Nicolas Tang's Blog

Merrill Lynch to Get $6.2 Billion From Temasek, Davis

By Yalman Onaran and Chia-Peck Wong

Dec. 24 (Bloomberg) — Merrill Lynch & Co., reeling from the biggest loss in its 93-year history, will receive a cash infusion of as much as $6.2 billion from Singapore’s Temasek Holdings Pte. and Davis Selected Advisors LP.

Temasek will invest up to $5 billion for a less-than 10 percent stake and New York-based money manager Davis Advisors will buy $1.2 billion of Merrill stock, the world’s largest brokerage firm said in a statement today. Merrill fell 2.9 percent to $53.90 at 1 p.m. in New York Stock Exchange trading, after the firm said Temasek will pay $48 a share, almost 14 percent less than the Dec. 21 closing price.

Merrill Chief Executive Officer John Thain, who took over Dec. 1, joins Citigroup Inc., Morgan Stanley and UBS AG in tapping a sovereign wealth fund to shore up capital. An $8.4 billion writedown of mortgage investments and loans led the firm to post a $2.2 billion third-quarter loss and oust CEO Stan O’Neal in October. Merrill may report another $8.6 billion writedown next month, said David Trone, an analyst at Fox-Pitt Kelton Cochrane Caronia Waller.

“Capital raising is a positive” for Merrill, said Mark Batty, who helps manage about $77 billion including Merrill shares at PNC Wealth Management in Philadelphia. “Given the challenge of the hits they’ve received to the equity base, that’s a necessity.”

Merrill also agreed earlier today to sell its commercial finance business to General Electric Co.’s finance arm for an undisclosed price to free up $1.3 billion of capital.

Selling at the Low

Temasek will pay $4.4 billion for new Merrill shares at $48 apiece and has an option to buy an additional $600 million of stock by March 28, according to a term sheet posted on Merrill’s Web site. Davis Advisors, a closely held firm founded in 1969, will make a “long-term investment” of $1.2 billion, according to today’s statement. Davis will also pay $48 a share.

“The only negative for these capital infusions is that they’re selling their stock at the lows,” said Ben Wallace, who helps manage $850 million, including shares of Merrill, at Grimes & Co. in Westborough, Massachusetts. “When you need the money most, you have to accept the low price.”

Temasek’s stake won’t exceed 10 percent, Merrill said. Neither the sovereign fund nor Davis Advisors will play a role in Merrill governance, the company said.

“What we like so much about John Thain is that he has a proven track record of creating shareholder value,” said Kenneth Feinberg, who helps oversee more than $100 billion at Davis Advisors, including its Davis Financial Fund, which has declined 4.6 percent this year.

The Right CEO

The firm had a 0.2 percent stake in Merrill at the end of September, according to a filing with the U.S. Securities and Exchange Commission. Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.

Thain, a former Goldman Sachs Group Inc. president, joined Merrill from NYSE Euronext, which he helped transform into a publicly traded company in 2006. By the time his departure as CEO was announced last month, NYSE shares had gained 35 percent since their first day of trading, twice as much as the Standard & Poor’s 500 Index in the same period.

Davis Advisors’ preference for financial stocks dates back to 1947, when Shelby Cullom Davis, the grandfather of the firm’s current chairman, invested $100,000 in insurers at the age of 38. By the time he died in 1994, the sum had grown to almost $900 million, according to John Rothchild’s book “The Davis Dynasty,” published in 2001 by John Wiley & Sons.

Temasek’s Homework

“Davis Funds are very credible,” said Ken Crawford, who helps oversee $900 million, including Merrill shares, at Argent Capital Management in St. Louis. “Their involvement signals that they believe the shares offer value and Thain is the right CEO going forward.”

Governments in the Middle East and Asia have agreed to invest more than $25 billion in Wall Street firms since banks began to disclose subprime losses. Merrill’s shares slumped 40 percent in NYSE trading this year, cutting its market value to $47.5 billion.

“Many take the view that the worst is probably over,” said Teng Ngiek Lian, who oversees $3 billion as head of Target Asset Management in Singapore. Merrill has “written down their books to a comfortable level and I’m sure Temasek would have done its homework.”

Set up in 1974 to run state assets, Temasek now manages a portfolio of more than $100 billion that includes controlling stakes in seven of Singapore’s 10 biggest publicly traded companies.

