What Merrill Means for MaineFail

When a shaky investment falls in value while no one's looking, does it still make a sound? Answer: only when it's time to sell. Earlier this week investment bankers up and down Wall Street began complaining about some serious ear-ringing at the exact moment that Merrill Lynch announced an impending sale of impaired assets at 22 cents on the dollar.

The mortgage-backed securities on Merrill's balance sheet are on everyone else's, too. Ever since the credit crisis began last August, there has been a tacit code of silence among the players: whatever you do, don't let on as to what these securities are really worth. Write these down gradually, a few billion this quarter, a few more the next. What we need is time to wriggle our asses, sorry, assets out of this mess.

Merrill has broken that code. (You may now cue up the Chambers Brothers' "Time Has Come Today--TIME!") Thanks to Merrill, there is now a market to which these assets can be marked, triggering massive write-downs throughout the industry. "Merrill Lynch converted its mark-to-market losses into permanent ones," noted investment strategist Ed Yardeni in an e-mail to clients Tuesday. "This is bad news for other investment banks and commercial banks trying to get rid of loans and securities in a market flooded with distressed assets."

Which brings us to Maine's failed investment in MainSail II. Yesterday Maine's Treasurer, David Lemoine, posted an update on the State's cash pool. Because accounting rules required a "valuation snapshot" of the MainSail investment on June 30, or fiscal year's end, consultants used their magic dartboard to come up with 33 cents on the dollar. That meant that Maine's cash pool was showing an unrealized loss of almost $13.3 million on that investment. But that was then. If we mark to Merrill, not to magic, we are looking at a paper loss in excess of $15.5 million on an initial investment of $19.9 million.

Let's keep going. Remember that Merrill accepted only 25% down on the sale of the CDOs, or 5.5 cents on the dollar. The loan of the other 75% is secured only by the CDOs themselves, which means that Merrill will get them back if they decline in value by another 25% from here. If you use the down payment as the real market value of such securities, then MaineFail's loss balloons to $18.8 million. Why does it suddenly sound so loud in here?

Lemoine's capsule summary is as good as any. "The market estimate confirms that the U.S. housing market and the worldwide credit markets continue to suffer, and that investors continue to shy away from mortgage-backed investments regardless of their underlying value. The arrival of a bear market on the equities exchanges, ongoing huge bank write-downs, relentless energy prices and inflation fears have stifled investor appetite for fixed-income instruments such as Mainsail II."

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.

A Mixed Bag

Will the U.S. Senate smooth out the kinks? The mortgage-relief bill passed by the House on Wednesday has some noble objectives. It seeks to protect hundred of thousands of homeowners from foreclosure and to extract concessions from lenders who floated risky mortgages built to fail. It favors owners of modest means who actually occupy their homes while leaving speculators in pricier properties exposed to market discipline. It creates loan-loss reserves funded by exit fees from relieved lenders and insurance premiums from relieved borrowers. It stiffens disclosure requirements for lenders and mandates a seven-day waiting period between the delivery of mortgage documents and closing. These are all good.

Now for the bad and the ugly. Yesterday I penned my disgust with the GSE bailout. Not only has the Treasury Department been given a blank check for loaning backup to the terrible twins, Fannie Mae and Freddie Mac, but it is not even required by law to demand the most senior position among lenders to these entities. This feeds the suspicion that the bill is intended to prop up Fannie and Freddie's debt (to the debtholders' benefit) as much as it is to rescue borrowers from sky-high mortgage payments.

Other flies in the ointment:

A one-year moratorium on risk-based pricing for FHA-insured loans. The Federal Home Administration is a government program that actually works. It helps mortgage borrowers with weak credit or little upfront cash, and it does so without costing taxpayers money. Congress wants the FHA to insure another $300 billion in home loans, almost doubling its exposure, while preventing it from charging high-risk borrowers extra. Said FHA Commissioner Brian Montgomery at a hearing this spring, "the FHA should not be forced legislatively to compromise its fundamental [lending] criteria at the future expense of the taxpayer." Sorry, Brian, consider yourself forced.

