Will a Stronger Economy and Credit Markets Reverse Merrill's Writedowns?

Jul.31.08 | About: Merrill Lynch (MER)

Analysts are calling Merrill Lynch & Co.’s (MER) decision to sell $8.5-billion in common stock, terminate its hedges with monoline counterparties and dispose of most of its ABS CDO portfolio a painful but necessary step to push the company forward and beyond the year-long detour linked to its legacy assets.

Merrill’s senior executives are buying 750,000 common shares, while Singapore sovereign wealth fund Temasek Holdings will buy roughly 124 million of the 310 million in total new shares with $900-million and a rebate of $2.5-billion linked to its original $4.4-billion investment. This cuts the cost of its shares in Merrill roughly in half to $21 each.

The Street slashed its 2008 earnings estimates as a result of the dilution that could bring the number shares outstanding up 38%, along with accelerated writedowns of $5.7-billion expected in the third quarter.

Analysts like Mike Mayo at Deutsche Bank liked the fact that Merrill is getting ahead of others in collecting money from monolines, compared with waiting 20 to 40 years.

In a note to clients, he added:

The good news is that the actual sales can give confidence that it is finally selling assets vs. merely marking them to market.

Among the downside risks he sees for Merrill going forward is unsurprisingly the performance of mortgages. However, Mr. Mayo says the potential upside from a strengthening economy and credit markets could lead to reversals of previous writedowns.

But despite the fact that the deal lowers Merrill’s CDO exposure, risks nonetheless remain. For example, Merrill is providing financing for 75% of the $6.7-billion purchase price, Goldman Sachs analyst William Tanona told clients.

Analysts are also forecasting negative implications for firms like Citigroup Inc.(NYSE:C). For example, Mr. Tanona noted that its assets appear to be marked in the $0.50 range, while Merrill sold its ABS CDO exposure for $0.22 on the dollar.