Once again, the analysts are trailing the market. Merrill Lynch has upgraded Morgan Stanley to “buy” from neutral:

13 Oct 2008 14:12 EDT *DJ Morgan Stanley Raised To Buy From Neutral By Merrill Lynch

It’s just a matter of time before the others now follow. Meanwhile, we hear that Trump Entertainment has been downgraded. That’s probably another of those “just a matter of time” scenarios too.

As we predicted last night, shares of Bank of America are falling today after it announced that it was acquiring Merrill Lynch. The stock is off around 15 percent this morning. Because the acquisition of Merrill is an all stock transaction, with Merrill shareholders receiving 0.8595 shares of Bank of America for each share of Merrill, the stock movements mean that the market is now pricing the shares of Merrill significantly below the $29 per share first announced. Bank of America is now paying $24.63 for a share of Merrill.

Merrill shares continue to trade at a discount from Bank of America’s, although you have to be cautious about reading too much into merger spreads in all stock deals. This could be a bet on further declines of bank of America stock, or a pricing of risk that the deal will not actually close. Alternatively, it could simply reflect the presence of speculative arbitrage in the market.

That’s the claim of a Merrill Lynch banker who has written to Here Is The City, a financial news and gossip site based in Britain.

“I wonder what the implications really are, and am concerned that the freeze itself is just a marker which firm executives are putting down to signal that there are much tougher times ahead,” the banker writes.

The banker emphasizes that he has not “got it in for my firm” but speculates that the hiring phrase will last much longer than the anticipated 20 weeks. “[I]t will remain difficult to obtain additional headcount throughout 2009,” he writes.

The entire letter, including the requisite Stan O’Neal bashing, is on Here Is The City. (Thanks to Hilary Lewis at the Business Sheet, who brought this story to our attention.)

The euphoria in financial stocks yesterday seems to have been largely built on the idea of that “cathartic vomit.” The idea was that by writing down assets once again and selling off CDOs to Lone Star for 22 percent of their original value, Merrill Lynch had finally purged itself of the junk on its books. Never mind that we’ve heard that particular tune three times before. Everyone wanted to dance to it again.

But the morning after lots of people are having second thoughts. For starters, Merrill Lynch’s financing for the deal is troubling. They put up 75% of the money used to buy the assets, and the loan is apparently non-recourse. This means that if the CDOs drop too much in value, Lone Star can basically put them back to Merrill rather than pay off the financing.

In a report entitled “On Second Thought … ” Bank of America analyst Jeffrey Rosenberg explained that “Merrill now finds itself effectively in the position of having sold off its upside but retaining its downside.”

In other words, this alleged sale seems like yet another sleight of hand by Merrill’s management, a way to move the CDOs from one column on the balance sheet to another while no one is looking.

Merrill CDO sale not as good as it looks: analyst [Reuters]

Merrill Lynch announced that it was going to move its earnings conference call from a pre-market 8 am time slot to after the market closes. Of course, in the current climate this prompted all sorts of concerned or gleeful whispers (depending on whether you were long or short Merrill). The last Wall Street firm to opt for a post-market call was…wait for it…Bear Stearns.

So what’s the real story? Is this a sinister development portending dire earnings news or does Merrill just hate its analysts and wants them to burn the midnight oil? After jump, BreakingViews.com’s gets to the bottom of Merrill’s time slot switcheroo.

We’re snacking this morning on the delicious irony that Merrill Lynch’s stock is getting hammered by rumors that it will announce new losses from Alt-A mortgages on the same day that analysts at Merrill Lynch cut their earnings outlooks for several large regional banks, and predicted dividend cuts from Bank of American and Wachovia. It’s credit crunch for breakfast!

While many on Wall Street focused on the second quarter earnings of Lehman Brothers, they may have overlooked something odd that occurred behind the scenes. In connection with this morning’s earnings report, Lehman issued a detailed financial appendix breaking down its balance sheet by various asset groups. But behind the numbers there was another story—the story of a persistent bit of data that no one caught until it was too late.

More after the jump.

