The B of A/Merrill Deal Won’t Happen

How do I know this? I don’t, but that’s what the market is telling me. The current stock prices of Merrill Lynch (NYSE: MER  ) and Bank of America (NYSE: BAC  ) imply that either the market doesn’t believe the deal will happen, or it doesn’t believe it will happen on the current terms (with Merrill shareholders receiving 0.8595 share of BofA for each of their Merrill shares). Let me explain why. 

Is this free money?
If we are certain that the deal will be completed, there is an easy arbitrage profit to be made:

  • Buy 10,000 shares of Merrill Lynch at $20.26. Cash outflow: $202,600.
  • Sell short 8,595 shares of Bank of America at $27.86. Cash inflow: $239,457.

Net inflow = +$36,857
[I’m not accounting for dividends in this calculation.]

At the deal completion, you receive 8,595 shares of BofA in exchange for your Merrill shares, which you deliver to close out your short position. You no longer have any stock position, and you keep the $36,857.

Congratulations! You’ve just earned an 18% total return ($36,857/$202,600) over the period that culminates in the deal consummation.

Wiping out on a merger arbitrage
Before you get on the phone to your broker, I’m going to have to disappoint you. This type of arbitrage (known as “merger arbitrage” or “risk arbitrage”) is widely practiced by investment banks and dedicated hedge funds. As a result, the market is pretty darn efficient, and it rarely hands out a riskless 18% return. One long-term study found that the annualized return of a risk arbitrage strategy is less than 11%.

A return of that magnitude indicates the market is skeptical that the deal will go through. I know this from bitter experience, having made a failed bet this summer that Fortress Investment Group (NYSE: FIG  ) would complete its acquisition of Penn National Gaming (NYSE: PENN  ) . The potential return in that situation exceeded 70% at times. Unfortunately, Fortress backed out of the deal, and I’m looking at a total loss on my option position.

Will they or won’t they?
In my opinion, the BofA/Merrill deal is going to close, but there’s a pretty decent chance the terms will be renegotiated in favor of Bank of America (terms can change -- remember that JPMorgan Chase (NYSE: JPM  ) was forced to up its initial offer for Bear Stearns from $2 to $10 to cinch the deal).

Alternatively, it's possible (though unlikely, in my opinion) that another bidder will surface and disrupt the process. I don’t think JPMorgan Chase or Citibank (NYSE: C  ) have the appetite for it, but some foreign banks such as Barclays might.

More Wall Street/Banking Foolishness:

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Alex Dumortier, CFA, owns calls on Penn National Gaming, but has no beneficial interest in any of the other companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2008, at 5:08 PM, nygal2 wrote:

    Irresponsible journalism at it's BEST. Why did you feel the necessity to put this headline on this article when the last paragraph of the article completely contradicts the headline?

    You did it knowing full well there are many average joe's out there who won't really understand MUCH if anything of the content of the article they will take the headline and the writer at their word and the rumors will begin.

    TOTALLY unnecessary and proves the point that the media is also to blame for much of the state of our country and our economy. Shame on you!

  • Report this Comment On September 16, 2008, at 5:38 PM, weiwentg wrote:

    Isn't it also likely, though, that BoA's stock falls? Merrill still has exposure to questionable assets and this could strain BoA's capital position, which would discourate BoA investors. They would then need to renegotiate the deal in Merrill's favor to win the latter's shareholders over.

  • Report this Comment On September 16, 2008, at 6:35 PM, TMFAleph1 wrote:

    nygal2,

    Thanks for your comment and I'm sorry you feel that way. I don't think the article is ambiguous and the first paragraph makes it pretty clear that there is more to the title than meets the eye at first glance.

    If the "average Joe" doesn't understand the content of the article but decides to start rumors on the basis of a title taken out of context, it seems to me it is 'Joe' who is acting irresponsibly, not me.

    Perhaps you are you aware that business/ financial journalism and commentary is a competitive field just like any other -- if people don't read my articles, then eventually I won't be able to feed myself. I don't think using titles to catch readers' attention falls outside the realm of journalistic ethics, particularly when that tactic is openly revealed in the first paragraph.

    I take my responsibility as a writer extremely seriously and I try to meet the highest standards of rigor and accuracy in the content of my articles.

    Let me reiterate that I am truly sorry that you feel I have disappointed the reader in that regard, but I'm not sure a fair-minded observer would agree with you.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 16, 2008, at 11:10 PM, jewelman4now wrote:

    Alex:

    I must say, that I not only agree with much of what Nygal2 wrote but found his comments refreshing to read. I often find headlines from TMF to be misleading. In fact, most of the time I don't read them anymore as the caption rarely corelates with the meat of the article.

    It's not that there isn't valuable information being presented by TMF, it just doesn't pertain strongly to the caption. So, if you're trying to grab readers by misleading them, congratulation! You've gotton me several times. But not so much anymore.

    By the way, I found the overall information presented very interesting. I'd just prefer to know it going in, then I wouldn't feel fooled by the Fool!

