Merrill's subprime woes continue

Asian investors led by Temasek shore up Merrill's equity capital base, while the US investment bank extends debt funding to Lone Star so that it can take CDO exposure off Merrill's books.
Merrill Lynch on Monday forecast a third quarter loss of $5.7 billion and announced a series of steps to shore up its capital by $8.5 billion, just days after it declared a second quarter loss of $4.6 billion. Measures to deal with the subprime-related problems include extending debt funding to Lone Star so that it can take $11 billion of collateralised debt obligations (CDOs) off the US investment bank's books.

The $8.5 billion capital increase is coming from an issue of new shares at $27.52 per share, the price at which Merrill closed on the New York Stock Exchange on Friday, July 25. MerrillÆs share price lost 11.6% on Monday and fell further to $22.50 in early trading yesterday, but then turned around as the broader market surged on the back of falling oil prices and a rise in consumer confidence, eventually finishing 7.9% higher at $26.25. The Dow Jones index closed 2.4% higher.

Singapore investment company Temasek will buy $3.4 billion worth of new shares, but on a net basis will pay only $900 million, with the rest being covered by a compensation payment from Merrill. Temasek invested $4.4 billion in Merrill in December 2007. At the time, it negotiated a price protection clause which stated that if Merrill sold stock within the next year at a price below $48 per share, Merrill would compensate Temasek for the difference between the lower issue price and $48 per share. Accordingly, Merrill has now paid Temasek $2.5 billion in compensation, which Temasek has agreed to reinvest in Merrill stock.

Temasek does not have price protection on the new investment. At the time of the December investment, Temasek had agreed that its shareholding in Merrill would not cross a limit of 10%. It is not clear from the NYSE filing whether this condition still applies. Temasek was Merrill's largest shareholder prior to this deal with a 9.4% stake.

Merrill has also negotiated new terms with Korea Investment Corp (KIC), Kuwait Investment Authority (KIA) and Mizuho Corporate Bank who bought $6.6 billion of mandatory convertible preferred stock in January. The convertibles carried a 9% dividend and were convertible in 33 months with a floor price for conversion of $52.40 and a ceiling at $61.31. Investors holding $4.9 billion of convertibles have agreed to exchange the preferred shares for 179.7 million common shares plus accrued dividends payable in cash or stock at the option of the investor at the same price of $27.52 per share at which the new shares are being issued. Merrill has made a provision for $2.4 billion of additional dividends related to the preferred shares.

One holder of $1.2 billion of convertible preferred stock has not agreed to immediately take common stock and will exchange its holdings for mandatory convertible preferred securities with a reference price of $33 per share. Further details of the new preferred securities, or of another investor holding $500 million of preferred shares who decided after MerrillÆs first NYSE filing not to exchange for common stock, were not disclosed. KIC held a press conference in Seoul yesterday confirming that it and KIA had agreed to convert their preferred stock into common shares. The new preferred shares also do not have a price reset clause.

Merrill Lynch's executive management team will buy 750,000 shares at the same price.

Merrill also agreed to sell CDOs with a face value of $30.6 billion to an affiliate of US private equity firm Lone Star Funds for $6.7 billion. At the end of the second quarter the CDOs carried a written-down value of $11.1 billion, meaning Merrill will have to book losses of $4.4 billion as a result of the sale. With this sale, Merrill reduces the aggregate CDO exposure on its books to $8.8 billion.

The CDOs have been valued on a face value basis at 22 cents for every dollar and on a written-down basis at 60 cents for every dollar. Merrill is providing financing to Lone Star to cover around 75% of the purchase price, or $5.025 billion.

The terms at which Lone Star has agreed to take the CDOs off MerrillÆs books is a good indication of how little appetite there currently is for such paper. On a face value basis, Lone StarÆs investment of $1.675 billion of equity for the CDOs translates to 5 cents for every dollar of CDOs and on a written-down basis it translates to 15 cents of equity for every dollar of CDOs. MerrillÆs recourse on the loan is limited to the CDO assets thus the risk on the debt over and above the equity Lone Star is putting up continues to be MerrillÆs.

It remains to be seen whether the valuation of Merrill's CDO portfolio has a cascading effect on the CDO portfolios of other subprime-affected banks.

Merrill also indicated that during the third quarter of 2008 it will book a maximum loss of $1.3 billion on contracts related to CDO hedges.

Less than two weeks ago, on July 17, Merrill, reported a second quarter loss of $4.6 billion and sold its 20% stake in news and data provider Bloomberg to Bloomberg Inc for $4.425 billion. Merrill has also entered a non-binding agreement to sell a controlling interest in Financial Data Services (FDS) for a firm value in excess of $3.5 billion û and most of this is being shown as a gain. FDS is a wholly-owned subsidiary of Merrill which provides administrative functions for services within the global wealth management business.

Merrill provided Bloomberg with debt financing for the deal and intends to provide debt for the FDS deal as well.

Merrill has reduced its number of employees by 4,200 during the course of the year, up from initial estimates that it would cut 4,000 jobs. Most of the job cuts have taken place in the US within the global markets and investment banking division and support functions. Of the total, 3,100 employees were let go in the second quarter, bringing MerrillÆs total headcount at the end of June to 60,000.

For Temasek, the further investment in Merrill comes only weeks after the Singapore-based investor was part of a consortium which bailed out Barclays BankÆs ú4.5 billion ($8.9 billion) rights issue, priced at ú2.82 per share. Only 19% of the British bankÆs shareholders decided to accept their entitlement. Qatar Investment Authority and Sumitomo Mitsui Banking Corp joined existing BarclaysÆ shareholders China Development Bank and Temasek in buying the remaining shares. The investment in Barclays has performed well for the bail-out investors so far as the shares closed at ú3.16 on the London Stock Exchange yesterday.
¬ Haymarket Media Limited. All rights reserved.
Share our publication on social media
Share our publication on social media