One thing we’ve noticed recently is that the chorus of dissenting voices inside of Merrill Lynch has quieted in recent months. In the weeks after John Thain replaced Stan O’Neal as chief of Merrill, the securities firm was bitterly riven as executives scrambled for authority (and, of course, money…always money) under the new regime. But by all accounts Merrill is a quieter, happier place these days.

This is a testament to the effectiveness of Thain’s leadership. But we wanted to know: how did he do it? After the jump, we explain why we think something Thain said on Wednesday indicates what happened.

Is it a coincidence that the first public statement from a chief of a Wall Street supporting extending the Federal Reserve’s discount window for securities firm came from Merrill Lynch, which enjoys the lowest leverage ratio on the Street?

There’s no question that any move to make the new Fed borrowing facility a permanent feature of our financial infrastructure will be accompanied by a new regulatory framework. Whoever pays the piper calls the tune, as they say. One feature of the new regulations will likely be a cap on leverage for firms with access to the facility.

Especially when compared with banks, securities firms are heavily reliant on leverage to boost returns. But some are more reliant than others. John Thain, who yesterday called for the window to be extended beyond its scheduled expiration in September, runs Merrill Lynch, which just happens to have one of the lowest leverage ratios—the measurement of how much a firm borrows compared to its equity—on Wall Street. He even indicated that he’d be willing to accept a cap below the 23.8 ratio his firm reported at the end of the last quarter.

Merrill’s competitors have higher ratios. Lehman’s leverage ratio, which was recently as high as 32, is now down to 25. (But the firm stressed it did not want to go any lower). Morgan Stanley’s last reported leverage ratio was 33. Even Goldman Sachs has a higher leverage ratio, at 24.

In short, Merrill may believe that it stands to gain from new regulations that push its competitors to adopt the kind of conservative ratios it has already put in place.

At a gathering of Wall Street dealmakers yesterday Merrill Lynch chief executive John Thain said he hopes the Federal Reserve will continue to permit securities firms to borrow from a new Fed facility launched amidst the implosion of Bear Stearns. We couldn’t help but notice, however, that Thain seemed a bit worried that the Fed isn’t going to keep the window open. To paraphrase a popular saying on Wall Street, “hoping” the Fed window stays open is not a strategy.

“I think it should stay available to the banks and investment banks — the primary dealers. It’s important that it does stay available,” Thain said to the audience at the Wall Street Journal dealmakers conference at the posh Pierre Hotel in Manhattan.

It had been widely assumed that the facility would be continued after its scheduled expiration in September. But recently opinions have shifted, with some reading the recent warnings from several Fed officials as indicating the window will be closed. What’s more, the investment banking community is said to be split on whether they should have continued access to the window. Goldman Sachs is said to be leaning toward opposing a move to make the borrowing facility permanent, and Lehman is said to support the move. Morgan Stanley reportedly takes a middle position, wanting to wait to see the kind of regulation that would accompany the window.

This is the first time we know of that a securities firm has gone on record with its support of keeping the window open. Thain’s decision to take this stance seems to indicate that he is taking seriously the idea that the Fed will not keep the facility open beyond September.

Merrill’s Thain Urges Fed To Extend Lending Deadline To Brokers [Dow Jones]

Merrill CEO wants ongoing Fed access, rules reform [Reuters]

Blackstone has replaced its chief financial officer with a top executive poached from Merrill Lynch. Laurence Tosi, who has been at Merrill for nine years and most recently was the chief operating officer of its investment banking division, will replace Michael Puglisi, a 14 year Blackstone vet.

The move by Tosi is being read by the cynical in two ways. First, it may be a sign that internal friction among the top executives at Merrill continues. Following the resignation of Stanley O’Neal, who appointed Tosi to his spot, and the rise of John Thain, there was lots of talk of internal wrangling at the bank. Lately the internal situation has quieted as executives adjusted to new leadership. But a high-level defection is sure to re-ignite whispers of internal dissent.

The second cynical read of the move highlights a structural change on Wall Street. As investment banks and brokerages lower leverage and come under deeper regulatory scrutiny, the relative power and profitability of alternative investment houses like Blackstone is sure to rise. Could Tosi’s move be further evidence of the coming decline of traditional investment banks and the ascendancy of the increasingly hybrid Blackstone, which many describe as a budding investment bank disguised as a buyout shop?

