Banking madness

A bottle in front of me? Or a frontal lobotomy?

IF THE definition of insanity is doing the same thing over and over again and expecting a different outcome, bank shareholders are certifiably mad. Time and again since the start of the credit crunch, shares in one bank or another have rallied after the announcement of another slug of write-downs on mortgage-related assets and other nasties. With each round of bad news, investors dare to hope that a bottom has been reached and that the bank in question can start to think about a return to health. Invariably their hopes have been dashed.

The pattern has repeated itself this month with Merrill Lynch. In mid-July, the investment bank announced a $4.6 billion loss for the second quarter, after a write-down of $9.4 billion. To help plug the hole in its finances, John Thain, Merrill’s newish chief executive, offloaded a long-prized 20% stake in Bloomberg, a financial-information provider. “We believe that we are in a very comfortable spot in terms of our capital,'” he told analysts. Could the worst finally be over, wondered investors?

On Monday July 28th, Mr Thain had a swift answer: no. Merrill announced more write-downs, this time to the tune of $5.7 billion, and further steps to bolster its capital through an $8.5-billion share offering (a figure that may rise to $9.8 billion). Temasek, a Singaporean fund that became Merrill’s largest shareholder when it raised capital in December, will buy $3.4 billion of the new stock, but will also be reimbursed for the losses it has suffered on its initial investment.

The speed of the about-turn does little for Mr Thain’s credibility, but this time it is not lunacy to wonder whether a turning-point has been reached. The new write-downs reflect a deal to sell collateralised-debt obligations (CDOs) with a nominal value of $30.6 billion at an eye-watering discount to a distressed-debt investor called Lone Star Funds. The CDOs are being sold for just $6.7 billion, valuing them at a mere 22 cents on the dollar. To make the deal even sweeter for Lone Star, Merrill is lending it money to complete the deal, using the very same toxic assets it is trying to get rid of as collateral. Merrill is also slashing the value of hedges it had bought from various bond insurers.

The pain is not over for Merrill but the risk of further big write-downs has been considerably reduced. The deal with Lone Star brings Merrill’s exposure to CDOs down to around $10 billion, much of that in the form of mortgage-backed securities from 2005 and earlier, when lending standards in America’s housing market were not as slipshod as they were in 2006 and 2007. The raising of new capital leaves some headroom for further markdowns. Whether Mr Thain can restore Merrill’s fortunes over the longer term is a bigger question. Some argue that a purged balance sheet, coupled with a battered share price, makes it a much more attractive takeover target. But the bank may finally be able to raise its head to the horizon.

The news for other banks is less good. Merrill was an outlier in terms of the size of its exposure to mortgage-backed assets, because of its leading role as a distributor of CDOs. But the Lone Star deal sets a new, and very low, benchmark for the price of these instruments. There is enough wiggle room in the accounting rules for banks not to be bound by this price level but the news from Merrill signals the likelihood of more fair-value losses to come. Shares in European banks tumbled on Tuesday morning as a result, with Barclays, a British bank with fewer write-downs and a lower capital cushion than many of its peers, taking the worst punishment. For most bank shareholders, the madness continues.