The forecasters who thought investors should now pile into the financials, that the sector would start seeing an upward trend, now know the pain of betting on a false bottom.

Merrill Lynch's shocking announcement after the market's close yesterday that it will book a huge pre-tax $5.7 bn writedown in its upcoming third quarter from its toxic securities and hedges with bond insurers, plus raise another $8.5 bn in new stock, should make investors who piled into the shares just last week at $31 thinking the worst was over after Merrill reported its disastrous second quarter results feel totally blindsided.

It defies reason that Merrill did not know about this massive problem in its book of business, that it didn't see this freight train of a writedown coming when just last week it disclosed $4.9 bn in second quarter losses due to $9.4 bn in writedowns for the period. Wall Street had expected lesser sums here, $1.8 bn in losses due to $6 bn in writedowns.

At minimum, do you really think it takes only about a week to convince foreigners to invest even more money at a time when the stakes they've already bought in Merrill earlier this year are now drastically under water?

The second quarter losses marked Merrill's fourth straight quarterly loss. The tally of losses is ranging around $21 bn,  and writedowns amounting to more than $46 bn.

Now more losses are on the way for the third quarter, the fifth straight quarter, at Merrill.

Wall Street is now wondering whether Merrill's chief executive, John Thain, has a credibility problem. On the July 17 conference call about its bad second quarter results with analysts, analysts who were skeptical as they were expecting smaller losses and writedowns, Thain said: "Right now we believe we are in a very comfortable spot in terms of our capital."

Really? And 10 days later you announce both a massive writedown and another eye-watering, dilutive capital raise? 

Since he took over in December, Thain has repeatedly dismissed the notion that Merrill needs any more capital after the firm reported poor results, with the refrain being new capital would not be necessary. For a round up of Thain's comments that the firm does not need new capital, click on this link: http://in.reuters.com/article/governmentFilingsNews/idINN2824127720080729

When did Merrill know it planned to unload this distressed debt and when did it know it had to do another $8.5 bn equity raise? Did it really come as a eureka moment just overnight?

Investors who bought in last week when it was said the worst was over at Merrill, when it was trading at around $31, are getting hammered now. The stock is trending down toward $20. "Shareholders are seeing their positions diluted massively," says Dennis Gartman of the Gartman Letter.

Gartman adds the blame should also be put squarely on Merrill's former chief executive Stanley O'Neal, ousted last fall due to his mismanagement, who walked away with $161.5 mn in compensation, compensation "that is not being written down even as the shareholders are having their positions massively corrupted," Gartman says.

"If there is a crime on Wall Street it is this." That compensation effectively was paid out based on artificial profits made during the housing bubble. Merrill to date has laid off 5,200 people.

Yes, I have raised the question of what some analysts were saying, whether we were seeing a bottom in the financials.

I also warned you that thinking that way would be like trying to hold onto a piece of Styrofoam in a typhoon.

Merrill's stock got pounded in after hours trading, closing down 12% to $24.33. Shares are down 54% this year, and are trading at their lowest levels in ten years.

Meredith Whitney, a top analyst at Oppenheimer, says Merrill's pro forma book value per common share is more like $21 and that shares are still trading at levels that are "at a premium" and "expensive." Whitney does think Merrill is getting closer to being fairly valued and that "the hardest work" is behind the company. Whitney now expects Merrill to post a loss of $10.50 per share for the entire year, versus the $8.37 expected earlier.

Don't be fooled by false bottoms in the financials. As economist Ed Yardeni points out, the financial sector of the S&P 500 jumped 31% "in a six-day short-covering rally that was interrupted by a 6.7% drop last Thursday, the biggest decline since a 7.7% decline on April 14, 2000."

The jump came after Congress said it was close to signing the $300 bn housing bailout bill, which included the taxpayer backed rescue of publicly traded Fannie Mae (FNM) and Freddie Mac (FRE), and also turned these two as well as the Federal Housing Administration into a halfway house for severely delinquent, bombed out loans.

"The financials tend to rally following massive government programs to avert a financial meltdown," Yardeni says.  

What you should be watching for are writedown announcements such as Merrill's, because it means the rest of Wall Street will start marking down their assets to potentially 22 cents on the dollar. Watch out, Lehman Bros. (LEH). Watch out Citigroup, which has $22.5 bn in subprime securities exposures here, and UBS, $15.6 bn, both ranked the highest in this category, Oppenheimer's Whitney says.

A new report from Goldman Sachs on Merrill's 22 cents on the dollar pricing indicates it thinks there will be "a negative read-through to Citigroup given its exposure and the levels where these assets appear to be marked ($0.50)."

