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In going through the financial news stories on various sites tonight, this one from the NY Times struck me as particularly insightful.  Lets see what they have to say about the state of the financial institutions….

The story starts with this: Somehow, $4.4 billion just evaporated at Merrill Lynch. Less than two weeks ago, Merrill Lynch valued the toxic mortgage investments on its books at $11.1 billion. Now, it is selling those investments for $6.7 billion — and financing most of the purchase to boot.

So two weeks ago, Merrill Lynch claimed that the value of their mortgage holdings (the bad ones anyway - they haven’t disclosed all of them) were worth $11 billion.  Today they’re supposedly worth only $6.7 billion.  That’s $4.4 billion utterly gone, destroyed by the decrease in value of the underlying assets.

I say “supposedly” because you haven’t heard the best part yet - Merrill is financing $5 billion of the sale of these assets (which are worth 40% less than two weeks ago) to Lone Star Funds.   I can’t find where I read it right now, but I think Merrill owns a big part of Lone Star Funds.  If this is true, they’re selling these toxic CDO’s to themselves in order to get them off the books.  Not good.

Here’s something from FoxNews on the story:  Lone Star Funds, a Dallas-based distressed-debt investors based run by John Grayken, will acquire asset-backed securities with a nominal value of $30.6 billion for $6.7 billion. The sale will help cut Merrill’s exposure by $11.1 billion from its level on June 27, leaving $8.8 billion of these securities on its books.

That’s 22 cents on the dollar.  The NY Times story linked above puts it into perspective: Executives at Citigroup, JPMorgan Chase and Bank of America began reviewing the bundles of mortgages, known as collateralized debt obligations, or C.D.O.’s, that their companies hold on their books. Those companies may have to lower their valuations, and take additional charges, if their assets are similar to those sold by Merrill.

Of the companies they mentioned, I personally think Citigroup is the one most likely to pull a Bear Stearns and disappear.

The NY Times story also said: Still, financial stocks rallied on Tuesday, as investors hoped the deal at Merrill signaled the troubles plaguing banks’ balance sheets might be coming to an end.

Anyone want to bet on that?  How many times are these analysts going to say that the troubles are over, that this is the kitchen sink quarter, that this must be the bottom?  I can find dozens of examples over the past 10 months.

In just one month, Merrill had to drop the value of some of their CDO’s from $30.6 billion to $6.7 billion.  What does that say about the honesty of their accounting?  Damn near everyone knew they’d have to write these assets down last year - but Merrill tried to delay their day of reckoning.

Regardless of the way the market reacted today, there’s no way Merrill is worth more today than last week.  But that’s what the stock price says.

I am forced to conclude that many investors are stupid, that they are betting on a short term gain, or that they are smoking crack - because the numbers just don’t add up.

If I’m right Merrill (which closed today at $26.25) will be lower a week from now after investors have had time to understand what this really means for Merrill.  Bank of America ($32.22) and Citigroup ($18.46).

One of these days I’ll have the guts to short individual stocks and make some money off of these things that should be obvious to everyone, but I’m chicken.  I have no position in any of the stocks mentioned in this post.

There’s a lot more to say regarding the market and financial stocks, but I’m calling it a night.  Stay tuned.

gk

Wow, lots of stories today about the “shocking” earnings miss (and lowered forecast) by GE.  MarketWatch said “GE’s warning pokes hole in recent sentiment that credit crunch has passed” and “The rebound had been fueled by renewed sentiment on Wall Street that the worst of the credit crisis — including the threat of spiraling financial bankruptcies — was past.”

A story on CNN said “My guess is that earnings forecasts for 2008 are still pretty high relative to the economic reality,” Davidson said.

I have one word for Mr. Davidson - Duh!

As I posted just yesterday, I don’t think we’re anywhere close to a bottom yet, and the earnings estimates for 2008 and 2009 are way too high.  Eventually, stock prices adjust to reflect earnings, and sometimes the adjustment process is long and painful - as we all learned in 2000 through 2003.

All the stories about Goldman Sachs’ and Lehman CEO’s saying that they can see the light at the end of the tunnel - while simultaneously upping their own writedowns - are crap.  If the CEO’s are so good at predicting the future, why couldn’t they tell us what losses their own companies were going to have?

Speaking of Goldman, I think the glitter is coming off.  This past week they announced that the amount of “Level 3 assets” increased from $69 billion to $96 billion during the first quarter.  If you haven’t been keeping score, “level 3″ assets are those for which there’s basically no market, no one wants them, so Goldman is stuck with them. 

Kinda like having a house that’s “worth” $1 million, but no one will buy it, so you’re stuck with the mortgage payments - but you can say you have a $1 million house.  At least until you have to sell it because you can’t make the payments any longer - then it suddenly becomes a $500k house - and you just lost $500k.

It also means that the value of those assets is a 100% guess.  In effect, Goldman is saying “we think we might have $96 billion in assets, but we really don’t know what they’d be worth if we tried to sell them.  They might be worth $96 billion (but we’re almost certain that that’s not right) but they might be worth 3 cents on the dollar.  We don’t have a clue, so we pulled that $96 billion number out of our butt.”

Level 3 assets are, by definition, “hard to value”.  In fact, they are impossible to value, because no one will buy them.  So companies use a “mark to model” method to come up with a number.  And since “mark to model” varies depending on the model used, we’re back where we started - no one has any idea what these assets are worth.

You may be asking why it’s a bad thing that the value of the assets rose so much in one quarter, and that’s a good question.  Wouldn’t it be a good thing if my $1 million house went up to $1.5 million in one quarter?   The answer to why it’s bad is that it’s a made up number.  I know that this is probably getting old but you need to understand it - NO ONE WILL BUY IT AT ANY PRICE RIGHT NOW!

Your next question is probably something like “why would they make up a higher number for these assets if that’s viewed as a negative?  Another good question, but the answer is easy.  You see, if you claim that your assets are worth more, you can use them as collateral so you can borrow more money.

Kinda neat isn’t it?  Goldman increased its’ ability to borrow by $27 billion in just one quarter.  But who would take these level 3 assets as collateral you ask?  You’re on your “A” game tonight dear reader - another good question.

The answer is that there’s only one place to go to borrow against these assets that no one will buy - the Fed.  You and me (via the government) are loaning Goldman billions of dollars by allowing them to give (I’m going to make up some numbers here - let’s call them “level 3″ numbers) the Fed $10 billion in level 3 assets.  In exchange, the Fed give Goldman $10 billion in Treasuries.

So you and I are now on the hook for $10 billion of basically worthless assets, while Goldman now has $10 billion of nice safe Treasuries.  Nice trick ain’t it?  That’s the Federal Reserve’s new Term Securities Lending Facility (TSLF) in a nutshell.

That’s one of the ways that the Fed is propping up the banks and brokerage houses right now - short of an indirect buyout like they did with Bear Stearns anyway.  But sooner or later, the losses from these made up level 3 assets need to be accounted for. 

The only question remaining is who will pay for the losses - the banks who made the risky loans, the investment houses that took the risky loans and leveraged them, or the taxpayer.  My best level 3 guess is that we’ll see a combination of the above, but taxpayers will eat a significant chunk of the losses.

As a result, the Fed will have to print more money to pay the bills, so the dollar will continue to fall, and the stock market will drop in inflation adjusted terms - and quite probably in real terms as well.  Within the next 12 months, Dow 9,000 is much more likely than Dow 15,000 in my opinion.

gk