied bonuses more to the overall performance of the company, a move that may change the risk taking behavior of those who were looking for the big payoffs.
In fact, according to the Journal's report, Merrill threw risk controls out the window and demoted and "pushed out" key managers and employees who began to raise concerns about the firm's increasing risk taking in the mortgage backed securities market while assigning a trader "without much experience" to the task of transferring the CDO debt to Merrill's own books.
As time passed, Merrill found itself holding large amounts of high risk paper, with no buyers interested. According to the report, the company then tried to repackage the paper into other CDO's or vehicles similar in concept to the off the book partnerships used by Enron. But again there were no takers for the repackaged security offerings.
Merrill then sought to have several bond insurers take on some of the insurance risks for its CDO holdings, including deals with XL Capital Assurance, MBIA, and a small insurer names ACA Financial Guaranty, a company that was "under capitalized" and with whom Lehman Brothers had been having problems with due to capitalization issues.
Still, Merrill, by doing business with MBIA, XL, and ACA was able to show a reduction in its CDO related risk in its last quarterly report of 2007. ACA, though, continued to have its problems, as its own financial strength rating was cut to junk by S & P, leaving Merrill with a $1.9 billion write down due to its deals with ACA.
XL tried to walk away from its deal with Merrill and Merrill has sued, while XL has countersued. And MBIA's deal with Merrill only insured the principle of the CDO's it took on, and that isn't due for 40 years.
Conclusion
This is classic financial alchemy by Merrill Lynch, in many ways similar to the way Enron did business and eventually unraveled.
It seems that those in control of the firm in 2005 believed that they were invincible and ignored the cooler heads in the crowd, replacing them with yes men who did what they were told without asking questions.
When things became obvious, those in charge tried to take the bad investments off the books by trying to hide them inside insurance policies, much as Enron hid its debt in off the book partnerships.
The problem with that strategy now, as it was with Enron, is that you can't fool all of the people all of the time. At some point someone is actually going to want to get paid. And that's when the troubles usually start.
Unless we're missing something, it looks as if Merrill Lynch could have gotten out of its bad problems in 2005 with a $3 billion hit. Now, the company has a $30 billion problem on its hand and three straight quarters of bad ink on its books.
Wall Street has a short memory. But it's not because they forget, it's because companies that do stupid things get taken out of the game. Does anyone remember Shearson, Drexel Burnham or E.F. Hutton? Didn't think so. They did stupid things and got erased.
If Merrill can't get out of this mess within a few more quarters, it may join the ranks of the former "Masters of the Universe" that got gobbled up by actually believing in their own publicity.
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Technical Summary: |
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Chart Courtesy of StockCharts.com
Stocks Could Resume Rally
The stock market continues to be undecided, although it could have a decent day on 4-16, if the Intel news manages to hold things up throughout the day. There is a lot of economic data due out, though, so the day could be volatile.
So far, we've seen a good amount of abstinence from "buy on the dips" crowd, which is a bad sign. That could change, though, so we have to wait and see.
We have reset our S & P timing model and have added some new picks to the growth list. Build small positions right now, and pay attention to your sell stops.
This is a tough market, and there is no reason to take big chances.
Chart Courtesy of StockCharts.com
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Intel (Nasdaq: INTC) and Linear Technology (Nasdaq: LLTC) delivered better than expected earnings and future outlook news on 4-15.
Chart Courtesy of StockCharts.com
The long abandoned chip sector may get a bounce in the next few days, especially if more companies deliver good news that began last week when DRAM chip companies announced that they had been able to raise prices.
Intel and Linear Tech. had decent after hours rallies after making their positive announcements.
Now comes the question of whether the cheer can spread throughout the sector, and whether it will actually translate into sustainable gains for the stocks in the sector, which are heavily weighted in the Nasdaq and key sector indexes for technology.
If past behavior is any indication of what could happen, and if this trend gathers momentum, we could see a nice rally in the sector, which is what the stock market needs, a good run from the traditional technology sector.
A whole lot has to happen, though, with one key development being what happens with the Philadelphia Semiconductor Index (SOX). If SOX fails to break out above 380, we could see yet another disappointment. |
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