Bank of America to buy Merrill while Lehman running out of options

Merrill to be bought out by Bank of America? Sure looks like it.

UPDATE (Sunday 3:57PM CST)
NY Times dealbook saying BofA and Merrill in talks.
Having personally started my financial career at Merrill, I am honestly shocked by this headline. Tough to believe that Mother Merrill will no longer be an independent entity.

From the New York Times: Bank of America is in advanced talks to buy Merrill Lynch for at least $38.25 billion in stock, people briefed on the negotiations said on Sunday, as a means to preserve that investment bank while Lehman Brothers looks likely to collapse.

The move suggests a desperate effort at triage on Wall Street, as Bank of America works to shore up the likely next victim of the credit crunch. A deal, valued at between $25 a share to $30 a share, could be announced as soon as Sunday night, these people said. Merrill shares closed at $17.05 on Friday.

Bank of America, the nation’s second largest bank by asset size, had been mulling buying Lehman, perhaps in a consortium with other financial players. But with financial aid from the government looking unlikely, Bank of America has moved on to Merrill, these people said.

As Lehman began to totter in recent weeks, investors feared that Merrill would be the next victim of the credit squeeze. Shares in Merrill, which has already reported tens of billions of dollars in losses, have plunged more than 68 percent over the past year.

Lehman continues to fight for its life after Barclays deal falls apart this afternoon. As I pointed out in my suitors list, Barclays has the capital but the problem was that any deal from Barclays would have required shareholder approval. Needless to say, that won't work.

Wall Street prepares for worst as Lehman deal stalls

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Lehman Brothers basically done today
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The Family Ties in the Lehman Drama

There's continues to be lots of speculation today on which firms might be interested in taking on Lehman. And it’s no mystery now that Lehman is looking for a buyer. The firm confirmed that Dick Fuld is actively seeking the white knight scenario.

I am leaning towards a BofA - Lehman deal.

With that said, I decided to put a small list together of firms that could be involved in potentially buying Lehman. In no specific order…

Bank of America – represents the best chance of a US-based bank to take on Lehman. Of course, BAC struck a bad deal earlier this year (Countrywide acquisition) which leads me to believe that they probably still have a “bad taste in the their mouth” at the moment. However, they do have the resources to make it happen and coupling LEH with BAC might even make sense from a “net positive synergy” standpoint.

LEH would provide their strong equity underwriting platform to BAC’s extensive roster of heavyweight banking clients. BAC would also be able to leverage LEH’s oil and gas group to gain more market share in investment banking.

And finally, BAC would be able to step into the prime brokerage business (actually step back into it after they recently sold their platform to BNP Paribas). Although, I am not sure they want to get back into prime brokerage considering how bad the hedge fund market is right now with respect to the industry-wide deleveraging.

Plus BAC still has a few other problems which includes $5 billion settlement for the auction-rate securities debacle.

While I would say “spending” is a bit tight at BAC right now, they do have the balance sheet to put a deal together. They are definitely in the mix - the question is "how much?"

Probability: BAC is the most likely of all US firms to do a deal. But I am not sure any US firms are comfortable enough to take the risk.

Goldman Sachs – the match of Goldman and Lehman hit blogs this morning and, of course, CNBC’s Charlie Gasparino put an end to that rumor with his “sources.”

GS might be somewhat interested in doing this deal but I believe under two conditions: (1) at a price of about $1.5-$2.00 per share (“takeunder” price where its bought cheaper than its current market price) which most certainly Dick Fuld will push away and (2) assurances that the Fed would provide a liquidity backstop of-sorts as they did for the JP Morgan-Bear deal.

And let’s suppose hypothetically those conditions were to be met, it might still be asking a lot. GS, who steps up to earnings plate next week, might be facing their own host of debt-related problems at the moment. One of the largest holders of Level 3 assets on Wall Street, GS would be reluctant to take on the responsibility of trading more toxic debt into this beleaguered market environment.