  • Report this Comment On September 16, 2008, at 11:57 PM, icesword2 wrote:

    Alex,

    I'm on your side on this debate. The title wasn't misleading; it was simply taken out of context, like any good headline. Would you click on an article titled "There is a moderate probably that BofA won't buy Merrill"? If I'd passed it up, though, I would have missed a profitable lesson on merger arbitrage.

    Also, I think Nygal2's association of TMF with "the media" is comical at best.

    Still, I think that you should fight the urge to reply to comments on your own post. I've seen a lot of good blogs turn into never-ending competitions for the last word. I can't imagine that ever happening to The Fool; we all must do our part to prevent it. You know you're an honest journalist, and if Nygal2 keeps reading your posts, and if jewelman decides to give you another chance, they'll eventually know it, too.

    Foolish regards,

    Austin

  • Report this Comment On September 17, 2008, at 12:20 AM, TMFAleph1 wrote:

    jewelman4now,

    Thanks for your comment; it's good to get another opinion on this matter.

    Here is how I view the matter. I can't consider that the title of my article is misleading since it expresses a hypothesis that the market appears to have adopted -- that's the whole point of the article.

    The truth is that neither I nor the market know with certainty whether or not the deal will close, and I think it would be naive on the part of a reader to expect that solely on the basis that the title is a direct, unqualified statement. The expectation is particularly inappropriate since The Motley Fool publishes commentary rather than breaking news flashes.

    Furthermore, there are rarely any certainties in investing, but one can attempt to think about different outcomes and weigh their respective probabilities. That's something I explore in the article.

    Finally, it seems to me that either a reader is interested in this situation and they will read the article to find out more about its subtleties or they aren't -- in which case, it would be unwise to rely on the title of the article to make any sort of judgment, particularly an investment decision.

    Nevertheless, I hear your criticism and thank your for taking the time to express your thoughts.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 17, 2008, at 12:24 AM, TMFAleph1 wrote:

    Austin,

    I'm going to go against your recommendation and respond to your comment: Thanks for your words of support.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 17, 2008, at 2:11 AM, jewelman4now wrote:

    Alex:

    I need to clarify if not restate some things:

    First of all, I don't know you or your writings. My frustration is more w/TMF than with you per say.

    Secondly, I don't agree w/nygal2's opinion with regard to the effect a headline does or does not have with one's investment decisions. If a person makes a decision based on a headline, then they're an idiot as far as I'm concerned, and they deserve whatever comes. I am a firm believer in responsibility for personal choices.

    Frankly,I enjoyed your article. In particular the lesson on arbitrage. How great to be able to use that word in context and know what the hell it means!

    My frustation is this only: Most times when I click on a MF article, it does not relate strongly to the implied subject. Often times, there is some little historical snippet that is in insignificicant relative to the headline. This has happened so many times that for the first time in my life, I not only have written to a blog, but went through the process of signing up, just to do so.

    I agree w/the reader regarding his/her "irresponsible" comment.

    That's it!

  • Report this Comment On September 17, 2008, at 10:08 AM, OptionalFool wrote:

    Alex,

    My first ever comment to a blog too. I have to say that your headline is spot on. That was my feeling from the beginning when the announcement was made and the price of MER only went to 22. If it were expected to go through as proposed, MER would be trading at around 29. The market has spoken!

  • Report this Comment On September 17, 2008, at 12:42 PM, TMFAleph1 wrote:

    OptionalFool,

    First comment for you and not the last, I hope. Thanks for your kind words. Note that the price of Bank of American shares fell on Monday, reducing the spread a little bit as the share offer was no longer worth $29.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 17, 2008, at 12:43 PM, TMFAleph1 wrote:

    Erratum:

    "Note that the price of Bank of *America* shares fell on Monday, [...]"

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On September 17, 2008, at 6:28 PM, rd80 wrote:
  • Report this Comment On September 17, 2008, at 7:27 PM, TMFJoeInvestor wrote:

    I'm offended by all these comments about the "Joes" of the world being the problem here. :-)

  • Report this Comment On September 18, 2008, at 11:04 PM, grweiss wrote:

    I'm very new here, but I would agree with nygal2. The headline contradicts the conclusion. The ends (getting people to read one's article) do not justify the means (having a headline that is not just sensationalist but actually totally disagrees with the end-conclusion reached by the author.) Suckering in web readers is lousy and is not a good business to be in. I do respect that Alex responded to nygal2's position and tried to explain his position... but I don't buy his reasoning. If Alex wants a headline that is dramatic and raises doubts that ultimately he doesn't think will occur, isn't that possible without the need to contradict onesself and lose credibility? For example, one could just add a question mark to the end of the headline-- "The B of A/Merrill Deal Won’t Happen?" raises attention and concern without being nearly as misleading as "The B of A/Merrill Deal Won’t Happen", particularly since the Alex thinks the deal WILL probably happen. Ah well, consider that next time perhaps?

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