Ratchet Provisions Soak Merrill Lynch, Will Sink WaMu

It was just 5 days ago in Death Spiral Financing at WaMu, Merrill Lynch, Citigroup that I wrote about ratchet provisions and how they would bite companies that agreed to them. Here is the key snip:

The investors in the equity raise would have their investment “protected” by a provision which states that should the bank afterwards raise money at a lower price than what they paid, these investors would be compensated retroactively by having their initial investment priced at this lower price, thereby being issued new shares for free.

It doesn’t take a mathematician to see how these provisions can result in massive dilution should the bank subsequently raise even a paltry amount of capital. A new offering will trigger a lower price because of the dilution it would cause, which would trigger even more dilution because of the lower price, which would then trigger an even lower price because of the even higher dilution, etc. This is why we call such securities a death spiral.

As expected, Merrill Lynch needed to raise capital again. And this one hurts because Merrill previously agree to ratchet provisions. Inquiring minds may wish to consider Merrill to Sell $8.5 Billion of Stock, Unload Money-Losing CDOs.

Merrill Lynch & Co., the third biggest U.S. securities firm, will sell $8.5 billion of stock and liquidate $30.6 billion of bonds at a fifth of their face value to shore up credit ratings imperiled by mortgage losses.

Temasek Holdings Pte., the Singapore-owned fund that became Merrill's biggest investor by acquiring shares in December, will buy $3.4 billion of the new stock, Merrill said yesterday in a statement. The New York-based company is paying Temasek $2.5 billion to offset losses on its earlier investment.

My Comment: That $2.5 billion is because of ratchet provisions. Mother Merrill is really only raising $6 billion.

Almost $19 billion of net losses in the past year forced Merrill Chief Executive Officer John Thain to backtrack from assurances that the firm had enough capital to weather the credit crisis. Since taking the post in December, Thain has raised $30 billion in an effort to keep pace with mounting charges on mortgage bonds amassed by his predecessor, Stan O'Neal.

My Comment: The market cap of Merrill Lynch is $23.97 billion. Mother Merrill has raised $30 billion since December. It is taking herculean capital raising efforts to keep the good ship Merrill afloat.

In yesterday's statement, Merrill said it agreed to sell $30.6 billion of collateralized debt obligations -- the mortgage-related bonds that have caused most of the firm's losses -- for $6.7 billion. The buyer is an affiliate of Lone Star Funds, a Dallas-based investment manager.

Merrill will provide financing for about 75 percent of the purchase price, according to the statement. The financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion.

My Comment: Desperate mothers do desperate things, such as provide 75% of the financing to sell CDOs at 22 cents on the dollar.

Thain's Track Record

In December and January after raising $6.6 billion each month Bloomberg quoted Thain "We're very comfortable with our position. We could have raised substantially more money. We turned people away.''

In April he sold $2.55 billion of preferred stock.

On July 17 in a conference call Thain said "We believe that we are in a very comfortable spot in terms of our capital."

Now Thain is back at it again, selling $8.5 billion in stock but only netting $6 billion in cash from it. It will be interesting to see how long it takes before Thain is back at it. One thing we can assume is that this will not be the last time Thain needs to raise cash, no matter what Thain says.

One good thing for Merrill is their Press Release shows Merrill is no longer exposed to those death spiral ratchets.

In satisfaction of Merrill Lynch’s obligations under the reset provisions contained in the investment agreement with Temasek Holdings, Merrill Lynch has agreed to pay Temasek $2.5 billion, 100% of which Temasek has contractually agreed to invest in the offering at the public offering price without any future reset protection.

Washington Mutual Ratchets

A quick check shows WaMu's market cap is $6.71 Billion. It's share price is $3.95. TPG bought $7 billion of stock at $8.75 with a ratchet provision that if WaMu raises more than $500 million in equity, WaMu has to pay TPG the difference. The odds of WaMu not needing to raise capital are slim and none. Washington Mutual is in deep trouble over many things, and those ratchets make matters worse.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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