“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.

All Money and No Sense
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.

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.

15 2008 - Australasian Investment Review – (AIR)

Suddenly the spectre of inflation no longer hangs over the world: it’s gone, banished by the reversal in sentiment in commodity and financial markets. Banished by fears of recession, which were confirmed overnight with Europe contracting in the second quarter, with Germany and France following Italy into a slump. Oil, copper and gold down, and wheat, corn and soybeans as well it’s been a sea change in sentiment in the past month. Slowing Europe and Japan suddenly mean the US is not alone, so it’s off into the greenback because you’ll be more protected there. Europe moved into a real slowdown in the June quarter,with growth contracting by 0.2%, Germany’s economy contracted by 0.5%. France slowed as well, with the economy falling a surprising 0.3% in the quarter. Growth is still up for the first half after the March quarter saw growth of 0.7%, but the size and speed of the slump was surprising, and emphasised why commodity prices are weakening, along with the euro. Inflation is supposed to have peaked, or is close to peaking; growth is slowing, and so will price pressures as recession bites. That’s why the surge in consumer inflation last month in the US came as a complete shock to the markets. Despite the slump in oil and petrol prices from mid-month onwards, and the rise in the value of the US dollar, the CPI surged by a rather large 5.6%, the highest rate since January, 1991 when the first Gulf War was raging. That compares to an annual 5.1% in the year to June. The CPI rose 0.8% in July, compared to June when it jumped 1.1%, so there was a small slowing. But the surprising news had no impact on interest rates, shares or sentiment. Oil was still easier, gold fell sharply, losing the gains of the day before and copper was lower. Higher food, petrol and energy costs were responsible, despite the drop in oil and petrol prices. Those falls are continuing, that’s why economists believe the CPI will drop sharply this month. Now the older and wiser of those in the market wonder if there’s something more dangerous approaching, along with the slumping global economy: deflation. More of that shortly. All year long, the debate has raged over whether the world faces a greater risk from resurgent inflation or from a deflation, caused by the credit crunch, to match Japan in the 1990s. The fall in commodity prices has, for now, convinced the market that we need not worry about inflation. In the US, the market for government inflation protected bonds (called TIPS) now implies that inflation will average 2.16% over the next decade. That’s the lowest in five years, but is it just as much an overshoot as the upward drive in commodity prices when they peaked midway through last month? What is still clear is that inflation is still with us: from the United States, through Europe and Asia, prices are still rising. Wholesale price inflation is double digit in China (but consumer prices are easing); in the US, Europe and the UK wholesale and consumer price inflation are at levels not seen for more than a decade in some cases.  In Japan this week’s report of a 7.1% jump in wholesale inflation was the steepest rise in 27 years In the eurozone, the consumer inflation hit 4.0% in July; more than double the European Central Bank’s inflation target of 1%-2%. Inflation stands at 3.6% in France, at 4.4% in Britain (its highest level for 16 years) and at its highest level for 12 years in Italy at 4.1% and 11 years in Spain where its running at 5.3%. In Germany inflation hit 3.3%, the highest rate since 1993 and enough to get the old anti-inflationist Bundesbank rolling in its grave. Inflation hit 4.3% in Norway, Eastern Europe it’s 6.7%, while in India it’s running at nearly 12% and in Japan at 1.9%, the highest for more than a decade. In some countries such as Argentina there’s doubt about the declared rate (9.3% there) because of changes to the way the government accounts for and reports inflation. In Thailand it’s running at 27% and higher in Egypt This week China reported a slowing in consumer inflation to 6.3% from 7.1% in June. But core measures which discount food and energy have risen past 2%. Now the point of this international roll call is to make a point: normally it would be enough to see interest rates rising everywhere: in India, the central bank is tightening policy, but apart from the increase at the start of July by the European Central Bank, central banks are holding back, transfixed in the case of the Fed and with the Bank of England by fears of a downturn and fears about inflation. So why then are financial markets (even bond markets) suddenly more relaxed about price pressures and galloping into equities and out of oil and commodities? Relative growth differences between the US, Asia and Europe is the one reason already stated, but the Merrill Lynch’s August fund managers survey provides a second reason. Big international investors no longer fear inflation.They worry more about recession, which they believe will take care of cost pressures.So does that indeed signal a deflationary period of rapidly falling growth and prices?

