Merrill Tattled on Lehman

The FT reports that Merrill officials warned the SEC and the Fed in early 2008 that Lehman was "incorrectly calculating a key measure of its financial health" (or, "cooking the books" as you or I might call it.) The former Merrill officials' intentions were far from humanitarian. They alerted regulators because Lehman was touting its reported liquidity position to investors and counterparties as proof that it was sounder than Merrill. Merrill officials probably said to themselves, "Hey wait a minute. I know we're insolvent, but Lehman is DEFINITELY more insolvent than we are. " We're talking about Wall Street guys here. They're so damn competitive.

The Merrill guys didn't believe Lehman's claims. In fact, they thought that Lehman was including regulatory capital in its liquidity calculations. Big no no. So, they picked up the phone and called the SEC and the New York Fed, both of whom did, well, absolutely nothing about it. But we already knew that because we know how this story ended. The SEC declined to comment beyond saying that the folks who fell asleep at the switch at that particular unit are no longer there. The NY Fed claims it was unable to verify that the conversation with Merrill ever took place.

Retail Sales Rebound and Other News

Retail sales perked up and rose 2.7% from the previous month as folks rushed out to take advantage of the cash for clunkers program. I guess that's what happens when you hand out checks for $4,500. Consumers will spend it. It's the American way. Subtracting out the effects of the clunkers program and gas, other sales rose a less impressive 0.6%. Still, better higher than lower. However, July retail sales were revised lower to a decline of 0.2% from 0.1% and total sales for June through August 2009 were still down 7.6% from the same period a year ago. So while sales appear to have hit bottom, we're operating at low levels. Calculated Risk has good graphs which you can see here. It will be interesting to see what happens after the clunkers program expires. The really good news is that if retail sales fall off a cliff again, we can always give everyone a check for $4,500 to buy a new refrigerator, or washer/dryer, or, well, just fill in the blank and write your congressman.

In a remarkably sane move, a federal judge threw out the SEC's $33 million proposed settlement with Bank of America over its disclosure (or lack thereof) of bonuses paid to Merrill Lynch. US District Judge Jed Rakoff pointed out that the SEC fine levied on B of A "does not comport with the most elementary notions of justice and morality" because the company's shareholders - the victims of the alleged misconduct - are the same people being asked to pay the fine. Well, that and taxpayers, who also happen to fund the SEC's payroll, which made the whole settlement even more preposterous. Judge Rakoff has set a court date of February 1st so we all get to hear the juicy details of how the SEC conducts its investigations. It's nice to know that somebody is taking a stand against all of the recent government kowtowing to Wall Street. I happen to think that the $3.6 billion in bonuses paid to Merrill Lynch employees after the firm lost $20 some odd billion dollars and required an additional $20 billion from the government to close the merger with Bank of America is one of the the most egregious and distasteful actions I have ever seen a Wall Street firm take. And I don't think a silly $33 million fine even begins to cover it. I'd really like to know how the move was ever justified and who was involved in making those decisions. Nothing better than a trial to get everything out into the open.

In yet another remarkably sane move, Wells Fargo fired the employee who was throwing parties at a beachfront Malibu pad that had been seized from Madoff investors. Apparently, Wells Fargo frowns on that sort of behavior. It's too bad she didn't work for Merrill Lynch, because she probably would've gotten a promotion and another bonus. At any rate, no more wild and crazy parties, which is a major bummer because I was hoping to get an invite to the next one.

Unemployment Hits 8.1%

The jobs report was as dreadful as expected by those who can still stand to look at economic headlines.  The economy lost 651,000 jobs and the unemployment rate leapt to 8.1%.  Revisions for the prior two months showed losses of an additional 161,000 positions bringing the total number of jobs lost since the recessions began in December 2007 to 4.4 million.  The jobs report is sobering and yet really makes you want to have a drink all at the same time.

Following the lead of other financial institutions looking to retrench, Wells Fargo slashed its dividend in order to save $5 billion annually.  Clearly there is no longer a stigma related to reducing the dividend as investors have begun to prefer the idea of their banking institution actually remaining a going concern over a quarterly dividend check.  JP Morgan and GE made the same announcement recently and I view these actions as prudent, but necessary, if an institution is going to survive the brutal downturn.

Finally, in the "investment bank that needs to finally go away" category, Merrill Lynch is once again in the headlines.  The bank informed regulators that it had discovered discrepancies in certain trading positions.  Conveniently, the losses, which occurred last year, weren't discovered until after Bank of America purchased the investment bank and allowed it to pay out accelerated bonuses.  The details are sketchy so far, but apparently a London currency trader who had recorded a trading profit of $120 million for the fourth quarter, may instead have lost a "large amount."  The Bloomberg story doesn't specify whether we are talking Nick Leeson-large or Jerome Kerviel-large.  At least we have some insight into how Merrill managed to punt $15 billion in the fourth quarter.     

