Merrill relief another illusion in hall of mirrors ?

Pedro Nicolaci da Costa

U.S. bank stocks may be staging another suckers’ rally.

The launchpad for this week’s recovery in financial sector shares was another huge $5.7 billion writedown from Merrill Lynch, which was swiftly followed by what is fast becoming Wall Street’s motto in the year-long credit crisis: the worst is over.

Not so fast, say skeptics, who argue that Merrill’s announcement actually contains the seeds of another downturn in the credit markets.

Nouriel Roubini, whose long-time view that the U.S. economy was headed for trouble has been vindicated by slumping house prices and rising defaults on mortgages, says the devil is in the collateralized debt obligations which are often backed by mortgage debt.

In particular, he argues that the fact that Merrill was forced to finance three quarters of the sale of $30.6 billion of its collateralized debt obligations, or CDOs, means that the securities are worth even less than the depressed value they garnered in the transaction.

“That implies that these CDOs are worth much less than 22 cents of the dollar,” said Roubini. “The true market value of this garbage is closer to zero.”

In the latest twist in financial engineering, Merrill actually used the toxic securities it had been unable to offload as collateral in the transaction with distressed debt investor Lone Star, so the bank is still on the hook for possible losses, analysts said.

In addition, Merrill’s attempt to raise capital via a $900 million stock sale to Singaporean sovereign wealth fund Temasek, also came with a caveat of its own: the investment bank will give the Temasek a rebate of $2.5 billion on an earlier $4.4 billion share purchase.

Moreover, the market price fetched for the CDOs, however fuzzy, sets a new, lower benchmark for other financial institutions when they have to mark-to-market or value their assets. This means rather than signaling an “end-game” for write-downs, as some optimists had suggested, Merrill’s move could actually be the start of another round of headline-grabbing losses.

“It just shows this is going to continue,” said Thomas Nyheim, vice-president and portfolio manager at Christiana Bank & Trust Company, in Delaware. “This is setting a lower bar.”


Merrill’s case gets to the heart of the country’s financial crisis: Wall Street developed financial products that were so complex that nobody knows what they are worth.

All investors know is that, until the prices of the underlying assets — houses and home mortgages — start to recover, these things are not worth very much.

“Herein lies the problem,” said Jack McHugh, an analyst at Pretorian Advisors in Chicago. “Nobody knows how to value the stuff an institution holds until a price is rendered in the marketplace.”

Sure, financial stocks have rallied this week. On Wednesday the S&P financials index was up 2.0 percent, and Merrill itself was up 2.51 percent. The broader stock market rode the wave, with the Dow Jones Industrial Average .DJI up 1.6 percent.

Yet most investors believed this has been a relief rally, helped on Wednesday by the Federal Reserve’s renewed assurances that it will continue to provide a backstop for market liquidity, rather than the start of a real rebound.

Even those analysts who greeted Merrill’s announcement with glee were having second thoughts.

“Perhaps the initial euphoria over Merrill’s asset sale and capital raise … overstates the positive implications,” said Jeffrey Rosenberg, a Bank of America strategist who initially welcomed Merrill’s news as the beginning of the end for the banking sector’s woes.

“Merrill now finds itself effectively in the position of having sold off its upside but retaining its downside.”

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