No sooner than the International Monetary Fund has warned that global financial markets remained “fragile” and indicators of systemic risk were still “elevated” almost a year into the credit crunch than the troubled US investment bank Merrill Lynch confirmed the accuracy of the warning by revealing another $US5.7 billion in write-downs on subprime mortgage related securities, and an emergency fund raising to grab $US8.5 billion from investors.

The move comes only 10 days after the investment bank reported a $US4.6 billion loss for the second quarter, including a $US9.4 billion write-down, and announced asset sales aimed at raising $US8 billion.

These latest Merrill write-downs raise new questions about whether banks themselves understand the extent of their problems.

Merrill has attempted to fix the problem by selling off assets at a loss to try and limit further damage. But Merrill has financed 75% of the purchase of these dodgy assets through vendor finance with the purchaser, a group called Lone Star. The bank says it will sell a large portion of asset-backed securities and terminate hedges linked to bond insurers, two of its most troubled areas since the credit turmoil began last year. The ANZ Bank, meanwhile, has written down its involvement with similar bond insurers by well over $420 million so far this year (but will recover much of this in future years).

At its second quarter report, Merrill’s total write-downs were put at approaching $US40 billion: now they are on their way to $US50 billion and chasing Citigroup which has around $US55 billion in losses and write-downs. The sale of asset-backed securities will cut its exposure by $US11.1 billion from its level on June 27 and Merrill says it will take a $US5.7 billion pre-tax write-down during the third quarter as a result.

But that transaction holds considerable fears for other banks and investors because it establishes a new low for CDO values of 22 cents in the dollar (It was only 10 days ago that a London based group of CDO assets were sold by Goldman Sachs for 44 cents in the dollar for cash walk away deals).

Merrill said it would sell CDOs with a nominal value of $US30.6 billion to Lone Star Funds, a distressed-debt investor. At the end of the second quarter, the bank had estimated the value of the CDOs at $11.1 billion. However, it said yesterday it was selling the securities for just $US6.7 billion, or about 22 cents on the dollar, and financing 75% of the purchase. This smacks of desperation.

The Merrill news came well after Wall Street had closed a difficult day’s trading. Monday saw the Dow tumble 2.5% or 239 points on the IMF warning, mixed quarterly profit news and a rise in the oil price after more unrest in Nigeria.

The IMF said that while likely losses on US subprime mortgages have “largely been acknowledged” in the form of write-downs, financial institutions faced a second wave of losses on other loans.  Credit quality “across many loan classes has begun to deteriorate with declining house prices and slowing economic growth.” The Fund said bank balance sheets were under “renewed stress” and that the decline in bank share prices had made it more difficult for them to raise new capital. Within hours of that being published Merrill provided evidence that the IMF was spot on.

As a result Temasek Holdings, the Singaporean government investment fund that helped bail out Merrill last December to become the firm’s biggest investor, will buy a further $US 3.4 billion of stock in the new offering. As it invested $US5 billion in Merrill late last year, the latest injection will enable it to avoid making a write-down of its own on the first stake. In a complicated shuffle of funds, Temasek received around $US2.7 billion from Merrill Lynch, and then uses part of that for its new capital subscription.

Merrill said it will take a $US2.5 billion expense related to the transaction as well as that $US5.7 billion of additional write-downs on the collateralised debt obligations and associated hedges. Merrill shares lost 11.5% in normal trading Monday on Wall Street as rumours spread that it could be making another big loss announcement.

Peter Fray

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