Hybrids Raise Question For Insurers

Investors in Aflac, the insurance company with the hilarious duck commercials, were stunned a few weeks ago when the stock dropped like a stone on seemingly no news.  In-the-know investors were privy to an investment bank research report about hybrid securities which showed that Aflac had significant exposure to these types of securities and could face writedowns large enough to imperil the insurer's capital position.  Aflac predictably said that it was  confident with its capital position and now investors await the earnings report after the close today.

The Wall Street Journal has an article today discussing hybrid securities and their perils.  These securities combine characteristics of both debt and equity and grew into a very popular product during the credit boom when investors were starved for yield.  The securities offered yields of 0.6 to 0.7 above corporate bonds with the same ratings.  How could investors resist all of that extra yield without any extra risk?  The problem, of course, is that there was more risk with these securities and that the risks were mispriced.  The issuers of these hybrids, mostly banks, had the option to delay repayment on the bonds.  In December, Deutsche Bank opted not to repay its hybrid securities as it was cheaper for the bank to leave the debt outstanding rather than find an alternative source of financing.  Deutsche's move caused investors to dump the securities in December.  Fears of nationalization of the UK banks in January pummeled hybrids further, causing them to decline by 25% to 75%. 

Issuance in the hybrid market around the globe jumped from $32 billion in 2000 to $175 billion in 2007, with the size of the market estimated at $700 billion.  At the height of the credit boom, insurance companies were buying 30% to 40% of the issuance.  Consequently, insurance companies are set to suffer if these securities do not regain in value.  I'm not holding my breath.

  

In my opinion, the real issue here is when is all of this "discovery of hidden risks on financials' balance sheets" crap going to end?  Every couple of months, some sort of news of a financial product meltdown like this pops up and lo and behold, it was a $700 billion market and now these securities are down like 40% and some major bank or insurance company owns a boatload of them.  I pride myself on being fairly well informed on many exotic derivative products, yet I'd never heard of hybrids until a few weeks ago when Aflac got the beatdown.  But I expect surprises like this, which is why I haven't and wouldn't touch any financial company's stock with a 10 foot pole, no matter how "cheap" it gets.  I am so sick of listening to money manager boobs on CNBC talking about "cheap" insurance company stocks etc.  Sure they are.  If you can comb through their balance sheets and tell me exactly what it is that they own and how every single one of these securities would react under a variety of scenarios, including a possible depression, I might be willing to listen.  

Merrill's $15 billion fourth quarter loss was insidious for reasons that go beyond the absurdity of its bonus payouts (which will need to be tackled in a separate post.)  I still want to know how the hell Merrill lost $15 billion in the fourth quarter after John Thain had claimed several times that it had marked assets down to distressed levels in prior quarters.  I'm sure attacking Merrill for the bonus payments is more politically savvy for regulators, but I would offer that there may be issues with accounting fraud at that firm.  A steep yield curve, a zero overnight interest rate policy for the foreseeable future, and record wide spreads in the bond market which actually narrowed in December indicates to me that Merrill's losses should've narrowed instead of nearly tripling from the prior quarter.  It is highly possible that Merrill was marking assets way too high before the Bank of America merger.  

The problem with financials is that the mistakes from the bubble years were astronomical, and they own so much illiquid garbage that is blowing up left and right, that the worst offenders can't break-even despite the many gifts from the Fed and Treasury.  I suspect that hybrids are not the last of the "but we thought it was AAA" surprises that investors will be forced to confront.  But then again, if the government just keeps bailing out the banks, then it's the taxpayers that will be facing these surprises.            

Thain and Montag to Leave Merrill Amid Bonus Controversy

The Financial Times reported this morning that Merrill accelerated bonus payments by a month, doling out billions in compensation just three days before stuffing Bank of America with a huge loss.  Here's a quick timeline just as a refresher:

• December 5th - Shareholders of both banks approve merger.
  
• December 8th - Merrill's comp committee approves accelerated bonuses.
• December 29th - Bonuses paid to Merrill employees
• January 1, 2009 - Merrill/BofA deal closes.
• January 20th, 2009 - Reports confirm that Merrill had a $21.5 billion operating loss in the fourth quarter and the government provided BofA with additional funds plus a massive guarantee on over $100 billion in Merrill's garbage.

I'm a little fuzzy on what happened between December 8th and December 29th.  At some point Ken Lewis discovered the loss, informed the government that he wouldn't go through with the purchase, and received a bailout to close the deal and avert a possible collapse of the financial markets.  In between all the negotiating, you'd think that Mr. Lewis could've found some time to issue a stop payment on all the bonus checks.  Clearly, somebody somewhere should've issued a stop payment.  Obviously, Mr. Thain was not in a position to do so because, well, he's either criminally insane or just a criminal.  But holding a special board meeting to accelerate bonus payments right before you inform your acquirer that it's gonna need a bailout from the government because you happened to puke yet another $15 to $25 billion or so is inappropriate, as well as, perhaps, fraudulent?  I don't know.  I'm struggling to find the right words.

