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Merrill Lynch — top junk bond issuer on Wall Street

I HAD recommended a short six weeks ago on Wall Street investment bank Merrill Lynch at 89-90. My argument was that, exact quote, Merrill is the top junk bond issuer on Wall Street.

Its private equity business is powered by financial sponsors who will be hit if credit spreads widen and LBO finance reprise risk, its merger advisory pipeline goosed by trophy deals like Freeport Mc Moran could get sandbagged if the animal spirits of Wall Street restrain their risk appetites. The Cheshire cats of investment banking live and lie on their access to easy money. But what if the music suddenly stops. What if volatility drifts higher and credit risk premiums on interest rates rise.' Amazingly, this scenario played out with a vengeance on Wall Street last week.

The Merrill Lynch short recommendation, consequently, was extremely profitable, falling from 90 when my column was published to as low as 75 now. Investment banks shares are a high beta, pure play on the Wall Street zeitgeist which suddenly went big time ugly week.

A 586 point weekly hit in the Dow so soon after the index rose above 14000 only suggests that the 'buy on dips' psychology that was so profitable in February and March could prove painful yet, particularly with the Chicago VIX having spiked to 24 and, thanks to the Black Death in financials, volatility in the SP500 index actually higher than NASDAQ . Moreover, the unwinding of the carry trade occurred at the same time as the recalibration of credit risk on Wall Street. The plunge in the dollar-Japanese yen exchange rate below 119 and the Pavlovian sell offs in Asian, Latin and East European markets mean that emerging markets equities are as vulnerable as any time in the past to the new 'American flu' that could spell an economic slowdown, a housing recession, an ice age in the LBO and high yield debt issuance markets, possible even a protectionist Congress at a time of $80 crude oil.

Yet as the old Persian proverb goes, it is always darkest before dawn, not that dawn was anywhere visible on the Big Board, NASDAQ and the global markets last week. While risk aversion, the unwinding of the carry trade and the disappearance of the proverbial LBO put means that ghosts of the grizzly haunt every nervous long in global markets, the fundamentals in American equities and Europe are really not too bad. The SP500 now trades at 15 times 2007 earnings at a time when the US Treasury ten year note has fallen to 4.75 per cent, an attractive valuation metric and 2Q corporate profit growth was generally just fine. Yet the credit market bloodbath is a sword of Damocles over the bull market in global equities.

The high yield debt market, the leveraged loan market, even Gulf sukuk Eurobonds ( the $ I billion Dana Gas deal was postponed by Citigroup and Barclays Capital as it is simply impossible to flog high yield GCC paper in times when risk spreads go ballistic and syndication risk rises exponentially. This is bad news for the stock market because the $ 450 billion in leveraged buyout deals announced since the beginning of the year provided so much valuation ballast and psychological reassurance to the equities market. Financing risk is now a threat to every LBO, particularly since Wall Street investment banks could take huge losses on their loan commitments. The risk arbitrageurs could make a killing or get killed in such pending international LBO deals as Hilton Hotels, AG Edwards, Alcan or Harrah's Entertainment. I had repeatedly mentioned my deep distrust of the Blackstone IPO ('leprosy on Wall Street,' to use exact quotes!) and spurned the relentless efforts of several bank RM's to get me to bid on the IPO. This scepticism was vindicated because Blackstone has now plunged to 24, almost one fourth its $31 offer price. In retrospect, Steve Schwartzmann had the last laugh because he unloaded a juicy stake in Blackstone to a gullible world with no idea of value, particularly now that the LBO finance market has basically shut down.

Investors in the UAE who have scrambled to buy regional or international private equity funds should realise that the impossible new realities of leveraged debt finance mean disaster to the deal flow that anchors projected IRR. Mark to model, sadly, is a joke when mark to market means misery. The aborted Chrysler deal has saddled its syndicate of investment bankers with huge losses on their LBO loan commitments and unfunded loans must now be viewed as banking toxic waste. The unfunded LBO is the Achilles heel of bank stocks valuation. After all, Bank of America and Citigroup now both trade at barely above 10 times earnings and offer dividend yields near or above 5 per cent . However, analysts will cut EPS estimates to reflects the new realities of credit risk on Wall Street and the inevitable slowdown in IPO, debt underwriting fees, merger advisory and LBO finance. Hedge funds generate 30-50 per cent in revenues for the Wall Street investment banks and the distress in the credit markets is a huge margin call on the leveraged gunslingers of world finance. This is bad news for Wall Street, seriously bad news.