Merrill Brings a Lot of Baggage to BofA

Bank of America's $44 billion acquisition of Merrill Lynch sets up a financial powerhouse like no other -- if CEO Ken Lewis can make it work.
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Bank of America

(BAC) - Get Report

Chairman and CEO Ken Lewis is calling the $44 billion acquisition of

Merrill Lynch

(MER)

the "deal of a lifetime," but the merger of the two powerhouses is not without challenges.

Bank of America

and Merrill formally announced the stock-for-stock swap early Monday morning. The deal creates a mammoth organization in which BofA will become the largest brokerage in the world with more than 20,000 advisers and $2.5 trillion in client assets. Merrill's strengths will also bring expertise in global debt underwriting, global equities and global M&A advisory to BofA.

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By merging with Merrill Lynch, BofA will be able to grow its business by gaining market share, doing more business with clients and bringing them the best array of products, Lewis said at a joint press conference in New York on Monday along with Merrill's CEO John Thain.

"We've gone through a golden era in banking and financial services in general," Lewis said a little later on. "It's going to be tougher and so there are going to be fewer companies and we're going to have to be better at what we do."

Still, challenges exist for BofA, particularly given the backdrop of a crumbling financial system that it is working against.

Also Monday,

Lehman Brothers

(LEH)

filed for Chapter 11 bankruptcy after weeks of speculation regarding the brokerage's attempt to find capital. Separately,

AIG

(AIG) - Get Report

was rumored to be on the verge of a major restructuring plan.

The acquisition of Merrill Lynch marks BofA's fourth sizeable deal in less than two years. Less than three months ago, the bank completed its purchase of failed mortgage lender

Countrywide Financial

. Last year it acquired

ABN Amro's

LaSalle Bank, shortly after completing an acquisition of

Charles Schwab's

(SCHW) - Get Report

high-net-worth business through

U.S. Trust

. BofA did its last transformational deal in 2004, when it paid $47 billion for

Fleet Financial

.

Analysts remained concerned about the prospect of further writedowns at Merrill Lynch as well BofA's capital levels, given how close it is in timing to the Countrywide deal.

Standard & Poor's lowered BofA's long-term counterparty credit rating down one notch to "AA-" from "AA" on news of the acquisition and placed the company on CreditWatch with "negative implications." Moody's Investor Service also placed the bank's long-term debt ratings on review for downgrade.

"While BofA has a history of successfully integrating bold acquisitions, the purchase of Merrill carries integration risk, particularly since it comes during a period of severe market turmoil," S&P analysts write in a note. "BofA has never integrated an investment bank the size of Merrill. Events of the past year demonstrate the high business risk of the securities industry. Moreover, management of a substantially bigger and global franchise could present challenges unknown to BofA."

In a separate note, Moody's said integration challenges include retaining Merrill customers and key personnel over the next few months while the deal is being finalized and the need to resolve cultural differences "that are frequently major obstacles to success," among other things, it says.

Richard Staite, an analyst in London at Atlantic Equities, writes that the deal makes it more likely that BofA will have to cut its dividend.

Jeff Harte, an analyst at Sandler O'Neill & Partners, is specifically cautious about management's ability to have done "sufficient due diligence" on Merrill Lynch's $966 billion balance sheet, he writes in a note.

He too worries about "capital and management resource constraints" as BofA integrates its July acquisition of failed mortgage lender Countrywide Financial, which is still reeling from soured mortgages and home equity loans after the meltdown of the housing market.

Under terms of the deal, which executives say came together in roughly two days, BofA will exchange 0.8595 shares of common stock for each Merrill Lynch common share. BofA is paying 1.8 times tangible book value, it said. The deal is expected to be completed in the first quarter.

Shares of BofA sank 20.5% on Monday to $28.83, making the price of the deal effectively cheaper. Merrill's stock surged 10.6% to $18.86.

Lewis said BofA has not asked for any "capital relief" as a result of the deal. The acquisition of Merrill would drop BofA's Tier-1 capital levels to roughly 7.40% and the company would look to build capital levels to its target of over 8% over time, "but that's done with almost every single acquisition we have done," he said.

BofA expects to achieve $7 billion in pre-tax expense savings, which will be "fully realized" by 2012, while the acquisition is expected to be accretive to earnings by 2010, it says.

"This is too important not to get right," Lewis said. "This is the strategic deal of a lifetime."

Still, Merrill's exposure to toxic assets is an ongoing concern. Merrill has taken roughly $30 billion in writedowns resulting in three consecutive quarters of losses, according to Oppenheimer analyst Meredith Whitney.

As of the end of the second quarter, it still had roughly $91.3 billion of risk exposure in its trading book -- $1.6 of net Super Senior CDO exposure on its balance sheet, $7.5 billion of leveraged finance commitments, $17.6 billion in commercial real estate exposure, $43.7 billion in residential mortgage exposure and $18 billion in the U.S. bank investment securities portfolio, Whitney writes.

Thain did successfully navigate an agreement to sell roughly $30 billion of collateralized debt obligations to an affiliate of Lone Star Funds for $6.7 billion, or 22 cents on the dollar. Still, analysts are concerned about further mark-to-market adjustments the large investment bank could write down and how that will affect earnings at BofA.

The acquisition of Merrill Lynch "meets three of BofA CEO Ken Lewis' key requirements for acquisitions -- brand, scale and best-in-class franchise," Whitney wrote in the note, published early Monday. "While we view this clearly as a long-term positive for

Bank of America the stock will likely not respond accordingly as investors near term will focus on greater systemic risk, and

Bank of America's sizeable consumer loan exposure will overshadow any near-term positives in the deal."

Another regulatory issue that will have to be addressed is BofA's surpassing the 10% deposit market share limit for U.S.-based banks. Analysts say that federal regulators are likely to grant the bank an exception for the time being.

Some analysts are already looking on the bright side.

"BofA is integrating two very separate businesses," which require "two different skill sets," says Nancy Bush, an independent bank analyst in Annandale, N.J. For companies like BofA and

JPMorgan Chase

(JPM) - Get Report

"acquisitions become just another skill set," she says. "It's like another line of business."

"I believe it works out long term," Bush says. "As Lewis said

on this morning's analyst conference call 'We've done this before.'"