In any event, Mr. Thain, who up until this morning faced a bright future at BofA, has been asked to leave.  Mr. Montag, the man who pocketed $40 million just for showing up for four months of work last year, is also being shown the door.  No word yet on their severance packages, but I'm thinking $50 million a piece ought to do it.  Right?

Update:  Tom Montag is not leaving Bank of America as I initially erroneously reported.  He will continue to run Global Markets (into the dirt) and report directly to Ken Lewis.  Apologies for the confusion.

Merrill- Gone But Not Forgotten

Although the Bank of America/Merrill deal is done and should be old news, many angry questions remain about how this government-backed-merger-debacle was completed without informing stakeholders (i.e. BAC shareholders, Merrill's board, US taxpayers) of some crucial details.  For example, how is it that Merrill Lynch managed to lose $15 billion in the fourth quarter, but conveniently only after Bank of America shareholders approved the deal? Here's another good one:  Why did Mr. Thain waste Merrill's last board meeting on December 8th to plead for a $10 million bonus, when he perhaps should've mentioned the $15 billion hole in Merrill's finances?  Nevermind, that one was rhetorical.  Oh wait, I have another one:  Why, for the love of God, was J.C Flowers paid $20 million for his "expertise" to advise Bank of America on the Merrill purchase, when his "extensive due diligence" somehow overlooked said $15 billion in losses?  But wait, there's more:  How did the Fed get roped into guaranteeing credit derivatives positions as part of its $138 billion guarantee to Bank of America? How about:  Why did Bank of America learn of the losses from Merrill's transition team and not John Thain?  Better yet: Why does Bank of America care about retaining any of the senior clowns from Merrill?  Didn't they already run the company into the ground?  Are they really going to threaten to leave?  Who cares?  Let them go start their own business using their own money.  Some of these guys that have milked their free career calls to the max and bled shareholders dry in the process should have to go out on their own and risk their own capital for once.  

What I have the hardest time understanding as I read all of the gory details of what went down in the past couple of weeks that led to the government ultimately stepping in and allowing Merrill to live, is how on earth John Thain has not been hung out to dry.  Frankly, I couldn't believe how the press, shareholders and the SEC let Mr. Thain get away with virtual accounting fraud following the firm's second quarter earnings results.  For those who don't recall, Mr. Thain emphatically stressed that the street was grossly undervaluing Merrill's CDO portfolio.  Then, around 10 days after second quarter earnings, he announced another $5 billion loss for the third quarter and that Merill had "sold" the CDOs to an investment fund for 22 cents on the dollar plus 75% financing.  Clearly it was not the Street who was undervaluing Merrill's assets.  Why anyone trusted Merrill's marks on any of its portfolio after that kerfuffle is a mystery.

What happens next?  Will the angry mob force out Ken Lewis?  I, for one, hope not.  Why?  Because I really worry that somehow, Teflon Thain will wind up in charge.            

Wagoner Pressured to Resign, Thain Looking for Bonus

The front page of the Wall Street Journal rarely crackles with irony as much as today.  Clearly it was a fairly slow news day when two of the top stories revolve around CEOs.  Senator Chris Dodd is calling for Rick Wagoner's head (figuratively) if the government follows through with the billions in loans that GM has requested.  Meanwhile, in a separate, yet somehow completely related story, Merrill's John Thain is tussling with his board over a $10 million bonus, which he claims he deserves.  Mr. Thain believes that he saved the firm from imminent collapse by selling the company to Bank of America.  For this Herculean feat he is asking his (shocked? appalled? incredulous?) board for $10 million in comp.  I still firmly maintain, as I've stated many times before, that selling Merrill to B of A is not what averted the investment bank's collapse.  Sure, it was a shrewd move.  What saved Merrill was billions upon billions of financing from the Federal Reserve through a variety of new and unprecedented lending facilities, in addition to billions in direct capital injections from the Treasury.  Merrill's survival is due to actions by Ben Bernanke and Hank Paulson, not John Thain.  If Merrill's board is going to write a check to anyone, it should be to those two.      

Again, it is interesting that our lawmakers are even hesitating for a moment about helping the auto-industry, given how easily they showered their largesse over the banking system.  Furthermore, it is a bit hard to stomach that the bailouts were handed out to banks without any restrictions on dividends and pay.  The fact that Merrill's CEO is even thinking of asking his board for compensation in these politically charged times is unbelievable.  Even the heads Goldman Sachs, a firm that actually made money this year instead of losing billions like Merrill, gave up compensation.  Mr. Thain is demonstrating that what he lacks in common sense, he more than makes up for in cojones.    

Update:  The Wall Street Journal is reporting that Mr. Thain met with Merrill's board and will be passing on a bonus this year.

