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No More Bull

Posted on: September 17, 2008 - Email Article - Printable Version

Adam Brown

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The landscape of Wall Street, ever changing, transformed this weekend with the liquidation of Lehman Brothers [LEH: 0.00, N/A (N/A)] and the purchase of Merrill Lynch [MER: 0.00, 0.00 (0.00%)] by Bank of America [BAC: 13.98, -0.35 (-2.44%)]. The latter took down one of the largest and most venerable institutions on Wall Street in less than 48 hours of negotiations between the two banks.

The Details

Merrill Lynch agreed late Sunday to be purchased by Bank of America. The deal was an all stock transaction, with BoA exchanging 0.8595 shares for each Merrill share. That put Merrill’s value at $29.00 a share, representing a 70% premium from their closing price on Friday. The deal is expected to close in the first quarter of 2009. Bank of America Chief Executive Ken Lewis announced that the deal is projected to bring about $7 billion in pretax cost savings. BoA sought to expand its global footprint with Merrill’s investment banking unit and take advantage of their very profitable retail business. Merrill, after a 36% drop in their stock price on Friday and fears of worsening capital constraints, started shopping for a buyer over the weekend.

Interestingly, shares of Merrill remained well shy of the $29.00 price of the deal, trading around $22.00. This usually occurs when investors feel that an acquisition would destroy shareholder value. With little fear, regulators will hold up the purchase, in fact they probably encouraged it. The price was instead a reflection of fears of the future of BoA stock. Despite projected synergies, investors were mindful BoA will be assuming a large portfolio of mortgage and real-estate assets onto their books.

Details emerged that Merrill had also been in talks with Goldman Sachs [GS: 88.78, +2.02 (+2.33%)] and Morgan Stanley [MS: 17.62, +0.63 (+3.71%)] over the weekend. Thain, a former president at Goldman, discussed the prospect of selling a minority stake in Merrill to raise capital. Morgan Stanley said it did not have enough time to properly assess the value of the company in the time frame Merrill wanted to complete a deal. Bank of America, on the other hand, had previously been in talks with Merrill and likely had the most complementary business to make possible such a merger.

Moving Forward

While it is difficult not to lament the inevitable job loss that comes with such a transaction, I do think the deal has real long-term value. From BoA’s perspective, it’s hard to argue Ken Lewis’ synopsis that the merger “brings together two storied brands and creates a company unrivaled in its breadth of financial services and global reach.” My issue with the deal comes in the details. With the looming collapse of Lehman and the inevitable further roiling of the markets coming on Monday, BoA easily could have waited for a cheaper price. Lewis clearly overpaid for Countrywide and took little heed in doing the same with Merrill. Additionally, the projected $7 billion in synergies may be a bit ambitious. Any company’s ability to ingest two firms the size of Merrill and Countrywide in such a short time period is questionable. This prospect is made all the more troubling by the difficulty in valuation of the two companies’ assets in such market environments. That being said, with the financial services landscape slimmed down considerably, BoA’s size and global scope make them the dominate player moving forward.

From Merrill’s perspective, Thain seemed to realize the inevitable. Taking a step back, one has to assume his time at Merrill was running out. The firm’s stock lost 61% of its value since Thain took over and there seemed little prospect of that turning around in the near future. At a 70% premium for the company, I cannot blame him for the sale. While the 70% figure is a bit inflated after the beating the stock took Friday on news of Lehman, I think Merrill got a generous offer for a firm still holding so many “problem assets.”

Our financial system continues to teeter after a roller coaster weekend followed by more troubles with AIG Monday. Overnight the LIBOR exploded to 6.44% and the Fed was forced to inject $70 billion through open market transaction to keep their target rate of 2.00%. Morgan Stanley 5-year CDS jumped 128bps wider after today’s earnings report. The remainder of the trading week will be volatile as investors take time to ingest the onslaught of changes to the marketplace seen over the past several days.

-Adam Brown

Disclosure: The mutual fund the author is associated with is long GS and BAC.

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