Investors in Merrill should be notably concerned with what is happening at the country's largest brokerage. Merrill was a repackaging factory for some truly toxic subprime debt, including those pumped out by Countrywide Financial. Countrywide pointed its conveyor belt of nasty loan products at Wall Street, and Merrill was first in line to gin them up into asset-backed securities.

Merrill's latest writedowns resulted from the sale of a huge $11.1 bn slug of its asset-backed securities, helping to create the latest $5.7 bn pre-tax writedown. It also pulled the plug on hedges with troubled bond insurers, the two white hot zones on many financials' balance sheets.

Watch how this deal to unload a whopping slug of Merrill's distressed debt breaks down. Merrill said it sold $30.6 bn worth of distressed debt in the form of super senior asset-backed debt, once rated Triple A, for just $6.7 bn. Merrill had just said at the end of its second quarter these assets were worth $11.1 bn, or just 36 cents on the dollar.

So, being that it has sold this distressed debt, called collateralized debt obligations, for just $6.7 bn to a unit of Lone Star Funds, a Dallas private equity firm, when you do the math, that's about 22 cents on the dollar. That's a writedown of 78%. Gasp. That created $4.4 bn of the writedown.

Moreover, Lone Star only has to pony up $1.7 bn to seal the deal, borrowing the rest, or 75%, from Merrill. So Lone Star is effectively putting up just 25% of the deal, about six cents on the dollar, for the gross value of the deal. "That does not sound very good for the about-to-be diluted shareholders, now does it?," says Jill Schlesinger, executive vice president and chief investment officer for StrategicPoint Investment Advisors.

One of the sharpest minds on Wall Street, Whitney Tilson, points out that Merrill's announcement said Lone Street " will not own any assets other than those pursuant to this transaction." Tilson says that means Lone Street is setting up a special unit to house Merrill's toxic CDOS, sheltered away from the pension, family trusts, endowment assets and insurance company portfolios Lone Star manages. That means if Lone Star defaults on its loan from Merrill, the only assets Merrill has recourse to are these CDO assets, Tilson notes.

So Tilson asks whether Merrill got to book this deal as a $6.7 bn sale, or as a $1.7 bn deal, with an account receivable on its balance sheet of $5.0 bn.

Does anyone at Merrill or on Wall Street know what these assets are really worth?

The sale cuts Merrill Lynch's total CDO long exposures from $19.9 bn at June 27, 2008, supposedly to $8.8 bn. Most of what's left is made up of older vintage securities, dating back to 2005.

Take a closer look through Merrill's books and you'll still see problems. As of June 27, it said it had exposures of $33.7 bn to U.S. prime mortgages, $1.01 bn to U.S. subprime mortgages, $1.54 bn to "Alt-A" mortgages and $7.45 bn to non- U.S. residential mortgages.

It's also got a big $18 bn in exposures to subprime- and commercial-backed securities. Of that sum, its net exposure to subprime alone is $4.5 bn.

Merrill has been in acute pain due to what it has had on its balance sheets, with 30 CDOs worth in the aggregate $32 bn for deals Merrill underwrote in just 2007 alone. Some 27 of these have seen their top triple-A ratings downgraded to "junk," Janet Tavakoli, a structured-finance consultant in Chicago, reportedly said. Their performance has been "dreadful," she says.

Merrill has about $41 bn in net worth, or shareholder equity against about $34.4 bn in illiquid level three securities, those securities it has price tagged itself because no one wants them.

The $8.5 bn capital raise will dilute existing investors by nearly 40%. Merrill has to compensate Temasek and the Kuwaiti Investment authority who both bought shares in Merrill earlier this year at a higher price.

Last week, Merrill announced it would unload its stake in Bloomberg for $4.43 bn to raise capital. It had to unload this asset due to the fine print of an earlier $12 bn equity offering sold to Singapore's investment fund Temasek and the Kuwaiti investment authority, which forces Merrill to remunerate them in the event of any further dilutive equity raises.

The new equity offering now forces Merrill to reset its earlier deals with Temasek and Kuwait, an issue I warned you would happen (see earlier blog, "Why Merrill May Cut Into its Muscle").

Temasek had bought $5 bn at $48. As Merrill is now trending toward $20, Merrill has to pony up $2.5 bn to Temasek, and Temasek is expected to turn around and invest that remuneration into its new $3.4 bn investment in Merrill's latest equity raise.

So in effect Merrill lent $5 bn to Lone Star to buy, gross value, $30 bn in securities, and at the same time it paid Singapore's Temasek $2.5 bn to buy its shares.

Merrill also is in talks with the Kuwait Investment Authority to renegotiate the terms of its original investment. And Merrill's management will buy 750,000 shares in the new offering.