Merrill Lynch Has Trouble With Math

A Bloomberg story this morning claims that Merrill Lynch is said to be cutting bonuses by 50% this year.  I'm sure that headline was meant to be eye-catching, so that readers are shocked by the huge haircut Merrill's bankers will be forced to stomach.  What caught my eye, however, was the fact that Merrill's revenues dropped 96% in the nine months ended September 2008 from a year earlier.  Investment banks generally pay out 50% of revenues as compensation.  Something about the math here doesn't really add up.  Revenues shrink by 96%, the firm loses over $20 billion, nearly fails, and is forced to merge and get various bailouts from the government.  Yet somehow, Merrill is only reducing bonuses by 50% from last year, which was a record year for pay?  The article clarifies that bonuses account for the bulk of a year's pay for most traders and investment bankers.  While that is certainly true, we are talking about people who have base salaries of $150,000 or so, and then receive bonuses of like $650,000.  Let's not be mistaken that anyone here is working for commissions alone.  So while our lawmakers argue over putting GM out of business, the recipient of $10 billion in cash from Mr. Paulson and multiple billions in loans via Mr. Bernanke, is busy handing out bonuses.  Nice.    

Merrill, Citi, UBS: What a Debacle!

Merrill Lynch, the investment bank which slyly sold itself to Bank of America the weekend Lehman went kaput, has proven to the world that it is consistently capable of losing $5 billion a quarter.  The former investment banking powerhouse posted a $5.2 billion loss on, um everything.  Merrill had a total of $9.5 billion related to, CDO's, leveraged loans, paying Temesek back for diluting the funds original investment, you name it.  $3.8 billion was specifically labeled as "write-downs tied to GSE's and other investment banks which were either taken over or failed during the month."  The company declined to offer more details on those investments only to say "yes, we really are that bad at managing risk."

In other horrible bank earnings news, the financial disaster powerhouse that is Citigroup lost $2.8 billion in the third quarter on more than $13.2 billion in charges bringing the total credit losses taken by the bank to an eye-popping $64 billion.  I now know for certain where Citigroup came up with the idea to sue Wells Fargo for $60 billion for stealing Wachovia.

Just as a small reassurance to the US taxpayer who may be reading this news with horror, rest assured that the US investment banking industry remains highly competitive with the rest of the world.  Even the Swiss, those conservative, secretive, banking geniuses, are getting bailouts from the Swiss government.  UBS announced that it is selling $60 billion in garbage to the Swiss government which will be taking a 9% stake in the firm.  Credit Suisse has opted not to take a government handout, but will be raising capital in order to shore up its adequacy ratios.

Needless to say, the global banking industry is in shambles.  But you already knew that because governments around the world have been bailing out their banking institutions.  

What all of this proves, using Merrill as an example, who has now given back all profits since 2001, is that the practice of paying out 50% of revenues in bonuses at investment banks was a complete and total joke.  I wrote a piece on August 4th claiming that the Fed's dramatic financing of illiquid assets of investment banks amounted to a subsidy for investment banking bonuses.  I used the example of Thomas Montag who was awarded a $40 million signing bonus to run Merrill's sales operation in early August.  In light of Merrill's $5 billion loss, Mr. Montag has obviously not been worth the $40 million that Merrill punted on his hire.  My post was viewed by some as controversial, because yet again, the claim was made that all of that great "talent" at banks would flee if it wasn't getting paid.  Maybe now we can return to a more normal world where the neighborhood urologist makes more money than the guy who's mispricing default risk on a CDO.   

The Fate of Morgan and Goldman

While Lehman's assets are getting a true mark to market in bankruptcy court and Merrill and Bank of America are busy hammering out the details of their proposed merger, investors have turned their attention to Morgan Stanley and Goldman Sachs.  Both investment banks reported positive yet much lower earnings this quarter, but questions about their future as stand-alone investment banks remain.  Why?  Because the money markets are no longer willing to support an investment banking model.  Investors have finally figured out how risky it is to borrow money short to finance a huge, risky trading operation.  Morgan Stanley and Goldman Sachs have emerged as the best risk managers on The Street, yet sentiment has now appeared to turn against them.  Despite the AIG bailout by the US government, which was a far better alternative for the investment banks than allowing a bankruptcy filing, both Morgan Stanley and Goldman Sachs' stocks are getting routed in pre-market trading.  Credit default swaps on Morgan Stanley have now spiked to levels last seen on Lehman Brothers' debt.  Remember Lehman?  That other investment bank that went bankrupt last weekend?  If you thought the turmoil was over, think again.    

Lehman Bankrupt, Bank of America Buying Merrill

Both Barclays and Bank of America opted out of purchasing Lehman.  No surprise.  I wouldn't have bought Lehman without a $60 billion guarantee from the Fed either.  My sources are telling me that a bankruptcy filing by Lehman is imminent.

Meanwhile, Bank of America has moved on to considering a purchase of Merrill Lynch.  Interestingly, a sale of Merrill wasn't even in the cards until this week when it became apparent that investors were losing confidence in any leveraged institution's ability to survive through the credit crunch.  No word on Washington Mutual or AIG's fate.  I guess we'll resolve those issues next weekend.     

