Posted by Debbie on Sep 16th, 2008

Bank of America has offered to buy Merrill Lynch in an all-share deal valued around USD$45 billion. In return it gets everything - good and bad at Merrill’s, including all of Merrill’s 16,500 “financial advisers”, its brokerage revenues and its collateralized debt obligations (CDOs).

This isn’t the first takeover by Bank of America. In fact they have made a habit of it. In the last three years it has bought ABN Amro North America for USD$21 billion in cash. It bought US Trust Corporation for USD$3.3 billion cash. And in January 2006 it bought MBNA Corporation for USD$34.6 billion.

Now it is paying USD$45 billion for Merrill Lynch.

As a shareholder it is good to see an ambitious company grow. It is also good to see a return on the investment. Since the start of 2006 the share price has nearly halved and company profitability has fallen.

Revenue increased from USD$28 billion in 2005 to USD$47 billion in 2007, yet profit only increased from USD$7 billion to USD$9.4 billion.

Bank of America is no small fry themselves when it comes to debt securities. Last week the company presented at a - wait for it - Lehman Brothers [NYSE:LEH] investor conference and proudly explained that BofA has a 17% market share for mortgage backed securities. That’s more than double its previous year’s exposure. And a 21% market share for leveraged loans, a 50% increase on the previous year.

Financial Jargon Master Class

“US super senior ABS CDO net exposures and losses.”

“High grade, Mezzanine, CDO-squared.”

“Sub-prime residential mortgage-backed securities.”

“Alt-A residential mortgage-backed securities.”

“Whole Loans/Conduits.”

We won’t pretend to know what any of those things are. All we know is that for Merrill Lynch [NYSE:MER] it spelled TROUBLE. And as only investment bankers can do, they’ve packaged it all up into a nice bundle and sold it to Bank of America [NYSE:BAC].

That’s providing Bank of America shareholders want anything to do with it. An unintended consequence of this is it may make BofA shareholders take a closer look at their company’s own financials.

We downloaded a copy from the website last night. Shortly afterwards we went home with a headache. After another crack at it this morning this is what we’ve come up with.

The Murky Grey Knight That Could Make Things Worse

It also has “Criticized utilized exposure.” If there are any bankers out there please drop us a line to let us know what this is. We’ve searched the internet and the only references we can find are all linked back to BofA. It appears to be the only bank that uses the term.

Anyway, its “criticized utilized exposure” is 15.62% of a USD$62 billion commercial real estate loan book. That’s about USD$9 billion. A year previous the “criticized utilized exposure” was only 2.96%. We hate to assume, but surely in this environment an increase to 15.62% isn’t a good thing.

Interestingly, at the BofA earnings conference call in July the only analyst who expressed a concern about the level of the “criticized utilized exposure” was Ed Najarian. Najarian happens to be one of the senior analysts at Merrill Lynch.

Based on what we’ve seen BofA doesn’t look so much of a ‘white knight’ as a murky grey one.

Will an Australian Bank Fail?

Can we expect anything like this here? To some degree we’ve already seen it with Allco [ASX:AFG], Babcock & Brown [ASX:BNB], Opes Prime, Tricom and MFS [ASX:OCV]. But they mainly peripheral players. Merrill Lynch, Lehman Brothers and Bear Stearns were not on the periphery in US markets.

The next phase is to see if any of our major banks get caught in the wash-up. Could an Australian bank or major brokerage firm fall to the same fate? ANZ Bank [ASX:ANZ] and National Australia Bank [ASX:NAB] have been touted as the riskiest of the four major banks. As for the broking firms, only those with proprietary trading desks, deal heavily in debt securities or who have unsustainable loan books, are candidates for trouble.

We have said it for a while now. We are content to stay away from the finance sector. We may miss out on some of the upside when the market turns, but we are prepared to take that chance.

This article is written by Kris Sayce from Money Morning. Money morning is a website that aims to give you intelligent and enjoyable commentary on the most important financial stories of the day, and tell you how to profit from them.

One Comment to “Bank of America Offers to Buy Merrill Lynch”

1. on 17 Sep 2008 at 7:04 pm1Dhukka

   You omitted one very important detail here. Bank of America also purchased CFC earlier in the year and overpaid enormously for that pile of crap. I suspect the Merrill deal will go down as one of the more silly purchases in recent times.