Will Merrill's Bungee Break?

Shell-shocked shareholders got more bad news from Merrill Lynch last night when the company announced the sale of new common stock in a desperate attempt to stay afloat. The number of shares outstanding will increase by one-third, a painful dilution that compounds the injury of depreciation. Merrill's stock price has declined by three-fourths in the last eighteen months (and is still over-priced, according to Oppenheimer's Meredith Whitney).

This latest stock offering is supposed to raise $8.5 billion, but don't count on shareholder equity increasing by that much. Merrill will turn around and give $2.5 billion of that to its largest investor, a Singapore-owned sovereign fund, as compensation for losses suffered on an earlier stock purchase. Merrill now expects a third-quarter write-down of nearly $6 billion. So the "new" $8.5 billion is basically gone before it even comes through the door.

CEO John Thain, who has been on the job for less than a year, inherited this mess and so can be spared much of the blame. Still, he has been slow in gauging the depth of the doo-doo. In April he remarked that "we have plenty of capital going forward and we don't need to come back into the equity market," and less than two weeks ago he reiterated that "we are in a very comfortable spot in terms of our capital." Further damaging Merrill's credibility is the liquidation, also announced last night, of over $30 billion worth of collateralized debt obligations at a discount of nearly 80%, a markdown that should have been booked long before now. "Why these assets are written down when you're selling them and weren't written down in your earnings is a question," observed one research analyst.

How toxic are these CDOs? Merrill was forced to finance 75% of the sale price--i.e. they practically gave 'em away. Since the financing is secured only by the assets sold, Merrill will be on the hook if the CDOs decline in value by another 25% or more. The firm had tried to hedge against such depreciation through guarantees purchased from bond insurers, but those insurers are facing insolvency themselves. Merrill is currently trying to extract termination fees from these insurers and managed to collect $500 million from Security Capital Assurance.

What times we live in that such an iconic franchise has to search between the sofa cushions for whatever loose change it can find.