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Thursday, August 7, 2008

Merrill Sale Fuels Worries

Investors Question How Much Risk Was Offloaded

Investors are questioning just how much risk Merrill Lynch really offloaded with its sale of $30 billion of toxic mortgage securities.

Their immediate worry is that Merrill could still be hit with losses if these collateralized debt obligations continue to plunge in value. That is because Merrill financed 75% of the $6.7 billion that Lone Star paid for these complex debt products.

Lone Star's portion of the sale price gives Merrill a $1.6 billion buffer against further losses. But the financial crisis has shown that even such a seemingly large amount can disappear quickly.

And investors don't have much to go on. Merrill provided scant detail about the terms of the financing it offered to Lone Star. It also hasn't said how it financed its $4.45 billion sale last month of a 20% stake in Bloomberg LP. Merrill is now in a quiet period while it finalizes an $8.5 billion offering of new stock.

Granted, the amounts involved are small -- the financing for the Lone Star deal as well as that provided for the Bloomberg stake is less than $10 billion. That is a drop compared with Merrill's nearly $1 trillion balance sheet.

But Merrill needs to fill the information vacuum fast.

It is possible that Merrill arranged the financing so that its downside risk is limited. Earlier this year, for example, Citigroup sold off a portion of its beaten-down leveraged loans. As part of the financing, the bank used a derivative called a total return swap to protect against further falls in the debt's value.

But such protection can carry hidden costs and can be viewed by some as balance-sheet sleight of hand. Any such move by Merrill also could serve as another example of how more of investment banks' balance sheets are getting tied up in illiquid holdings.

If that is the case, it adds weight to arguments that formerly nimble investment banks like Merrill can no longer afford the risk of using high levels of borrowed money, or leverage. Worries about the investment banks' leverage levels have grown since they got access to the Federal Reserve's discount window.

To ease concerns, Merrill needs to detail whether the financings were straightforward loans, or, if there were bells and whistles, just how they work and how it will account for the various pieces.

The firm also needs to show whether it will be using market values to assess risks that it still may hold. That would require it to consider what others in the market would pay for the financings, potentially making the values more volatile.

This could increase the chance that the firm will see some additional losses. But it also forces the firm to take a more realistic view of the value of the holdings.

Merrill should make clear which of its various units arranged the financing. If it was done through a banking unit, this could affect how Merrill values its exposure to the Lone Star financing and how it views gains from the Bloomberg deal.

In normal times, questions about such small amounts of financing would seem picayune. Today, with markets roiled and with Merrill forced to repeatedly raise new capital, every risk needs to be clearly explained.

ArcelorMittal Should Turn Its Focus to Debt

The willingness of ArcelorMittal's customers to pay high prices for its steel is almost as impressive as the amounts of metal they are buying from the Luxembourg-based company.

The company shipped 3.9 million tons to Africa, Asia and former Soviet-bloc countries in the second quarter -- about the same as in the previous quarter. But it made an extra billion dollars on those deliveries.

That is testament to the efficiency of ArcelorMittal's expanding business. All global steelmakers have faced high iron-ore prices, up at least 60% in the past year. Coal prices have gone up more. But ArcelorMittal owns ore and coal mines near its plants. This has translated into high operating margins in emerging markets, up at 32% from 19% quarter-on-quarter.

Much has been achieved by quick integration of acquisitions and using the free cash flow to buy more assets, without ignoring the needs of investors.

But ArcelorMittal's debt should now be the focus. While it generated free operating cash flow of $2.9 billion at June 30, net debt rose to nearly $30.7 billion from $27.4 billion.

That isn't alarming, but neither is it comforting as growth is expected to flag in a post-Olympics China and a slowdown looms in emerging markets.

Before ArcelorMittal makes any more acquisitions, it should pay down more debt.

By: David Reilly
Wall Street Journal; July 31, 2008