Or, you know, may he just wanted a new job and more money. But, as Nick Walker says in one of our favorite movies, “It would be better if it meant something.”

Blackstone appoints new CFO [Reuters]

So maybe trouble at Lehman Brothers isn’t just short-sellers spinning a web of financial panic after all. Standard & Poor’s cut the ratings of Lehman Brothers, as well as Merrill Lynch and Morgan Stanley today. Counterparty credit ratings, which have been getting a lot of attention lately, were one prong of the S&P credit analyst Tanya Azarchs critique of the banks. The weakness of investment banking business—IPOs off 70% and M&A down 40%, according to some estimates—and the potential for more write-offs didn’t help either.

Azarchs is also criticizing the brokerages’ much vaunted capital raising. A good portion of the money raised by the firms has been in so-called hybrid securities that combine equity and debt aspects. The ratings agencies are wary of these because certain debt-like covenants and payment obligations can impose increased cash flow stress on banks.

The stock prices have taking a beating and the credit-default swap spreads are getting wider.

The larger commercial banks also didn’t escape S&P’s negativity on the financial sector.

Kevin Zrenda serves in a military intelligence unit in Afghanistan, but he’s still got Merrill Lynch on his mind. Last year Zrenda, who is a member of the National Guard in California, took leave of his job at Merrill Lynch’s Pasadena office, to serve a year-long stint in Afghanistan.

Zrenda, who graduated from Harvard in 1999 and joined the Army National Guard after 9/11, has received numerous care-packages from his colleagues in Pasadena. And he returned the favor by having local Afghan artisans create a rug feature the Merrill Lynch bull logo superimposed over a map of Afghanistan. The rug, which also features the US flag, was flown over the Capitol to honor Zrenda’s unit. The rug now hangs in the Pasadena office.

Merrill has continued to pay Zrenda’s salary while he serves overseas, Charles Rogers, Zrenda’s boss at Merrill, told the Pasadena Star-News.

Putting Aside His Portfolios [The Day]
Co-workers back National Guard member serving in Afghanistan [Pasadena Star-News]

A key question in the liability of brokerages in the failure of the auctions for auction rate securities is what customers were told about the risks of the products they bought. The brokerages now claim they properly warned customers about the products, and that they never considered them cash or cash equivalent. Most individual brokers we’ve spoken to off the record say that this is very inaccurate, and every retail customer we’ve spoken to (including some who are friends and family of DealBreaker editors) say they bought these securities with the understanding that they were “highly liquid” or “cash equivalents.”

So what did the brokerages tell retail customers? There were lots of disclosure documents that say a variety of confusing things but almost none of them reveal the risk of systemic and perhaps permanent auction failures for the auction rate preferred securities that pay low interest rates even after auction failure. And, as the screen shot of a ARPS customer online account above reveals, the brokerages did, in fact, take actions that encouraged customers to regard the ARPS as cash. This account comes from a Merrill Lynch customer account. (Click on image for a bigger version.)

A class action lawsuit was filed in federal court yesterday against Merrill Lynch, hours after we reported that Merrill had been threatened with suits by brokerage customers whose assets were frozen in auction rate securities. Merrill is the latest entrant in a club that includes Morgan Stanley, Deutsche Bank and UBS, all of whom have been separately sued over alleged deceptive marketing of auction-rate securities.

Merrill also faces a separate arbitration claim from ASTAR Air Cargo, which seeks compensatory damages of $9.125 million and punitive damages of at least $27.375 million. ASTAR, an air carrier based in Wilmington,Ohio, filed the claim with the Financial Industry Regulatory Authority to gain access to ASTAR’s funds that currently are frozen in illiquid auction rate securities in the company’s Merrill Lynch account.

According to ASTAR, the air carrier instructed Merrill Lynch to place its cash reserves in products that would provide complete safety of principal and complete liquidity. In response, Merrill Lynch reportedly recommended the company purchase various ARS.

Update: Here’s a copy of the complaint against Merrill.

Merrill, Morgan Stanley sued over auction rates [Reuters]
ASTAR alleges Merrill Lynch fraud [Willmington New Journal]

Several months ago Bear Stearns blocked employees in its headquarters from reading DealBreaker. They offered us lots of technical excuses for this, including a few that almost made sense, but all of them were lies. Bear Stearns blocked us because we had ticked off the upper levels of its management. They’d probably still deny this if we bothered to ask, but how many times do you need to let someone lie to you before you simply quit asking questions.