Speculation on a Really Slow News Day

Labor Day is over.  Financial market participants are back from vacation.  The action is supposed to heat up, with exciting news and announcements ending the summer market doldrums.  Instead we get groundbreaking new stories such as this one from the Associated Press entitled "Merrill slides against mostly rising market."  Don't bother clicking on the link, I'll summarize:  Merrill's stock is down today while other brokerage stocks are higher.  The reporter called Merrill for a comment and no spokesman was available.  Had a spokesman been available they may have had the following to say: "Um, hmmm, that's odd.  Hold please...We just fired our fundamental analyst last week for not forecasting that we'd lose $40 billion dollars this year so no comment from him, but our technical analyst says our stock was clearly overbought last week."  

If the Merrill news was not hard enough news for you, there was yet another report on KDP's continued interest in taking a stake in Lehman Brothers.  The new version of the story is that KDP is rounding up a consortium of Korean Banks to possibly buy Lehman.  The Korean market liked that news so much that it promptly plummeted 4% yesterday.  No sources were cited in the story, which firmly puts it in the category of "rampant speculation."  At this point, I wouldn't be surprised at all if insiders at Lehman were donning their best fake Korean accents and calling up reporters to keep the story alive.  Drastic measures are necessary to keep the market focused on the idea that somebody wants to buy something that Lehman has to sell.  Otherwise, Lehman has to come up with a new hare-brained scheme involving good banks and bad banks and crazy spin-off recaps with financing included to report in conjunction with the large losses it will surely report this quarter.  The good news is, the truth will be revealed in a few short weeks when Lehman reports earnings.  Speculation in the meantime is sure to continue.  

Analysts Continue Quarterly Brokerage Earnings Slashfest Ritual

Guy Moszkowski of Merrill Lynch downgraded Goldman and Lehman to "underperform" noting that "conditions have deteriorated significantly from July."  Meanwhile, Deutsche Bank analyst Mike Mayo cut his price target and estimates for Lehman Brothers.  He now expects Lehman to post a third-quarter loss of $2.68 a share, revised from a profit of 33 cents a share.  Why do I feel like I am experiencing deja vu?  Oh, that's right, because we go through this every single quarter.  How and why Mr. Mayo decided that today was the day that Lehman was going to go from a profit to a steep loss is only slightly mysterious.  After all, the market has been riddled with rumors of Lehman looking for buyers for its assets ("You need an asset management unit? Level 2?  Level 3?  We've got it all to go.  Just give us a bid.") for months.  If the company was cruising along making money, it wouldn't need more capital in addition to all the capital it has already raised.  Let's be honest, did conditions really deteriorate that much or are banks finally starting to face the music?  I know that spreads have widened back out again in the past month.  But the market price of the CDOs that Merrill Lynch puked for 22 cents did not drop from 40 cents at the end of the quarter to 22 cents two weeks later when Merrill sold them.  Merrill had these assets marked too high.  The same is probably true for some of the assets that Lehman holds in Level 3.  No market exists for these securities unless Lehman is willing to unload them at highly distressed levels and take a large loss.

In any event, I think it is a convenient coincidence that the brokerage analysts cut their estimates right after the SEC's naked short sale ban expired.  It was wise to wait until it was no longer a major inconvenience for hedge funds to short these stocks again.  That way, when various magazines are handing out analyst awards for great calls, analysts can say they had the timing right.  Maybe by then investors will conveniently forget that most analysts were estimating brokerage firm profits for the past three quarters before having to slash those estimates two weeks before the earnings announcements to avoid looking foolish.  The fact that investors still pay attention remains a mystery to me. 

UBS and Merrill Pay to Make it Go Away

Following Citi's lead yesterday, UBS settled with federal regulators in the auction-rate securities probe.  UBS has agreed to pay $150 million in fines and will bailout retail investors (details are yet to be announced, update to come).  Merrill Lynch has also announced that it will buy back auction-rate securities from its clients over a one-year period beginning January 15, 2009.  The total amount that Merrill will repurchase is expected to be between $10 and $12 billion.  I'm certain that other investment banks who sold auction-rate securities to retail investors will more than likely follow suit.  Sometimes it is just easier to pay to make a problem go away than risk damaging your reputation with clients.  In the grand scheme of things, paying a $100 million fine and maybe a couple of hundred million more to eat losses, is really a drop in the bucket when you are losing billions of dollars a quarter in MBS, CDOs, CDS...etc.  Furthermore, you don't want to lose your loyal retail investors because you will need them when the next bubble rolls around in another couple of years.  It's much easier to pump and dump when you have "dumb money" in the kitty.  The "smart money" falls for the routine too, but they usually can't get away with suing you because they were an "unsuitable" investor.  They are just more than likely to yank their money because they are mad and take it to another broker, who is going to do the exact same thing.  But the "dumb money" is loyal to a fault, as long as you keep bailing them out...   

Update: Details of the UBS settlement with the New York AG, the Massachusetts Securities Division and the SEC: UBS will buy back $8.3 billion in securities from private clients for two years starting Jan 1, 2009 and $10.3 billion from institutional investors starting June 2010.  It will pay the $150 million fine without admitting or denying guilt.  UBS estimates it will cost $900 million, which will be booked in second-quarter results.

