How Merrill trampled the little guys

By Jim Jubak

I don't care how cheap Merrill Lynch (MER, news, msgs) shares get. Why would any individual investor in his or her right mind buy even one after the scam that CEO John Thain just pulled?

I thought the idea of common stock is that everyone buying a share gets an equal piece of the appreciation, if any, and takes an equal piece of the loss. But Merrill has just paid out $2.5 billion to make one great big shareholder, the Singaporean state investment fund Temasek, happier.

At the same time, in order to raise $8.5 billion in new capital -- part of it to pay off Temasek -- Merrill's other investors are going to see their holdings diluted by 38%. So on top of the punishment the market has dished out to Merrill shareholders this year -- the stock was down 49% for 2008 as of the close on July 30 -- Thain has just dished out a 38% haircut. After the deal is done, existing shareholders will own 38% less of the shrunken company.

But shareholders shouldn't feel utterly outraged. On July 30, the Merrill Lynch board of directors voted to pay the company's regular 35-cent-a-share quarterly dividend on Sept. 3 to holders of the stock as of Aug. 14. A year ago, when the stock traded at $74 a share, that annual dividend of $1.40 amounted to a paltry yield of 1.9%. On July 30, with the stock at $26.91, the yield has soared to 5.2%. See, Merrill shareholders do have something to feel grateful for.

The running of the bulls

Here's how Merrill's thundering herd trampled ordinary investors.

On July 28, Thain gave in to reality. The company's huge portfolio of securities backed by mortgages wasn't getting any healthier. The company had already written down the most senior and least risky part of its portfolio of mortgage-backed securities (derivatives called CDOs, or collateralized debt obligations) to 36 cents on the dollar. But investors looking at the $31 billion face value of that portfolio -- plus the $7.4 billion in non-U.S. mortgages, the $1.5 billion in somewhat risky Alt-A mortgages, the $18 billion in commercial-real-estate loans and the $18 billion in mortgages at Merrill's banking subsidiaries -- weren't convinced that the company wouldn't have to take even bigger write-offs.

All of that put Merrill in a real bind. The company had raised $15 billion in new capital in late 2007 by selling shares. And it had just raised an additional $4.5 billion in capital by selling off its almost 50% share of financial information and analytics provider Bloomberg.

But if the company needed to take yet another big write-down and raise yet more capital, Thain didn't have much in the way of assets left to sell. There was the company's stake in investment manager BlackRock (BLK, news, msgs). That stake was worth a chunk of cash, but credit rating company Moody's (MCO, news, msgs) had warned that it would downgrade Merrill's bonds to junk if the company sold its piece of BlackRock. And investors were balking at buying more Merrill shares as long as they couldn't tell how big the next write-off was going to be.

Who could blame them? The big institutional investors that had ridden to Merrill's rescue earlier in this crisis had taken a bath. Temasek, which had put $4.4 billion into Merrill Lynch in December, at $48 a share, and then threw good money after bad by putting $600 million more into Merrill in March, when the stock still traded in the $40s, was looking at a loss of about half its investment in seven months.

As the value of its investment sank, Asian criticism of management at Temasek mounted. At best, Temasek had blundered the timing of the investment; at worst, management had been outsmarted by Merrill Lynch and had squandered money that belonged to the government and citizens of Singapore.

Continued: Reset clause

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