American banks set for further big write-downs

Two of Wall Street's biggest banks are preparing to write off tens of billions of dollars of investments in the US mortgage market, and to replace the capital with an $18bn cash infusion from emerging market investors.

The "clean slate" strategy being pursued by Merrill Lynch and Citigroup is aimed at drawing a line under the six-month-old credit crisis, and in so doing it will dramatically reshape the ownership of the American financial industry.

Both banks are due to report their 2007 financial results this week and their advisers were scurrying over the weekend to finalise a rescue refinancing that will hand substantial equity stakes to the governments of China, Kuwait and other emerging markets, as well as to other wealthy private investors.

The pair have been among the worst hit by the financial crisis, which has been snowballing since last summer, but new chief executives at each are determined to start 2008 with as close to a clean sheet as possible.

Merrill Lynch, where the former head of the New York Stock Exchange, John Thain, was installed in November, is expected on Thursday to write down the value of its mortgage market investments by up to a further $15bn (£7.7bn) – on top of the $7.9bn write-down it took at the end of the third quarter.

Citigroup's new chief executive, Vikram Pandit, who was promoted last month after the ousting of Chuck Prince, is expected to write down its mortgage-related assets by up to $15bn too.

It is common practice for incoming executives to "kitchen sink" their early financial results, taking as large a loss as possible in order to establish a clean slate from which to grow in the future. However, this strategy is complicated in the banking industry, where companies must maintain a sufficient capital base to allow them to continue to grow their lending operations. Neither Merrill nor Citigroup could easily afford to write down billions of dollars without replacing much of that money, and it is for this reason that both are this week expected to accompany their financial results with news of substantial cash infusions from new investors.

Jeff Harte, finance industry analyst at Sandler O'Neill, said different banks have written off different percentages of their investments in sub-prime mortgages and derivatives such as collateralised debt obligations (CDOs).

Merrill will need additional funds if it decides it wants to write off as much as $15bn, Mr Harte calculates. "Estimating CDO/sub-prime write-downs is quite subjective given the range of marks we have seen from peers. Our current estimate of $10bn represents an estimated mark-down to $0.40 on the dollar from Merrill's starting exposure levels. While this mark-down is arguably quite aggressive, certain peers have been even more aggressive in putting these issues behind them. For example, we estimate that Morgan Stanley marked its exposure in the range of $0.25 on the dollar. We continue to believe that more aggressive loss assumptions than we are modelling would likely necessitate a capital raise."

Rumours swirling around Wall Street in recent days suggest that Merrill Lynch is planning to do just such a capital raising, attracting $3bn to $4bn from a Middle Eastern government investment vehicle – one of the so-called "sovereign wealth funds" swollen in recent years by oil revenues. Mr Thain has already sold a $5bn stake, ultimately worth 5 to 10 per cent of the company, to Temasek, an arm of the Singapore government.

Citigroup is understood to be putting the finishing touches to an even more ambitious recapitalisation plan. The Kuwaiti government and its largest existing shareholder, the Saudi prince Alwaleed bin Talal, are among those said to be ready to invest in a $14bn rescue refinancing. The biggest single new investor is likely to be the Chinese government, which has used the financial crisis to snap up large chunks of the US finance industry. Most recently it paid $5bn for a stake in Morgan Stanley, and is also putting $1bn into Bear Stearns.

Sovereign wealth fund investments have so far been broadly welcomed by US politicians, who are more concerned about averting a financial crisis, but the scale of the investments due to be announced in the coming days could reopen a debate about the long-term wisdom of giving foreign governments significant financial leverage over the US financial system.