At the time we warned that there was something wrong with management that was concerned enough about how a sarcastic, gossipy website that they’d lash out against it. We regularly mock the higher ups at places like Goldman Sachs but they know they’ve got better things to worry about. We also pointed out that we actually break news around here, and offer serious commentary on news breaking elsewhere. A bank that wants to cut its traders and bankers off from sources of information seems to be making bad choices. What’s more, cutting us off hardly stopped us from writing about Bear Stearns. It just stopped Bear Stearns from getting to know what we were saying about them.

Look. We’re not saying that Bear Stearns collapsed because they decided to block DealBreaker. We’re saying that a Wall Streets firm whose management focuses on crushing dissenting journalists who report embarrassing stories probably doesn’t have it’s priorities straight.

So who else is blocking DealBreaker? Oh, that’s right. Merrill Lynch. They’ve had a $24 billion in write-downs, and currently have a market cap of $42 billion.

It’s not just the heads of giant Persian Gulf funds who are trash-talking each other’s favorite banks, the chief executives of rival institutions are getting into the mix too. In a meeting with a group of Wall Street analysts recently, Merrill Lynch chief executive John Thain said that he believes that Citigroup will need another large capital injection.

His words were echoed today at a private equity conference in Dubai, where the top man of Dubai International Capital, Sammer al-Ansari, was asked about the billions of invested in Citigroup by rival sovereign wealth funds and Prince Walid bin Talal. “It’s going to take more than that to rescue Citi,” he said.

Thain did not go into specifics about the financial condition of Citi but his words struck a chord with those at the meeting. Today news reports say that analysts at Merrill Lynch have reduced their full-year earnings forecast for Citigroup and projected that the bank could book another write-down of debt tied to souring mortgages. But hearing the words from Thain himself had a powerful effect on those present. If Wall Street’s ultimate insiders are this negative on the prospects of their rivals, perhaps the downturn on Wall Street could be even worse than expected.

Both Merrill Lynch and Citi have suffered badly from the financial market turmoil that began last year. Merrill has written down $24.5 billion in losses, while Citigroup has recorded $22.4 billion in losses.

In a filing with the Securities and Exchange Commission on Monday, Merrill Lynch said its cash flow statements for 2005, 2006 and the first three quarters of 2007 were wrong. The statements overstated cash provided by derivatives financing transactions. But, lucky for them, they made another mistake, overstating cash used for trading liabilities. So no big deal, right? Take a little from here, add a little there. It offsets.

Except that we have no idea what this means. What exactly did Merrill get wrong? The actual filing is extremely vague about these errors and it would be helpful to know how and why these were made. It’s hard to be confident that Merrill understands its exposure to various derivatives if it only discloses non-specific errors and provides no detail. Anyone care to venture a guess what Merrill’s mistakes were?

Merrill 8-K [ML.com]

There are gray storm clouds hanging over Wall Street this February but Merrill Lynch’s Greg Fleming appears to be weathering the storm. The Securities and Exchange Commission has initiated a formal investigation into whether the brokerage knew more than it revealed to shareholders about the value of its subprime investments prior to announcing the giant write-downs with its third-quarter results. Federal prosecutors have opened a preliminary investigation, leading to speculation that criminal charges could possibly brought against some Merrill executives. But sources at Merrill Lynch say Fleming, who continues in his role as president of the bank after the losses forced the departures of a co-president and the chief executive, was not involved in the businesses reportedly being scrutinized and they do not expect him to be a subject of the investigation.

Wall Street abounds with speculation that Greg Fleming, who has managed to hold on to his position as sole president of Merrill Lynch through a whirlwind of management changes, might finally be facing a challenge that could shake him out of his elevated position.

Fleming’s presidency has endured the worst losses in the history of Merrill, internal criticism, and alleged pressure from newly minted chief executive John Thain. Although the Justice Department’s investigation is in its earliest stage, rumors are already spreading, both within and outside of Merrill, that the threat of a criminal investigation might bring Fleming down.