Fed's Lending Facilities Subsidize Egregious Wall Street Executive Compensation

Thomas Montag just received $40 million to start work today as Merrill Lynch's new head of sales.  Mr. Montag is clearly a brilliant salesman, having negotiated such a rich deal from Merrill.  Not only has Merrill been forced to raise billions to replenish its capital as it has lost an insane amount of money in the past year, but the investment bank didn't even need to steal Mr. Montag away from a competitor.  Mr. Montag left Goldman in December and was presumably collecting unemployment checks from the government when Merrill's John Thain drove up in a Wells Fargo armored car filled with bars of gold and handed Mr. Montag the keys.

It seems that despite enormous losses, layoffs, incensed shareholders, government handouts, and the Fed's extreme generosity, Wall Street hasn't changed its tune.  Although bonuses are supposedly discretionary, banking executives continue to claim that it is necessary to compensate "talent" with millions of dollars in bonuses or risk losing them to competitors.  Frankly, shareholders should know this fact and anyone who views Wall Street compensation practices to be distasteful shouldn't own the stocks.  My beef is therefore not with the banks themselves, or with shareholders.  It is with the Fed.

Since the credit crisis began, the Federal Reserve has jumped through fire-rimmed hoops to concoct new lending facilities to keep the banking community afloat.  Without these lending facilities, it is my belief that several banks, in addition to Bear Stearns, would've collapsed under the weight of illiquid mortgage securities due to severe restrictions in the money markets.  Until the credit crisis began, the Fed never accepted mortgages (with the exception of agency pass-throughs) as collateral against its repo loans during open market operations with Wall Street.  The Fed couldn't accurately price mortgages and didn't want to be faced with the prospect of selling illiquid securities in the event of a default by a counterparty.  The beauty of a repo is that if the couterparty defaults on your loan, you can immediately turn around and sell the securities and be made whole.  When there is no market for the securities you are holding as collateral against the loan, you cannot recoup your money.  That is the precise reason why money markets froze last summer and have failed to recover.  Previously liquid securities have become less liquid and it is hard to determine where securities would be liquidated in the event of a default.  The Fed is now assuming that liquidation risk as it enters into repos using questionable collateral.  Furthermore, the Fed has lowered interest rates a number of times in the face of rising inflationary pressures, also in an attempt to bail out the banking sector, and is offering loans to Wall Street on illiquid collateral at roughly 2%.  Initially these lending facilities were supposed to be temporary until credit markets thawed.  But the Fed just extended them through January 2009.  In my opinion, as Wall Street's new regulator, the Fed had (and probably still has) a unique opportunity to make a bold statement.  In return for access to the discount window, the TAF and the TSLF, Wall Street should not be allowed to pay out cash bonuses until the "temporary" lending facilities cease to exist and the Fed is no longer exposed to potential losses from its illiquid holdings.  If shareholders want to continue to throw money at these institutions that have continually misled them about the risks on their balance sheets, that is fine with me.  But being on the hook as a taxpayer for a bank failure that could cause the Fed to take losses immediately after Wall Street paid out record bonuses in 2007 really pisses me off.  If Mr. Bernanke wants to avoid looking like a shill for Wall Street, he needs to step up his game.  If we're going to socialize the losses, we should get some protection.  It is incredibly hard for me to believe that banks are even considering paying out bonuses in the face of enormous losses.  But a $40 million guarantee to a new hire that has yet to make a penny for a bank that just posted $10 billion worth of losses in the past two weeks is evidence that the culture hasn't changed.

It has been a year since Jim Cramer went off his meds and ranted on CNBC about the Fed needing to open the discount window.  Bear Stearns proceeded to pay out $3.4 billion in compensation for 2007, a 21% decline from the prior year, despite a 94% decline in net income from the prior year and then went bust a few months later.  Some believe that had Bernanke opened the discount window earlier, Bear would still be around.  I believe that had the bank preserved some cash by not paying out bonuses, it might still be around.  I'll let my readers draw their own conclusions.  For nostalgia's sake, I'm including the Crazy Cramer video.  Enjoy...  

Merrill Marks CDOs to Market, Other Banks Cringe

During Merrill Lynch's earnings report on July 18th, CEO John Thain claimed that buyers were offering prices for the $19.9 billion in CDOs remaining in its inventory that were too low to justify a sale.  At the time, I argued that he was admitting that the assets were marked too high on Merrill's balance sheet and that it would required further write-downs.  I didn't realize it would happen within two weeks.  I find it extremely disturbing that the report of Merrill's CDO sale and new capital infusion came so close to the second quarter earnings report.  Frankly, it implies that the company's earnings report was a sham.  Nothing happened in the past two weeks that caused CDO prices to fall.  Merrill consciously chose not to mark the securities to market, arguing that the market was wrong and that its models were right.  It seems very hard to believe that the deal to sell the $11 billion in CDOs to a Lone Star affiliate, while providing the financing, was scraped together in two weeks.  It had to have been in the works and it implies that Merrill deliberately marked the CDOs at a higher price than where they were ultimately sold.  Had Merrill marked the CDOs to the price where it sold those assets a mere two weeks later, it would have reported a net loss of $10 billion rather than $4.65 billion.  That number may have proven too high for investors to stomach and would have spoiled the plans for the equity issuance.  Perhaps Merrill had to wait for the SEC to put a clamp on short selling first before announcing the deal?  Maybe Merrill thought it would sound better splitting the loss into two chunks?  I'm just making educated conspiracy theory guesses but something smells very fishy here.