Abu Dhabi, China

It holds 18 percent of London-based Standard Chartered Plc and 28 percent of DBS Group Holdings Ltd., Southeast Asia’s largest bank.

Temasek, owned by Singapore’s finance ministry, has reaped an 18 percent average annual return since its inception. It raised more than $800 million in the past month selling part of its stakes in China Construction Bank Corp. and Bank of China Ltd., the nation’s second- and third-largest lenders.

Citigroup, the biggest U.S. bank by assets, said Nov. 27 that Abu Dhabi would invest $7.5 billion in the New York-based company. State-controlled China Investment Corp. is buying almost 10 percent of Morgan Stanley for $5 billion after the second-biggest U.S. securities firm reported a loss of $9.4 billion from mortgage-related holdings on Dec. 19.

Government of Singapore Investment Corp., along with an unidentified Middle Eastern investor, agreed this month to inject 13 billion Swiss francs ($11.2 billion) into UBS, the biggest Swiss bank. The government fund manager, known as GIC, manages more than $100 billion of the nation’s foreign reserves.

Bear Trigger

“The valuation for banks seems very reasonable, which is why the sovereign wealth funds are keen,” Target Asset’s Teng said. “We, too, are more bullish about banks generally.”

Investments by sovereign funds may give some respite to banking stocks battered by at least $96 billion of credit- related related writedowns at the world’s biggest financial institutions.

“It just shores up confidence and will boost banking shares,” said Nicholas Yeo, who helps oversee more than $40 billion in Asian equities at Aberdeen Asset Management in Hong Kong. “Maybe the outlook is not so bad.”

Bear Stearns Cos., the securities firm that helped trigger the collapse of the subprime market, struck an agreement in October with China’s government-controlled Citic Securities Co. for a $1 billion cross-investment. The New York-based company announced a $1.9 billion writedown on mortgage losses Dec. 20, sending the firm to its first quarterly loss since it went public in 1985.

GE Capital

General Electric, based in Fairfield, Connecticut, said today it agreed to acquire about $10 billion of assets and $5 billion of commitments from Merrill Lynch Capital, the firm’s commercial finance business.

GE will buy Merrill units that specialize in equipment, franchise, energy and healthcare financing, according to the companies’ statement. The sale, for an undisclosed price, doesn’t include Merrill Capital’s real estate assets.

GE’s finance units, known collectively as GE Capital, have more than $612 billion in assets, with about $260 billion at its commercial finance division.

By now everyone can recite how crummy mortgages got packaged into asset-backed securities, and how, after the tastier tranches were sliced off, the meat by-products got sent along to the CDO sausage factory to be made palatable again. Now CDO investors are puking up all over town.

But there has been another derivatives party going on, where the bubbly is still flowing to a large extent. That, as many will relate, is the explosion in credit default swaps (CDS) that has appeared over just the past few years.

Structured finance has been around since the 1980s, but the CDS market is essentially brand new. The CDS was invented in the mid-1990s but it was minor until the last four years. Since 2003, this market has exploded in size by 10x, to a total notional amount of about $45 trillion. Yes, that’s trillion with a “t”. This market has never been tested in any kind of economic downturn, not even the most recent one of 2001-2002.

The credit-default swap is insurance against a credit accident. The seller of CDS receives a small monthly payment. If the insured bond fails to perform, the buyer of CDS receives a large one-time payment from the seller. At first, in the 1998-2002 period, this was mostly a way for holders of bonds to insure themselves. However, in recent years, the CDS market has become a way for CDS buyers to wager on credit deterioration, and a way for CDS sellers to act like banks.

Banks are a wonderful business, when everything is working right. They have returns on equity that can range from 15% to as much as 25%. These are the kinds of returns that get hedge funds, and their investors, interested. However, it is difficult to enter the banking business. You need offices, branches, depositors, employees, advertising, and so forth.

Banks traditionally profit on the interest rate difference, or “spread”, between the money they borrow, from depositors for example, and the money they lend, to corporations for example. They may lever up ten to one, supporting $100 billion of assets on $10 billion of equity. Thus, if their spread is 2%, and they are levered 10:1, their return on equity is a juicy 20% (actually more like 24% because of the return on the underlying capital).