Here’s what Merrill Lynch concluded this week:

Fund managers’ fears of inflation have all but evaporated to reach their lowest level since the downturn of late 2001, according to Merrill Lynch’s Survey of Fund Managers for August.

Merrills said a total of 193 fund managers participated in the global survey from 1 August to 7 August, managing a total of $US611 billion. A total of 161 managers participated in the regional surveys, managing $US432 billion.

The survey captures an extraordinary reversal in investors’ attitude towards inflation. A net 18% of the 193 respondents expect global core inflation to fall in the coming 12 months.

In June’s survey, a net 33% thought inflation would rise.

A falling oil price and growing evidence of recession have prompted this rethink.

More investors believe that the global economy has already entered recession - 24% of the panel take that view this month compared with 20% in July and 16% in June. During the credit boom, investors urged companies to borrow more, but with the credit crunch biting, they are now concerned about leverage.

The net percentage of investors who believe corporates are under leveraged has tumbled to 9%, down from nearly 40% at the end of 2007.

“The message from investors to corporates is that if we are headed for a recession, they should clean up their balance sheets and prepare a financial buffer,” said Karen Olney, chief European equities strategist at Merrill Lynch.

“As banks de-lever, non-financial corporates will have to wake up to far less flexible world of credit.”

Merrill Lynch found that US assets are indeed back in favour (as it seemed in the Mat survey).

“With the economic downturn spreading to the eurozone and certain emerging markets, investors are starting to view U.S. assets as attractive.

“The net balance of asset allocators overweight U.S. equities stands at 12 percent, its highest level in more than six years.

“Supporting this view is the widely-held belief that the U.S. dollar is undervalued.

“A record net 58 percent say this month that the dollar is undervalued, while a net 71 percent say the euro is overvalued. Investors believe that the U.S. has a better corporate profit outlook and higher quality earnings than the eurozone.”

In Europe, investors are moving from oil to consumer stocks.

“European investors have responded to the fall in the oil price by selling oil producers and buying into discretionary consumer stocks.

“The percentage of European investors overweight oil & gas stocks collapsed to 11 percent in August from 52 percent in July.

“Investors have also significantly scaled back large underweight positions in travel & leisure, personal & household goods and retail companies.

“Technology and media sectors, both with significant exposure to consumer demand, also swung back in favour.

“At the same time, inflation fears among the European panel have fallen to levels even lower than in the Global Survey.

“A net 45 percent of European fund managers expect the region’s core inflation to fall over the next 12 months. In June, 32 percent of the European panel were predicting rising inflation.

“The market appears to have overreacted to a fall in the oil price, and investors have turned a blind eye to second round effects of inflation, such as rising wages,” said Karen Olney. “It will take several months of slowing global growth to be sure that the inflationary dragon has been slain.”

But the Merrill Lynch survey contains a cautionary note.

“One consequence of the recent fall in the oil price has been a rapid unwinding of what the survey has highlighted as a highly-crowded trade: Investors have reduced ‘long’ or overweight positions in energy and started closing underweight positions in financials.

“But have they lost sight of the fundamentals in unwinding this position?”

Merrill Lynch says it believes that the energy sector will continue to be supported by a strong oil price.

The firm forecasts oil at $US119 in the fourth quarter, underpinned by low, real global interest rates.

Francisco Blanch, Merrill’s head of global commodities research, said in a statement with the survey results: 

“While we have started to see some demand for oil curtailed in OECD economies, the economic fundamentals in China and other emerging markets support oil at more than $US$100 a barrel into 2009.”

“Investors have moved to close underweight positions in European financials after second quarter results suggested banks are on the road to improvement.”

But, according to ML’s Stuart Graham, head of European bank equity research, toxic write-downs are coming to an end and banks have completed more than half of their capital raising.