Probability: Unlikely that it would happen with Goldman. They are probably too busy putting out their own fires and need to make sure that they don’t compromise the strength of their balance sheet. They probably figure they can win in the situation by simply eating up investment banking market share once Lehman gets swallowed up by another firm.

JP Morgan – after digesting Bear it would be a lot to ask from Dimon and his army of executives. No way they could do this kind of deal. The firm is stretched right now. Just wouldn’t make sense.

Citigroup – one word: impossible! The firm is too busy shedding non-core assets and dumping bad business units. Not only did they lose huge on Pandit’s hedge funds but are also suffering from writedowns in Fannie and Freddie Mac.

Probability: JPM and C are nowhere in the game - too many battles to fight on various other fronts. You have better odds on a Vegas table then betting that one of these two firms plays White Knight.

Korea Development Bank – might be the dark horse in all of the speculation. Up until about late last week, LEH and KDB were in close negotiations. KDB was said to have offered six trillion won (4.3-5.2 billion dollars) for a 25% stake. Think about what that sum of money could buy them now – the whole thing? Maybe so.

South Korean regulators would be the enemy to this deal. The chairman of the South Korean Financial Services Commission explicitly told KDB that such a transaction would be highly scrutinized.

Probability: At this new “discounted” price, I wouldn’t be surprised to see KDB roll the dice. In KDB's eyes, the "cheap just got cheaper."

Other firms to watch: HSBC and Barclays. Barclays intrigues me slightly to the extent that they enjoy about a $40 billion market cap and have plentiful resources to do a deal.

Lehman Brothers basically done today

LEH selling pressure overwhelming

(1) UPDATE (5:05pm CST): Word early this morning on another site, Naked Capitalism, was that Goldman Sachs could buy Lehman. I didn't think Goldman would be a player but I think can be if the Fed backstops their debt. However, at this point, I don't see that happening. Notice the words I use: "at this point."

Below is the post that hit the Naked Capitalism blog:

I heard this rumor from two sources, that Lehman is in its final day or two and Goldman is willing to buy the firm, and the second source, who volunteered the information, is sufficiently well plugged in that I trust the reading. This came from a former senior employee:

A couple friends of mine from LEH trading desk called me this a.m. to say that mgmt has taken employees aside to let them know that the end should come in next 24-48 hours. Ratings agencies apparently told them that the steps were not sufficient to prevent a d/g, and LEH mgmt asked them to hold off for a day or so to give them a chance to resolve situation (with sale of company). Apparently GS is willing buyer, but is buyer of last resort from LEH's perspective, b/c they would keep very few LEH employees.

If Goldman were to step in then they would probably wait until the stock price hits a buck, if it does. Then buy the firm for about $650 million. No need to spend $3 billion right now with all the toxic debt on the books. GS has their own problems with Level 3 and mortgage-backed securities.

(2) My current thoughts
The stock was down 40% today to $4.22. At this level, the market cap of the firm sits at about $3 billion.

I think thats still too much for anyone to move in and purchase up the firm ala a "white knight takeover."

To the best of my recollection, Bear closed shop at about a market cap of $250 million.

Its over for Lehman for at least three current reasons:

1) The dwindling share price is basically crushing any little leverage the firm might otherwise have in doing deals.
Lehman stock price

2) Counterparties and clients are getting nervous. So much of Wall Street is a confidence game.
Lehman's clients moving to protect themselves
Lehman struggles to shore up confidence

3) Moody's and/or S&P will step in shortly to finish off the firm.
Lehman Pushed to Fire-Sale After Moody's Warning, Share Decline

UPDATE (9:30am CST): Merrill Lynch analyst Guy Moszkowski has officially placed a "no opinion" on the stock as many other analysts are doing the same..

(3) Moody's: Ratings downgrade possible

From Reuters: Moody's Investors Service says that Lehman will have to complete a transaction such as a sale of a majority stake in the firm, or the entire company to avoid a ratings downgrade. In fact, they also stated that the bank will also need to take further action beyond the steps it announced on Wednesday to avoid a ratings cut.

