A pack of LYONs: explaining the Merrill shareprice fall

Discussion in 'Stocks' started by ASusilovic, Mar 7, 2008.

  1. Merrill Lynch’s share price fell 7 per cent in trade on Thursday, putting it at its lowest point since 1993. The sharp dip was odd, ostensibly on the back of the positive announcement that the bank was shuttering its subprime mortgage business. Indeed, reported AP, analysts were “surprised” by the “overblown” fall

    Andrew Clavell, at Financial Crookery, has a fascinating post. As he translates and explains:


    What really counts, though, is that one of the put dates falls next Thursday, March 13, and Merrill don’t want to run any risk of shelling out the $2.2bn redemption price. This is not “plan A” - these convertible bonds were supposed to turn into balance sheet equity at some point.

    Merrill are basically trying to avoid LYON bondholders making a painful $2.2bn cash call at all costs next Thursday. So they’re making it much, much, more attractive for LYON noteholders to sit tight, and hold onto their convertible with the distinct possibility of exercising it in the future, for more shares, at a higher price.

    Felix Salmon, at Portfolio’s Market Movers, picks up the thread:


    I’m quite sure that fiddling around with conversion rates “is considered an attractive financing option” within Merrill: it costs the bank nothing, at least in the short term. But I’m equally sure that it’s not considered a very attractive financing option if looked at from the point of view of shareholders, who have now seen their stock sink to levels not seen since 2003.

    But as Salmon notes, it isn’t the spectre of stock-dilution in the future which is depressing the share price.

    Rather, downward movements in the price have been driven by hedge funds engaged in popular convertible arb strategies - essentially long the convertible bond, and short the shares.

    Increasing the conversion rate on the LYON increases the relative sensitivity of the bond’s price to the underlying shares. And in turn, the way to eliminate that volatility if you’re a hedge fund using a typical delta-hedging strategy, is simply to increase the short positions on the underlying stock. Ergo the big drop.

    Or, put more succinctly by Salmon, “Merrill’s Financing Strategy: Harming Shareholders”