However, although earnings downgrades for banks are well under way, doubts remain about the sector’s ability to bounce back quickly.

“Banks are highly unlikely to see a V-shaped recovery in their share price given the uncertainties in the market,” said Stuart Graham. “Apart from the economic outlook, a key question is how stringent regulators will be in setting new rules to govern banks’ capital ratios. No one yet knows what the appropriate capital structure of the future is.”

Every month Merrill Lynch polls big investors around the world to see what they were thinking and posts the results on its US website.

Here’s the results of the June survey:

Investors are offering the clearest signal yet that the global economic slowdown is forcing them to overhaul their asset allocation, according to Merrill Lynch’s Survey of Fund Managers for July.

The credit crunch is leading to polarised investment allocations and is taking survey readings into uncharted territory, setting four records:

• Net 53 percent of asset allocators are overweight cash.
• 40 percent are underweight equities.
• 32 percent are underweight eurozone equities.
• 40 percent are underweight U.K. equities.

Risk appetite is close to record lows last seen in March.

However, despite the sell off in equities, only a net 16 percent of respondents find equities cheap.

Furthermore, the survey demonstrates that investors have an increasingly sceptical view of earnings forecasts.

A net 83 percent of managers polled believe consensus corporate earnings are ‘too high’. Of that figure, a net 29 percent believe they are ‘far too high’.

European inflation fears ease as recession looms larger

European fund managers are beginning to reassess inflation risks in light of increasing awareness that slower economic growth will put the brakes on inflation.

Responses in the regional survey suggest that inflation may be less of a threat than previously feared.

A net 24 percent of respondents are forecasting inflation to fall over the coming 12 months.

That sits in contrast with results one month ago when a net 32 percent of respondents predicted Europe’s Consumer Price Indices would rise. This trend is consistent with global consensus.

The regional survey picks up a significant uptick in fund managers who believe that Europe’s economic growth will deteriorate, with 96 percent who believe Europe’s economy will weaken over the next 12 months, a ten percentage point rise from June.

Fears over the economic outlook coupled with disillusionment with emerging markets have catapulted investors into healthcare stocks — a traditional safe harbour from wider economic trends.

One third of investors in Europe have a net overweight position in healthcare and pharmaceuticals, compared with zero in June.

“What investors are looking for right now is immunity from the ills of the market place and the healthcare sector provides that,” said Karen Olney, Chief European Equities Strategist at Merrill Lynch.

“Healthcare companies might have their own industry risks, but they do offer immunity from the three horrors that are bugging investors: a rising oil price, the slowing economic cycle and the credit crisis.”

Emerging markets caught in stagflation bind

July’s survey also captures an abruptly more negative view of emerging market equities. Back in May, a net 31 percent of fund managers were overweight emerging markets. This month, only a net 4 percent have a positive stance towards the asset class.

Investors are increasingly concerned that rising inflation in emerging markets makes them more vulnerable to monetary tightening and slowing domestic demand.

Asked whether emerging market risk is either ‘above normal’ or ‘normal’, a net 23 percent opted for ‘above normal’ in July, representing a large swing from June.

“The best combination for emerging market equities is rising commodity prices and falling EM interest rates; the worst is falling commodity prices and rising EM interest rates.

Weaker global growth and higher inflation in emerging markets is raising the risk of the latter, which is why asset allocators have become much more cautious on emerging markets,” said Michael Hartnett, Chief Global Emerging Markets Equity Strategist at Merrill Lynch.

Shareholders’ priorities shift towards balance sheet repair

Global investors indicate that they would rather corporates use cash to improve balance sheets, than return money to shareholders.

In a break with recent convention, 39 percent of respondents to the global survey said they would like companies to prioritize measures such as repaying debt and topping up pension plans.

Only 32 percent want companies to focus on share buy backs and dividends.

“Financial companies have taken steps to repair their balance sheets with an abundance of capital raising initiatives this year,” said Barnaby Martin, credit strategist at Merrill Lynch.

“Two questions arise for the second half of the year. Will they be able to complete their recapitalizations within the timeframe investors expect and will non-financials have to take similar measures?”