Financial services stocks have advanced smartly in the past few days after Merrill Lynch (MER) announced it would accept a massive write-down on damaged mortgage derivative assets and raise more capital through a stock offering.
But I can’t help but wonder if this is going to be short-lived, as Merrill’s deal was not everything it seemed.
On the day the deal was announced, Merrill shares initially collapsed. But then buyers came in, and by the end of the day the stock was up 20% from its low and up 8% for the day. A touch more than 293 million shares traded hands, which is a ton.
Just to give you give you some perspective on the size of that move, the largest previous day of trading for Merrill was around 60 million on three separate days around the March low this year. So it certainly conjures up the old cliché about shares moving from weak hands to strong hands. And the fact that it rallied on bad news gives the event special flavor.
Yet is it really that big a deal? The previous time I recall this sort of move occurring was, well, two weeks ago.
Merrill rallied from $23.64 on July 17th to $36.97 on July 23rd, a 60% jump. Then it fell by 40%. Before that, the stock rallied 44% from mid-March to mid-May. Then it fell by 55%. Before that it rallied by 25% twice, once in January and once in November. And it’s down 60% from there.
The only constant in all of these rallies is that they have become progressively more intense, and they all ultimately ended in new lows.
Why should this one be any different? I would look for the rally to continue for awhile, possibly another 40% higher to the $37 to $40 area, before the bears return for their next attack.
Here’s why: There’s little doubt that what Merrill announced on Tuesday took courage. It acknowledged that its attempt in 2006 and 2007 to become the largest underwriter of collateralized debt obligations was foolhardy and accepted an 78% loss on inventory with which it had been stuck. A set of senior debt securities with a notional gross value of $30 billion was sold for $6 billion, and Merrill had to finance 75% of the sale to boot.
But let’s not forget that this move simply allowed the new chief executive, John Thain, to blame the loss on previous chief executive Stan O’Neal. So "courage" may be a bit strong for an act that was politically expedient.
And MER was not the first to do this. You may recall that in my Friday report (“Don’t Trust the Bank Bounce“) I called your attention to the fact that National Bank of Australia decided last week to write down 90% of the value of its U.S. mortgage derivatives, a move that was shocking to many.
Now the problem is…>
that both of these moves place a lot of pressure on other financial services firms, such as Lehman Brothers (LEH), JP Morgan (JPM) and Deutsche Bank (DB), to do the same. This is exactly what has to be done to end the credit crisis, but the path leads through a heck of a lot of thorn bushes and hurt.
Plus, as independent credit analyst Brian Reynolds points out, the Merrill write-down and sale only relates to mortgage-related assets. Merrill and its peers were also highly exposed through derivatives to many other credit markets, such as consumer credit cards, auto loans, student loans and the like, so there are many more write-downs of this nature left to come—all of which will blow holes in balance sheets that will need to be filled by the raising of more capital. Merrill, as a trophy company, was able to raise money from a Singapore sovereign wealth fund, but that kind of money is limited.
Moreover, we need to be aware that since Merrill financed the sale of these assets to an affiliate of the private equity firm Lone Star (which is itself an affiliate of the billionaire Bass family of Texas), Reynolds points out that it may actually be nothing more than a "paper-shuffling" move and not one that actually removes economic risk from Merrill.
In other words, if the CDOs go bad, and Lone Star doesn’t want to take the losses, it can always default on its obligations—leaving its lender, Merrill, on the hook for them. I’m not saying that’s going to happen, but that’s far from an arms-length transaction.
And lastly Reynolds points out that the assets sold were "super-senior" pieces of debt, or the top of the pyramid of the credit structure, which means that lower tranches owned by Merrill or someone else will fetch much lower prices. Imagine how low the price would be if Merrill hadn’t agreed to finance the purchase!
So it was great that Merrill has gotten out in front of this problem, finally, and put itself first in line to get more capital from private equity and sovereign wealth funds—and that’s why, in part, the stock rallied. But it seems to me as if it sets up fellow brokers and investment banks for more volatility and strife to come.
Bottom line: I’m looking for a rally to around S&P 1,320 to 1,330 and then a renewed attack by bears. I’m also looking for the path ahead to be bumpy, with a lot of misdirection thrown in. The spike down on Tuesday was probably one of those errant signals and so was the reaction to the Merrill deal.
In Trader’s Advantage, my recommendations now are on the long side as the market temporarily points higher, but by mid to late August we’ll be ready to get short again.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights like this, visit www.InvestorPlace.com.
