You can call Merrill Lynch (NYSE:MER) the Michael Jackson of Wall Street. Remember a few years ago when Jacko delighted and shocked the media by dangling his baby outside a hotel room? What kind of moron does something like that?
On Thursday, Merrill Lynch quit dangling the mortgage market baby out the window and hugged the subprime mess tight against its chest. Specifically, Merrill did not auction off around US$850 million in mortgage-backed bonds it seized as collateral from two struggling Bear Stearns (NYSE:BSC) hedge funds. By stepping away from the cliff and backing slowly away, Merrill has averted-for now-a mortgage-backed meltdown where the market reprices hundreds of millions in securities stuffed with over- valued subprime loans.
As Jody Shenn of Bloomberg put it, "[Merrill's] plan may have confirmed that other funds were overvaluing their holdings of similar securities, potentially causing a chain reaction of writedowns causing billions in losses." There are some plans your friends are willing to go for because they’re you're friends and its rude to say ‘no’. For example, we remember nearly losing an eardrum at 16 as a home-made firework exploded in a mail box prematurely...about 14 inches from our face. We knew it was dangerous and stupid, but everyone was doing it, and at 16, at 3 in the morning in a car full of your friends, being rational and saying "no" is awfully difficult.
Merrill has agreed to scupper its plans because it was worried in that saving its own behind in the Bear Stearns mess, it might do a lot of damage to other Wall Street firms. The loss of public confidence in the intelligence of the brokerage industry would not be good for business. "It's an industry issue,'' Brad Hintz of Sanford C. Bernstein & Co. told Bloomberg. "How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?"
We didn't find out the answer to that question this week. But it's a long summer. Yields on ten-year US Treasury notes are rising. The more they rise, the more the truth will out.
Dan Denning
The Daily Reckoning Australia
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About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by Whig on 23 June 2007:
Whether Merrill executed their plans to sell or not, the entire industry is presently living in self-delusion. If the everyone has their holdings marked too high and everyone including blog-writers knows it, then they (the investment banks, CDOs and funds holding the impaired bonds) are liable for fraud.
Market value is highest price a bidder is willing to pay. The market clearing price is fair value. Anything else is a lie.
Market to market entities such as hedge funds, mutual funds and some CDOs are going to wake up one day and find themselves subject to lawsuits, jail time and unemployment checks if it can be proven they are marked too high and everyone knew it.
Financial history is laden with stories of financial excess. The longer the industry lives in denial the worse the pain is going to be when it comes. Strap in, it is going to be a rough ride and it has only begun.