A tax credit for first-time home buyers. This obviously departs from the main mission of rescuing borrowers trapped in unaffordable mortgages. At the same time that the House bill insists on adequate down payments for refinanced loans, it offers to cover (up to $7,500) the down payments of new borrowers with 15-year interest-free loans. These are taxpayer-funded teasers, all risk and no return--a desperate attempt to chew through the housing glut while possibly ensnaring a new generation of distressed borrowers.

A permanent increase in conforming loan caps. Remember that back in February the economic stimulus package passed by Congress temporarily raised the limit for a Fannie or Freddie loan. The new bill makes the increase permanent, from $417,00 to $625,000. Again I ask, how does this help low- and middle-income homeowners? The new cap serves only to restore liquidity and prop up values in the high-end market, where borrowers should have known better.

[update, July 30--]
The National Association of Home Builders admitted in a statement today who benefits most from the temporary tax credit for first-time buyers: "the tax credit will stimulate home buying, reduce excess supply in housing markets and shore up home prices." In other words, the ones who over-built in the first place get to hawk their inventory (buyer-assistance courtesy of the American taxpayer) before prices crash completely.

When Is a Bailout Not a Bailout?

When the President says so. "I don't think it's a bailout," insisted George Dubya last week as Congress was putting the finishing touches on a bill that would provide a financial backstop for mortgage lenders Fannie Mae and Freddie Mac. The President's reasoning? "The shareholders still own the company."

The Prez seems confused on two points. First, when he said "bailout," he probably meant takeover. After all, a major criticism of the mortgage-relief package is that it would be the first step toward nationalization of Fannie and Freddie, a government takeover of two distressed companies that cooked the books and rewarded top executives handsomely while taking on huge risk. Gains were privatized; losses will be socialized. Such an outcome must not sit well with our Capitalist-in-Chief.

Make no mistake, the owners are getting bailed out. The bill passed by the House of Representatives yesterday enables the Treasury Department to extend an unlimited line of credit to Fannie and Freddie. This obviously adds value to the franchises; witness the tripling in share prices in FNM and FRE over the past two weeks. If it walks and talks like a bailout, it must be one.

And it might, in the end, be a takeover as well--the other point of Dubya's confusion. Not only will the U.S. Treasury lend boatloads of capital to the GSEs, but it will buy their stock (or accept it as collateral for the loans). You might call it the Paulson Put, a taxpayer-funded option that protects shareholders from further downside. Republicans are choking on the idea, but heck, it's an election year. Besides, the President at the last minute has changed his mind about a veto, a sign that confusion and desperation reign supreme.

Mama Merrill!

Make it four consecutive quarters of red ink for Merrill Lynch, which reported Q2 earnings last Thursday. Did I say earnings? I meant losses, which have piled up to $19 billion over the past year. It took the investment firm four years to earn that much money--and only one to watch it go poof!

Write-downs for impaired assets came to almost $10 billion for the quarter, or over $40 billion since a year ago. To raise cash, Merrill sold its 20% stake in Bloomberg LP for $4.4 billion and its controlling interest in Financial Data Services for $3.5 billion. For now it is retaining its 49% stake in asset manager BlackRock Inc., but expect that one to go by the end of 2008. Merrill must liquidate, as it is simply no longer able to raise new capital. The window is closed.

Reporting the same day, executives at the nation's largest investment bank, Citigroup, were doing fist pumps. They lost only half as much as Merrill and only half as much as they had the quarter before. Progress! Still, over $7 billion in write-downs were taken, bringing the overall total to $40 billion since the credit meltdown began last August. If this keeps going, we'll soon be talking about some serious money.

Bay State Blues

State government in Massachusetts is running on fumes, finally cobbling together a budget two weeks into the new fiscal year. Presented with a $28.2 billion dollar budget, Governor Deval Patrick attacked it with a rusty jackknife, whittling away $122.5 million in earmarks. "We've got to prepare now for economic troubles ahead," Patrick said at a signing ceremony yesterday. "Our present circumstances demand increased restraint." Credit the governor with facing up to the new reality.

