Uncovering Material Information at Merrill Lynch

It’s the bottomless write-downs! According

to William Tanona of Goldman Sachs, the write-downs we’ve

already seen at Citigroup and Merrill Lynch 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 earlier this month.

Not only has Singapore’s Temasek bought

into Merrill to the tune of $4.4 billion, but US-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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