Furthermore, now that Merrill has traded these assets at a price, and that price is roughly 20 cents on the dollar for "super seniors", they have marked the entire market.  Anyone holding CDOs of any variety will need to reference this trade when marking their assets until someone comes along and trades them at a different price.  Before yesterday, there was no price because there was no market.  Dealers could claim they were doing their best to supply a price.  I smell a slew of write-downs to come.  But no worries, only 20 cents to go before they go to zero, and then, we can safely say that the worst is over.   

Merrill Raising $8.5 Billion in Equity, Punting CDOs, Settling Dispute With SCA, Having Busy Day

SEC Chairman Christopher Cox was preparing to give himself a big pat on the back for rooting out those evil "naked" shorts and causing a monster rally in financial shares.  Now that the GSE's are getting a government guarantee and shorting has been all but outlawed, financial stocks can only go higher because they were so darn cheap to begin with, right?  The decline in financials in the past few trading days has perplexed those who really believed that the worst was behind us, for sure, and this time they really meant it.  Unfortunately, neither the SEC, the Fed, nor the Treasury Secretary can do anything about the deteriorating assets at banks, brokers, insurance companies, or any financial institution that paid no attention to declining underwriting standards in the past three years.  Take Merrill Lynch, for example.  After reporting abysmal earnings and selling its valuable stake in Bloomberg just a few short weeks ago, the company has outlined plans to raise $8.5 billion via equity issuance.  Merrill announced a slew of other measures in the press release.  I will focus on the most crucial components.  

Most importantly, Merrill announced a "substantial sale of US super senior ABS CDO securities resulting in an exposure reduction of $11.1 billion from June 27th, 2008."  Furthermore, Merrill has terminated some hedges with XL Capital.  This is really fabulous news!  The company is punting $11 billion of its most toxic garbage and settling the acrimonious dispute with XL.  If you scroll down a bit, you get to the not so good news.  The company needs to take a pre-tax write-down in the third quarter of 2008 of approximately $5.7 billion.  "The write-down is comprised of a $4.4 billion loss associated with the sale of CDO's, a $500 million loss on the termination of hedges with XL Capital and an approximately $800 million maximum loss related to the potential settlement of other CDO hedges with certain other monolines."  Scroll down even further and you get to the really juicy part about the CDO sale.  First of all, Merrill is selling $30.6 billion in gross notional amount of CDOs which were carried on Merrill's books at $11.1 billion at the end of the second quarter.  Merrill is selling these CDO's for $6.7 billion to an affiliate of Lone Star Funds.  But that's not all!  It is providing financing to the purchaser for 75% of the purchase price.  Better yet, the recourse on the loan will be limited to the assets of the purchaser and the purchaser will not own any assets other than those sold in this deal.  Got that?  Basically, Lone Star set up a fund with around $1.65 billion in capital.  It borrowed the rest of the money from Merrill to buy the $6.7 billion in CDOs.  If this really is the bottom, Lone Star gets all the upside.  If the CDOs go to zero, Merrill will lose $5 billion because it can't go after Lone Star's other assets, it only has recourse to the CDOs.  Although technically it looks like Merrill is getting rid of the assets, it still retains risk that the Loan Star affiliate will default or will be unable to meet margin calls and then Merrill will seize the collateral and be stuck with the ensuing losses.  This deal smacks of desperation, but Merrill is in fact desperate to put this mess behind it and move on.

As for the stock offering, Temasek Holdings, the Singapore investment fund has agreed to purchase $3.4 billion in Merrill's offering.  Temasek, if you recall, thought $48 was a great price for Merrill back in January, 2008 when the investment fund took a $4.4 billion stake in Merrill.  If you loved it at $48, you might as well buy more at $24.  Unfortunately, this will require regulatory approval as Temasek's stake was close to 9.4%.  Furthermore, Merrill has agreed to pay Temasek $2.5 billion due to certain obligations under reset provisions contained in Temasek's earlier investment, which Temasek will reinvest in the offering.

If you were wondering why Merrill's shares were taking such  beating in the past few days, even relative to its broker dealer friends, this is the news you've been waiting for.  Whoever knew about the common equity issuance did a fairly decent job of telling a few of his closest friends without having it wind up in the mainstream press (as a few of the untrue Lehman rumors did).  What do you call a rumor about a common equity issuance that turns out to be true?  That, my friends, is called insider trading.  Where's Christopher Cox when you need him?

