Jeremy Warner's Outlook: Merrill's Thain hopes to draw line in the sand
Wednesday 30 July 2008
The banking crisis began as a problem with liquidity, but now it's been transformed into one of capital adequacy to judge by the kitchen sinking announced on Monday night by John Thain, chief executive of Merrill Lynch. Is this the third, or fourth, such exercise in writedowns to be announced by the thundering herd? It's easy to lose count.
Whatever the answer, Mr Thain's need is plainly desperate. Only a little while back, he said there would be no need for more capital. Now he's being forced to compensate Temasek, the Singapore wealth fund, for the losses sustained on the last equity issue – sold, it now transpires, on a false prospectus – in order to persuade it to subscribe to the latest $8.5bn infusion of life-saving capital.
Just as laughable, he's having to lend Lone Star 75 per cent of the $6.7bn it needs to take the bulk of the bank's remaining portfolio of mortgage-backed Collateralised Debt Obligations (CDOs) off his hands. What's more, Merrill's hasn't even completely got rid of the risk, as the loan is secured against the assets sold.
The sale sets a new benchmark of just 22 cents in the dollar for the CDOs disposed of, which we have to assume is a real bargain for Lone Star. So why didn't Merrill just sit it out and, like others, hold to maturity in the hope of eventually getting most, if not all, its money back? The problem Merrill had was that capital was being impaired at such a rate by mark to market accounting for tradeable credit that it threatened a crisis of confidence that might have sunk the whole bank. This was an extreme distress sale, or act of massive capitulation.
By selling the bulk of the remaining portfolio and coincidentally recapitalising, Mr Thain "de-risks" the bank and thereby finally exorcises the CDO exposure. Yet with shareholders diluted another third, the cost is an horrendous one.
As for British banks with large CDO exposures such as Royal Bank of Scotland and Barclays, there is plainly a read across from the latest mark downs and it's unlikely to be good. Barclays argues that the longer vintages of its portfolio mean it can adopt a less stringent approach to impairment, but it none the less has a lot of convincing to do at next week's results.
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