The CDS contract allowed hedge funds to act like banks. The monthly premium on the CDS is a spread between the equivalent Treasury yield and the implied yield on the underlying bond. This can be considered payment for the risk of default, which the Treasury bond presumably does not have. Imagine you’re a fund with $1 billion in capital. You could try to borrow $9 billion – from whom? – and then buy $10 billion in bonds, and enjoy the spread, like a bank. However, that $9 billion would probably have a higher interest rate than a Treasury bond, because the fund also has risk. And, the maturity of the borrowed money would likely be very short, while the bond has a long maturity, introducing duration risk (this didn’t seem to scare the SIVs however).

The CDS solves these problems. You just sell CDS on $10 billion of bonds. This doesn’t cost any money. You don’t have to put up any collateral. You don’t have to hire a single bank teller or loan officer. You just call your broker, put in the order, and start getting your monthly payments, just as if you had borrowed $9 billion (at the same rate as the Federal government) and lent $10 billion.

And the fund manager who made this one single phone call? If we assume a 20% return, and $1 billion of capital, he collects about $60 million per year. Which explains the explosive growth of the CDS market in the last four years.

Ah, there’s something. You “call your broker.” Actually, you call your dealer. It’s not so easy to just find a buyer for your $10 billion notional of CDS. This is an over-the-counter market. This is where the big broker-dealers, like JP Morgan, Bank of America, and Citibank step in. Over-the-counter markets are lovely for dealers because of the fat spreads – there’s that magic word again that pricks up bankers’ ears – between bid and asked in this market. So, what happens is you sell the CDS to your dealer, such as JP Morgan? JP Morgan then sells CDS – of its own issuance – to its customers that want to buy CDS.

So, you see that JP Morgan now sits in the middle, like a banker should. JP Morgan is “long” the CDS you sold to them, and also “short” the CDS it sold to someone else, and is thus theoretically hedged from risk while collecting the spread between the prices it bought and sold at. This is a lot like bankers’ traditional business of pocketing the spread between the rate it borrows and the rate it lends.

So, it should be no surprise that the big broker/dealer banks (JP, BofA, Citi) account for 40% of the CDS outstanding. Hedge funds account for 32%. This reflects banks’ monkey-in-the-middle dealer strategy for CDS. The remainder is likely insurance companies, synthetic CDOs, CPDOs, and other weird fauna that will soon become extinct. (Thanks go to Ted Seides of ProtÈgÈ Partners for aggregating this information.)

Now, that 32% of CDS sold by hedge funds has a notional value of $14.5 trillion. This means that, if all those bonds underlying the CDS were a total loss, the funds would have to pay $14.5 trillion. Not very likely. However, if there were only a 5% loss – not so impossible these days – the CDS-selling hedge funds would still be on the hook for $725 billion. Hedge funds, all together, have estimated assets of around $2.5 trillion. However, only a small fraction of those are CDS-sellers. Let’s take a guess at 10%, or $250 billion of capital. (It’s probably less than that.) How do you pay a $725 billion bill with $250 billion of capital?

There’s an easy answer to that: you don’t. So, who pays? The banks, remember, are in the middle. If the CDS-selling hedge fund doesn’t pay up on its $725 billion, then the bank is unhedged regarding the CDS that it sold. In this case, the banks would be liable for $475 billion. This is known as counterparty risk.

That’s four-seventy-five billion. More than four times the entire capital of Citigroup – capital which has already come under pressure from losses elsewhere.

So, what happens if there is a CDS counterparty-risk event? Do the big banks go bankrupt? Probably not, although there would be much wailing and gnashing of teeth. Instead, they would probably get a nod and a wink from the government to simply ignore their own CDS obligations. The counterparty risk shifts to CDS-buyers.

The CDS buyers can take the hit, because they aren’t really out any money. They paid their monthly insurance bills, but never got a payout after the credit market car crash. So, in a sense, this drama would likely end in more of a whimper than a bang. In fact, everyone got off OK: the CDS-selling hedge fund manager made a killing in management fees, before the fund went bust; the bank made a killing in dealer income, before kissing their obligations goodbye, and the CDS-buying hedge fund manager raked in the fees on the enormous mark-to-market profits of his CDS portfolio (20% of the aforementioned $725 billion), before these profits were eventually shown to be uncollectible. A perfect Wall Street happy ending.