Moody's said it would have downgraded Lehman's debt rating earlier on Wednesday, likely to the "triple-B" category, if it did not think a transaction was possible. Any deal would have to calm markets to preserve the ratings, the agency added.

Raising capital alone would also not preserve Lehman's rating, now "A2," as the firm suffers a crisis of confidence, Moody's said.

"Capital is one element but obviously confidence is a key element," said Bob Young, a team managing director at Moody's.

The rating agency on Wednesday put Lehman's ratings under review with the direction uncertain, citing the fluidity of the company's situation.

When it rains it pours. And keep in mind that when one rating agency downgrades the other usually does the same in a rather quick fashion.

Looks like #1 in my initial thoughts write-up is about to come true. Time is not Lehman's friend.

Sad day on Wall Street.

Lehman's credit rating at risk with Moody's after today's news

Moody's: Ratings downgrade possible

From Reuters: Moody's Investors Service says that Lehman will have to complete a transaction such as a sale of a majority stake in the firm, or the entire company to avoid a ratings downgrade. In fact, they also stated that the bank will also need to take further action beyond the steps it announced on Wednesday to avoid a ratings cut.

Moody's said it would have downgraded Lehman's debt rating earlier on Wednesday, likely to the "triple-B" category, if it did not think a transaction was possible. Any deal would have to calm markets to preserve the ratings, the agency added.

Raising capital alone would also not preserve Lehman's rating, now "A2," as the firm suffers a crisis of confidence, Moody's said.

"Capital is one element but obviously confidence is a key element," said Bob Young, a team managing director at Moody's.

The rating agency on Wednesday put Lehman's ratings under review with the direction uncertain, citing the fluidity of the company's situation.

When it rains it pours. And keep in mind that when one rating agency downgrades the other usually does the same in a rather quick fashion.

Looks like #1 in my initial thoughts write-up is about to come true. Time is not Lehman's friend.

Lehman Brothers: New Plan but Same Problems

Lehman decided to have their conference call today. The massive selloff of the stock over the past two days plus the negative credit implication by S&P forced management’s hand.

You can find their conference call HERE and their press release HERE.

Highlights from the release and call:

1. Estimated net loss of ($3.9) billion or ($5.92) per common diluted share.

2. Decreased residential mortgages from $24.9 billion in 2Q08 to $13.2 billion which includes a deal with Blackrock to unload $4 billion in UK assets.

3. Decreased commercial mortgages from last quarter’s $39.8 billion to $32.6 billion.

4. Intends to spinoff the commercial assets into a new entity named REI Global. Current Lehman shareholders will receive shares in REI. The spinoff should be completed in 1Q09.

5. Spinoff will require Lehman to inject capital of 25% into new entity and then debt finance the remaining portion.

6. REI will take custody of SunCal and Archstone investments.

7. REI will be able to show assets as on a “hold-to-maturity” basis thus allowing for more prudent selling.

8. Lehman also intends to sell off 55% of their Investment Management Division (“IMD”). IMD will include Neuberger, private equity and their wealth management arm. If, and when, the sale takes place, the firm will see a positive impact of at least $3 billion towards their capital base from the goodwill associated from the NB acquisition in 2003.

9. Firm also intends to cut their dividend to $0.05 per share which will allow them to retain $450 million annually

It is apparent that Lehman is in full survival mode. And even with these actions going into effect, there are still some serious hurdles that Lehman must face. Time is not on the firm's side and deals must be done swiftly but with a great deal of prudence.

My initial thoughts of Lehman moving forward:

1. Not enough time to shore up balance sheet before S&P downgrades their credit worthiness. Of course, a downgrade would have a significant impact across various business lines – violation of debt covenants, counterparty sentiments, etc.

2. For the REI deal to work, management is counting on a good price for IMD and I am afraid that Lehman is selling from a position of weakness. Will they get their asking price? I am not so sure. To further complicate matters, they intend to use funds supplied from that sale to inject capital into REI.

3. It is possible that even after an injection of capital into the REI spinoff, approximately 75-80% of REI will be debt financed by Lehman. Again, the firm still maintains some form of credit risk even after transferring the assets.

