Untangling the web

IFR Top 250 Borrowers 2008
5 min read

The past year has been challenging for all investment banks. For Merrill Lynch, the process of deconstructing a web of mortgage, LBO debt, CDOs and other problematic loans involved a multi-faceted financing strategy, targeting multiple investor bases on an opportunistic timetable. Stephen Lacey reports.

It was a busy Spring for Merrill Lynch, which issued more than US$25bn of long-term debt in April and May in US and Canadian dollars, and sterling, at tenors ranging from two to 30 years. Among the issuances were a US$7bn two-tranche; five and 10-year senior notes; and a £850m 10-year – its largest-ever sterling offering.

But its flagship offering of the year to date was a US$9.5bn deal in April when it shrugged off near historic wides to raise US$7bn from institutional and US$2.55bn from retail markets, paying more than 300bp for five-year and 10-year money. Having been absent from the market since January, a sizeable transaction was universally expected as it looked to bolster is liquidity perception. Even so, the second-largest of the year – after General Electric’s US$8.5bn issue a week earlier – was an impressive showing.

Between the Mays of 2007 and 2008 the bank had issued just over US$45bn according to Thomson Reuters data. Most of its deals – but not all – were led by Merrill Lynch itself: a number of euro-denominated bonds led by HypoVereinsbank and Unicredit Banca Mobiliare, issued in May, June, August and September last year, worth just over €1.5bn, among the exceptions. (It also joint-led a number of deals with the same banks.) There have also been issues in yen.

But arguably equity is an investment bank’s most precious commodity – one that has been difficult to preserve against a backdrop of deterioration of both economic and credit conditions globally. During the first two months of his tenure as CEO of Merrill Lynch, John Thain raised US$12.8bn of equity through two separate transactions: a US$6.2bn sale of common stock in December at US$48.00 – a 14% discount to Temasek Holdings and Davis Selected Advisors; and, in January, another US$6.6bn from the sale of mandatory convertible preferred stock to sovereign wealth funds Korea Investment Corporation, Kuwait Investment Authority and Mizuho Corporate Bank – a long-time strategic partner.

The strategy was to overcapitalise by sourcing liquidity from long-term investors at a fixed price. “We were very deliberate in raising more capital than we lost for the year, so that we will not be going back into the equity capital markets,” said Thain on the firm’s fourth-quarter earnings call in January.

Comprising almost one-third of its outstanding share base, the equity was designed to offset the US$12.3bn of net income losses incurred in the second half of the year, including US$24bn of valuation write downs. The aim was to avoid a credit downgrade by reducing leverage, which had risen from the 20-times range from 2000–2005 to 25.5-times by the second quarter 2007 and to almost 30-times by year-end.

Shrinking the balance sheet while simultaneously selling equity was made all the more difficult by continued write-offs. After reporting a US$2bn first-quarter loss in April, leverage had fallen to 23.8 but questions remained over the liquidity. The results included US$3.1bn write-down for securities held for sale and a direct hit to shareholders’ equity. The bank had intentionally postponed funding its 2008 capital budget as it waited out volatile credit markets: five-year CDS on the bank gapped in March to as wide as L+335bp – 200bp wider than at year-end 2007 – but had tightened to L+175bp by April.

Throughout, Merrill’s management remained committed to not selling additional common equity – in part due to the conditions of the original equity financings, which would require compensation for existing investors if it raised more than US$1bn from the sale of stock at prices below US$48.00 and US$52.50, prior to January 2009.

The alternative was a retail-oriented, US$2.55bn sale of 8.625% perpetual preferred equity, priced in late April. The security ordinarily receives 100% equity treatment from ratings agencies, subject to a 25% cap on the composition of preferred/hybrid securities in its capital base – the Fed allows up to 50%, so it is positioned for a Basel II regulatory framework.

Merrill was well above the 25% cap, leading S&P to downgrade its senior credit rating one-notch to A in early June. The bank was forced to post an additional US$3.2bn of collateral, which was not viewed as problematic relative to an excess liquidity pool at the end of the first quarter of US$82 – an all-time high.

For Merrill, the central question does not appear to be capital adequacy but whether its return on equity can return to historic levels as it shrinks balance sheet. Having dealt with much of the problematic credit on the books, management recently has suggested that the firm can achieve a 20% ROE on a sustained basis. Limiting additional capital raises would seem instrumental to that goal.