Citigroup Earnings Better, Merrill Earnings Worse

Merrill's $4.65 billion net loss reported yesterday afternoon was a shock even to the most pessimistic analysts, who had all been caught up in an earnings estimate slashing frenzy for the past couple of weeks.  The investment bank posted a $9.7 billion write-down which was somewhat offset by the $4.43 billion sale of its stake in Bloomberg.  The company's second quarter loss was actually higher than its first quarter loss.  Apparently, the worst was not over for Merrill then.  Is it over now?  Frankly, it is a really bad sign when a company begins to sell its valuable assets while burying its head in the sand on its real problem.  Merrill's remaining CDO holdings fell to $19.9 billion at the end of June from $26.3 billion at the end of March.  Mr. Thain claimed that buyers are offering prices for CDO's that are too low to justify a sale.  What does this statement really mean?  They have these assets marked too high on their balance sheets and will need to take further write-downs.  Unless of course, the CDO market magically reinvigorates and buyers emerge out of the woodwork.  

The interesting thing is that sentiment has improved so much in the past two days that Merrill's bleak earnings report did not dent its stock price much for a very peculiar reason.  Citigroup, in a real shock to the market, reported a mere $2.5 billion loss.  The company only posted $7.2 billion in write-downs on its exposure to bond insurers.  Of course, Citigroup's assets remain at $2.2 trillion.  If I could get my hands on the current copy of the balance sheet, I would consider spending my weekend attempting to determine what future surprises lie buried in the morass of Citi's assets.  But I suppose I'll have to wait another 45 days for the 10-Q like everyone else and join in the current euphoria over a non-catastrophic earnings report.  It will give me some time to figure out how Freddie Mac plans to raise $10 billion in equity when its market cap is only $5.39 billion.

Marginal JP Morgan Earnings Vs. Lousy Economic Number, Who Will Win Battle?

Yesterday's marginal earnings results from Wells Fargo (down 23% but exceeded estimates!) beat out a jarringly high CPI report and record low homebuilder confidence to propel the Dow up 276 points.  Not to be outdone, JP Morgan followed Wells Fargo with its own middling earnings report of a profit decline of 53% from the prior year that the market absolutely loves enough to ignore the abysmal housing starts number.  Housing starts rose due to a technical change in the way the index is calculated, but otherwise remained at 17 year lows.  The market is higher on what is perceived to be non-catastrophic results from two of the largest money center banks, which has caused a huge relief rally in the entire financial sector.  One has to wonder if the market is getting ahead of itself for a few important reasons.  First of all, we have yet to hear from Bank of America, Merrill Lynch, Wachovia, or Citigroup.  Merrill's decision to sell its Bloomberg stake for $4.5 billion, less than what it had initially anticipated is a sign that they are desperate for cash and are willing to part with some valuable assets (as opposed to perhaps the garbage that may still lurk on the balance sheet.)  

Most importantly, when banks report earnings, they do not supply a balance sheet.  In my opinion, it is nearly impossible to gauge a bank's financial condition without looking at the balance sheet.  Specifically for commercial banks, a line item called OCI (other comprehensive income) includes profits or losses taken on the bank's available for sale portfolio that the bank may deem as "temporary."  For some reason, investors seem to overlook this item, despite the fact that in times when spreads in the credit markets are at their widest levels in years, significant losses may be hiding in OCI, perhaps enough to wipe out reported earnings.  In any event the market seems to like the news for the time being.  We'll see how long this bear market rally lasts.   

Merrill Analyst Says Buy GM at $40 and Sell It At $11

A Merrill Lynch analyst put out some groundbreaking research on GM this morning claiming that bankruptcy was an option for the auto company.  He reversed his prior buy recommendation (issued in February 2007 when the stock was at $40) and cut the stock to an "underperform" now that it is trading below $11.  I'm not quite sure what caused the analyst to change his formerly bullish opinion.  Perhaps it was based on one of the following reasons?

• GM's debt is trading and has been trading at distressed levels for some time.
• GM's credit default swaps are already pricing in a 75% probability that the automaker will default on its debt within the next 5 years.
• Car sales have been in a steep decline and the auto industry just reported a roughly 20% decline in sales for the month of June.
• GMAC, the financing arm still 49% owned by GM, had to completely restructure its financing because its mortgage lending arm ResCap came dangerously close to declaring bankruptcy.
• GM's stock is down 56% year to date.
• The analyst needed to change his recommendation ASAP so he could tell everyone that he warned them of GM's bankruptcy, thus justifying his existence.

Since he didn't issue an apology with his downgrade to make up for being so incredibly ridiculously behind in following the GM headlines, I'm assuming he's not the least bit sorry for losing so much money for investors.  What I find even more absurd is that the stock actually sold off an additional 8% on the downgrade.  Who are the investors that use Merrill Lynch as their sole source of news?  How can anybody still be surprised by a report that claims that GM could go bankrupt?  Did someone actually receive this research report and then call every one of his brokers and scream "Sell all my GM!  All of it!  My analyst told me it might go bankrupt!"  It is price action like this that makes me a serious doubter of the "efficient market" hypothesis.  How on earth can all the negative news be priced into stocks when somebody actually thinks an analyst's opinion matters?