The budget takes half a billion from the Commonwealth's rainy-day fund and tacks on a buck to the cigarette tax. Even so, the business-funded Massachusetts Taxpayers Foundation foresees $1 billion of red ink in 2009, with capital gains tax revenues drying up and federal healthcare reimbursements falling short. Patrick himself realizes that more cuts may be needed, and he has asked lawmakers for the same authority to make mid-year cuts that was accorded Governor Mitt Romney in 2003. "Granting that authority now, before the end of the legislative session," said Patrick, "enables us to respond quickly and responsibly in the event of a serious downtown."

Troubles? Downturn? It appears that longtime economic adviser Rosy Scenario has been given the pink slip.

Phil 'er Up

Don't worry, be happy, says former senator Phil Gramm in a newspaper interview appearing Wednesday. Easy for him to say. He's already got his, having parlayed his political experience into a vice-chairmanship at Swiss banking giant UBS. Serving as John McCain's top economic adviser, Gramm insists that all this talk about America in decline is just that, talk. "Misery sells newspapers," he scoffs. "We have sort of become a nation of whiners. You just hear this constant whining, complaining about a loss of competitiveness."

O.K., let's check the headlines for the past 48 hours. GE to sell Japan unit to Shinsei for $5.4 billion. Citi to sell German retail unit to Credit Mutuel for $7.7 billion. Merrill may get $5 billion for Bloomberg stake. Earlier this spring Bear Stearns sold itself to JP Morgan Chase, and Lehman Bros. is next. Folks, this implosion in American finance constitutes the biggest yard sale in human history, and Gramm says that it is all "mental?"

To his credit, candidate McCain has distanced himself from Gramm's remarks. Meanwhile, Mr. Consumer, please ignore the four-dollar gas, the ten-dollar mozzarella, the pink slip, and the eviction notice. You are only imagining those things.

The Future of Gaming in Maine?

Build it, but will they come? Maybe not, if the chart above is to be believed. While the new Hollywood Slots opened with considerable fanfare this week in Bangor, less attention has been paid to the sliding stock price of the parent company, Penn National Gaming, Inc. Notice the 50% haircut since the first of the year. Investors are apparently worried that revenues will dry up in the current recession.

Yesterday a leveraged buyout of Penn National was called off. The original offer, announced in June 2007, was $6.1 billion, or roughly three times annual revenues. This translated to $67 a share, a 30% premium at the time. The day after the announcement, PENN shares gapped up about ten bucks. But that was the high-water mark. In August credit markets began to implode (that was when MaineFail defaulted, remember?), and by mid-January PENN had retreated to its pre-offer price.

By the one-year anniversary of the offer, the deal had still not closed. Investors, sensing that the LBO partners wanted better terms, began dumping the stock, which got a one-third discount in just two weeks. Now the buyers have walked away, although it will cost them to do so: a termination fee of $225 million, plus the purchase of $1.25 billion of preferred stock with no guaranteed dividend before the 2015 redemption date. That adds up to a $1.475 billion cash infusion for Penn National, which says that it will pay down debt and repurchase stock. Oh, and if there is anything left after that, they might expand their business--maybe.

As Maine voters go to the polls on November 4, they should realize that the gaming industry is in trouble. Call up any stock chart you want. Pinnacle Entertainment was trading at 35 in February 2007; now it is under 10. Over the same period, Isle of Capri Casinos has gone from 30 to under 5. MGM Mirage, trading for 100 as recently as last October, is now under 30. It can be assumed that insiders are among those jumping ship.

Will the anonymous backers of the proposed Oxford County casino be the next to walk?

[update, July 10:]
The stock price of MGM Mirage fell another 22% to 23 today following news that Nevada's gambling revenue fell 15% in May. The drop-off was even more precipitous in Las Vegas, where "the decline in Strip revenues is worse than the period immediately following Sept. 11, 2001," according to a UBS analyst. Revenues away from the casino floor are also under pressure, forcing reductions in flights and room rates.