4. I still think there will be further writedowns on the commercial assets before they are transferred over to REI (assuming the deal gets done).

5. The sale of the $4 billion in UK assets to Blackstone are requiring Lehman to seller finance.

6. The firm enjoyed much success from their ability to leverage. Unfortunately, that leverage will no longer be deployed as liberally as it once was. Thus, the earnings power that was based on higher leverage inputs will be negatively impacted.

I will continue to review conference call and the press release. At this point, the firm is still in a very dire position. I will have more later. Please stay tuned.

Lehman Brothers: Time is Up!

It appears at this point that the Lehman situation is going to hit a climax next week. There are so many questions that surround this entity and I believe the management team is in full gear to get the firm sold (or infused with fresh capital) before next week's conference call.

UPDATE: The conference call took place about 6 hours after this post. I will spend some time reviewing the call and examining the data in their release.

If you are interested in doing some homework before the call and the earnings release next week then I would recommend you review the following:

Lehman Brothers May 2008 10-Q
Be sure to pay attention to their discussion of the Level 3 assets on Page 29.

Lehman Brothers June 2008 Conference Call Transcript
Review the questions asked by Mike Mayo from Deutsche Bank - he really pressed them last time

Lehman Brother Financial Supplement from Last Quarter
You will want to reference Attachment II

Also, if you have a Merrill Lynch account be sure to spend a few minutes reading Guy Moszkowski's comments about the Lehman. Guy is a very good analyst but I would be willing to be that Lehman's results will be far worse than what he is currently predicting. (I will discuss this topic later this week)

In preparation for the Lehman call, I have put together a number of questions that I think would give us a clear view of Lehman's financial condition. The questions are as follows:

1. How much of their commercial related positions did they end up writing off for this quarter? They had roughly $30 billion on the books according to Attachment II of the financial supplement they provided investors last quarter.

2. What is the status of the undeveloped SunCal investment? How much more of a writedown did they take on that asset? I believe they had only taken about a $700M gross writedown last quarter.

3. Where do the Level 3 assets sit at this point? Their last 10-Q had it sitting at $38 billion. Let's hope for the sake of shareholders they were able to trim this down.

4. Are they still investigating the "Good Bank/Bad Bank" Model? Note: of course, this strategy could allow the firm to shed toxic assets however there are two real problems with this setup: (1) it will be tough to find a good manager to run it knowing that its a train wreck and (2) they will need to find financing for the new entity - which I would think might be very tough at the moment.

5. Will they give us more disclosure on the whole loans? The mezzanine side of the whole loans could give us clarity on more issues awaiting to surface.

6. Did they make any transfers/sales/negotiations with R3 Capital Partners? If so, please elaborate.

7. Where are they at with Neuberger? If they sell Neuberger, is there any expectation that they might compromise their credit rating which could also trigger another host of credit-related issues.

8. What are their thoughts on the S&P CreditWatch "negative" implication slapped on the firm this week?

I intend to add more questions to my list plus make a few predictions. Please stay tuned.

Thanks for reading.

Breaking News: Bloomberg reports that Lehman to form a new company to buy mortgage assets

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.

KKR LOOKING TO BUY NEUBERGER

KKR Indicates "High" Interest in NB.

Last week sources close to Lehman said that the asking price for Neuberger would somewhere in the $10 billion range.

A quick look at LEH as it trades today and it shows a market cap of approx $9.6 billion. Heck, the stock is pricing the investment bank plus NB even a tad bit cheaper than the asking price LEH has tagged on NB. A takeover of the entire firm could be a 2-for-1 deal: buy Lehman and we throw in a money manager for free.

Ah not so easy. If it were then it would have happened by now. The problem: if you buy the firm then you assume the downside of the toxic debt....and how do you value that? And maybe the "smart money" suspects that more bad news is still to come.

I for one will be very interested to see where LEH trades if a deal does materialize for NB.

Stay tuned, this will be interesting.