Uncovering Material Information at Merrill Lynch

Includes: C, MER
by: Felix Salmon

It's the bottomless write-downs! According to William Tanona of Goldman Sachs (NYSE:GS), the write-downs we've already seen at Citigroup (NYSE:C) and Merrill Lynch (MER) aren't even close to being final. Indeed, he reckons that both banks will see 11-figure write-downs in the fourth quarter alone, over and above what they've already taken.

Especially in the case of Merrill Lynch, this is very serious money: the $11.5 billion write-down that Tanona now expects in Q4 is equivalent to 37% of the bank's book value, and is likely to result in a single-quarter loss of $7 per share.

But if Tanona has managed to draw a bead on the magnitude of Merrill's upcoming losses, that means that the same question now arises at Merrill that I had about Morgan Stanley (NYSE:MS) earlier this month.

Not only has Singapore's Temasek bought into Merrill to the tune of $4.4 billion, but U.S.-based Davis Selected Advisors is putting in $1.2 billion as well. So let's try to run through the different possibilities here.

  1. Temasek and Davis are investing $6.6 billion into Merrill at $48 per share, but have no idea what Merrill's Q4 loss is likely to be. If it turns out to be enormous, they'll be surprised, and they'll be very upset at John Thain for not warning them of the enormity of the upcoming loss.
  2. Temasek and Davis have done their due diligence on Merrill, and have been warned by Merrill that a large write-down is coming in Q4: they're walking into this announcement with their eyes open. In fact, they understand that their capital injection is necessary for Merrill to be able to take this write-down in the first place.
  3. Temasek and Davis have done their due diligence on Merrill, and they know exactly what skeletons are located in its various closets. To them, it's largely immaterial whether and how Merrill marks its CDO holdings on a quarterly basis, since they're long-term investors. If Merrill decides to take a large quarterly loss, they might be surprised, but they won't be upset, since it's of no great matter to them.

Of these, the first is highly improbable: Thain would never treat a white-knight long-term shareholder in such a manner.

The second, I'm pretty sure, would constitute a breach of SEC regulations. Not on the part of Temasek or Davis, but rather on the part of Merrill. If Thain knows today that Merrill is going to take an enormous 11-figure write-down in the fourth quarter, that's material information, which he needs to communicate to the markets in a timely manner. ("Timely", in this context, has a precise definition: four days.) If he doesn't communicate that information by the end of the week, then one can assume that he doesn't have it.

What we're left with is a world in which the facts on the balance sheet can be known, but the way they're accounted for is largely left to the discretion of the bank's executives. Merrill has a shedload of CDOs on its books and isn't sure what to do about them? Well, now that it's got its capital injection, it can afford to take an enormous write-off. On the other hand, it could just as easily get away with not taking that write-off right now.

The last possibility is the most likely, but you'll never find a bank which will admit it's the case. According to them, they conform scrupulously with GAAP and all other reporting regulations, they have little if any discretion over what their results will be in any given quarter, and they certainly don't have discretion over whether or not to realize $11 billion in losses.

If Merrill reports a loss of more than a couple of bucks a share in the fourth quarter, then, it'll be very interesting to see which of these options they say corresponds to how things actually happened. Because none of them is something that Merrill would be very happy admitting.

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