Daily Market Reports | Jul 30 2008
By Greg Peel
The Dow rose 266 points or 2.4% while the S&P rallied 2.3% and the Nasdaq 2.5%.
Details emerged last night of the deal that Merrill Lynch has executed in terms of both equity and debt positions. On first blush it had appeared to be more bearish news that the struggling investment bank had written down another $5.7bn in CDO values having announced US$9bn in write-downs not two weeks ago at its second quarter earnings release. Furthermore, the bank was to raise US$8.5bn in fresh capital, further diluting the shareholder base. Why was this not pre-empted at the earnings release?
But now that the deal is understood it’s a different story. Clearly it is one Merrills’ CEO John Thain – who was brought in to replace the former CEO who put all the toxic positions on in the first place – has been working on beyond the cut-off date for second quarter reporting. And by its nature, it could well have marked a significant turning point in the credit crisis.
Ever since the credit crunch began, the burning question has been what is a subprime CDO worth? By their complexity, and lack of transparent trade, CDOs have only been able to be valued on a best-guess basis for the past twelve months, and those best-guesses have continually erred to the side of blind optimism. When the first CDO write-downs began, valuations were put at around the 90 cents in the dollar range. Even at that point commentators were suggesting these were “kitchen sink” write-downs and that the securities were ridiculously cheap. But as the months wore on, it was apparent that (a) there were no buyers at that price, nor indeed at any price and (b) the housing crisis was only getting worse, which translates into yet lower CDO values.
Almost a year after the two Bear Stearns hedge funds went under and the credit crisis began, Merrill Lynch has found a buyer for CDOs with a face value of US$30.6bn – a sizeable chunk of Merrills’ toxic portfolio – at US$6.7bn, or 22 cents in the dollar. That buyer is a private fund called Lone Star.
John Thain has thus cleared at least some of the decks. At the same time, Merrills has placed US$3.4bn of new capital with Singapore’s sovereign wealth fund Temasek. The placement forms part of an US$8.55bn share issue at US$22.50 per share. Merrills was trading at close to US$80 at its peak, and Temasek had previously moved in to buy a chunk of capital at US$48 as part of the wave of sovereign fund buying into US financials in the first leg of the credit crunch rout. The catch, therefore, was that Merrills has to reimburse Temasek with US$2.5bn before the fund would buy new capital. In other words, Temasek has had its original investment rebased at current levels.
In order to provide confidence to potential buyers of the remaining capital on offer, executives will buy 750,000 shares.
This announcement has its negative implications. Firstly, as a holder of Merrill you will have had your investment diluted after the stock has fallen over 70% and you will now have no chance to recover any value on a US$30bn portfolio of mortgage securities when the dust settles. Secondly, the Merrill initiative has thrown out the gauntlet to other financial institutions to bite their own bullets. At the very least, they must now mark down to 22 cents in the dollar, given a price has been established and “mark-to-model” can no longer be justified. This could trigger another wave of write-downs. It might also trigger a wave of capital raisings, and on Temasek’s lead potential rebasements of former investments by other sovereign wealth funds into other institutions.
But it also has its positive implications, and that’s what the market concentrated on last night. CDOs have found a price, which, in theory, thus marks the bottom of their spiralling losses in value. If one buyer of distressed securities has been prepared to make the move, maybe a rush will ensue. Toxic paper has been shifted from America’s third largest investment bank into the hands of cowboys – where it belongs. Furthermore, the Temasek investment may well encourage other investors – whether they be sovereign wealth funds or others closer to home – to get in. Clearly Wall Street decided last night it might be a good idea to follow the lead.
The sale of CDOs also has very positive connotations for the monoline insurers who are currently holding on by a gossamer thread. If the CDOs are sold as an investment, then insurance will not, in theory, be claimed.
Merrill Lynch shares jumped 8% despite the dilution. In a cross section of the sector, Lehman jumped 10%, Citigroup 6%, Bank of America 15% and Fannie Mae 12%. Shares in monoline MBIA jumped 15%.
Is this it? Is this the bottom? The answer to that is maybe it is, maybe it isn’t, but certainly it’s a step in a positive direction. Bank share prices will always rise before bank earnings have bottomed. But this is just one chunk of CDOs, and as the IMF pointed out yesterday the credit crisis is not limited to the subprime market, but has infected all credit from corporate loans to credit cards. The US economy continues to slow, and as the Case-Shiller housing index for May showed, the average price of a house in America’s top 20 cities has fallen 15.8% in a year – a record for the index.
For the broader market last night, it was all good news. More good news was provided by the July measure of consumer confidence, which rose to 51.9 from 51.0 in June. The market had expected a fall to 50.0. This early release set the initial tone.
Then it became a game of chickens and eggs. The US dollar rallied on the confidence number, and then continued to rally as the stock market gained. The rising dollar set in train a US$2.54 fall in the price of oil to US$122.19. The 122 level is considered technically significant. It could be a bounce point, or a breach could see 110 pretty quickly. Nevertheless, falling oil was another fillip for stocks.
But not for gold. Gold fell US$11.60 to US$918.40/oz. The Aussie over US0.3c to US$0.9528.
The rising US dollar also prompted somewhat of a rout in base metals, with only lead holding its ground. Copper and aluminium fell over 1% and nickel and zinc 3%.
The SPI Overnight was up 84 points.
Might the capitulation of some local bank analysts on Big Five earnings yesterday have also rung a bell after all?