However, the kind of situation in which large banks ignore multi-hundred billions of legal obligations is very extreme. The last time something like that happened was in the early 1930s. At that time, they called it a “bank holiday,” which has a nice festive ring. The celebration included a devaluation of the dollar, the first permanent devaluation in U.S. history. At least president Roosevelt had the good sense to repeg the dollar to gold at $35/ounce, parity it maintained until 1971. Feel free to make your own guesses as to what Paulson and Bernanke might try.

Regards,

Nathan Lewis

Betting against gold is the same as betting on governments. He who bets on governments and government money bets against 6,000 years of recorded human history.

~Charles De Gaulle~

There’s a greater than 50 percent probability that the financial system “will come to a grinding halt”.

~ Gregory Peters, head of credit strategy at Morgan Stanley.

http://www.bloomberg.com/apps/news?pid=20601009&sid=ahE9S0dlVt8g&refer=bond

I wonder whether GIC has thought about the full extent of the upcoming financial meltdown. UBS must have approached GIC because no one in the U.S. was prepared to be the single largest shareholder of UBS, which, according to the rumour mill, is technically bankrupt.

Singapore to invest almost US$10b in Swiss bank UBS

Posted: 10 December 2007 1625 hrs

SINGAPORE : The Singapore government’s investment arm announced Monday that it will inject almost US$10 billion into Swiss bank UBS.

The Government of Singapore Investment Corporation (GIC) said it would inject 11 billion Swiss francs (US$9.74 billion) into UBS, which on Monday announced further writedowns of around US$10 billion (6.8 billion euros) due to the US sub-prime mortgage crisis.

GIC said an undisclosed strategic investor in the Middle East is injecting an additional two billion francs into the bank.

“We made this significant investment in UBS because we have confidence in the long-term growth potential of the bank’s businesses, particularly its global wealth management business,” GIC’s deputy chairman and executive director, Dr Tony Tan Keng Yam, told a news conference.

GIC has committed to subscribe to 11 billion Swiss francs worth of mandatory convertible notes that will pay a coupon of nine percent until conversion into ordinary shares about two years after issuance, UBS said.
Depending on the conversion price, Dr Tan said GIC’s total shareholding “could amount to possibly around nine percent of UBS equity”.
GIC currently has less than 1.1 percent of the bank’s equity, he said.
“Nine percent is a large stake. I think we would be the single largest shareholder in UBS,” Dr Tan added.
GIC executives said the move marked a departure for the firm, whose practice has been to take relatively small public equity stakes for portfolio diversification.
“It is a departure from the norm in the sense that it is a larger than usual stake but we made the decision based on our confidence in the long-term prospects of UBS,” said Ng Kok Song, GIC managing director and group chief investment officer.

He and Dr Tan emphasised that GIC does not seek a say in management and said it would be premature to talk of GIC’s obtaining a seat on the UBS board.
“We’ve got no desire to control the business of the bank but as a large investor, as a large long-term investor, we would like to work with the board of the bank, the chairman and the management to create maximum value for all shareholders,” Ng said.

UBS, Switzerland’s largest bank, in October reported its first quarterly loss in five years after its third-quarter results were hit in the financial crisis caused by the ailing US home loans market.
On Monday the bank said in Zurich that it has revised the assumptions and inputs used to value US sub-prime mortgage related positions, resulting in further writedowns of around US$10 billion.

UBS said it expected to post a fourth-quarter loss and may record a net loss for the full year 2007.

“I don’t think that either UBS or any bank can say with absolute certainty that this is the last of the writedowns,” Tan said.
But he added UBS “have taken a very aggressive writedown” and acted before the market develops problems.
“Our intention is to remain a responsible, supportive investor in UBS, hopefully for the long term,” Tan said.

He added that UBS approached GIC about a possible deal, and then “at their own initiative” contacted the other investors whom he declined to identify.
GIC was established in 1981 to manage Singapore’s foreign reserves and now manages “well above” US$100 billion, making it one of the world’s largest fund management companies, its website says.
“The group strives to achieve good long-term returns on assets under our management, to preserve and enhance Singapore’s reserves,” it adds. – AFP/ch

“A gentleman is not to be found in the office before 11 and never stays beyond four.”

– Alfred de Rothschild, quoted in The World’s Banker – The History of the House of Rothschild by Niall Ferguson

“You could be somewhere where the mail was delayed three weeks and do just fine investing.”

– Warren Buffett, quoted on Global-investor.com

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