July 29 (Bloomberg) -- Merrill Lynch & Co. took the biggest step toward recovering from the worst financial disaster in its 94-year history by acknowledging that $30.6 billion of its holdings are worth barely a fifth of their original price and securing new capital amounting to a third of its market value.

Merrill liquidated more than half of the mortgage-linked securities known as collateralized debt obligations that have saddled the company with $27 billion of writedowns since the beginning of 2007. To cushion the loss on the asset disposal, the firm raised $8.55 billion today by selling new shares for $22.50 each, 60 percent less than Merrill's stock price at the beginning of the year.

``When you have a sick patient you've got to take some tough medicine,'' Winthrop Smith Jr., a former head of Merrill's international brokerage and the son of a former Merrill CEO, said in a Bloomberg Radio interview. ``Right now the strategy is to save the company, to right it, to make it healthy again.''

Almost $19 billion of net losses in the past year forced Chief Executive Officer John Thain to backtrack on assurances that the firm had enough capital to weather the credit crisis. Since taking the post in December, Thain has raised $30 billion in an effort to keep pace with mounting charges on mortgage bonds amassed by his predecessor, Stan O'Neal. Standard & Poor's cut the firm's debt rating last month and signaled that more downgrades were possible.

Beyond Zero

Thain ``is trying to control the mess that he inherited,'' Scott Rothbort, president of Lakeview Asset Management LLC, said in a Bloomberg Television interview. ``I would not rule out at this point their having to write down even more, but you can't write things down beyond zero.''

Merrill's shares rose $1.92, or 7.9 percent, to $26.25 in New York Stock Exchange composite trading, snapping a four-day losing streak. The cost of insuring Merrill's bonds fell by 0.6 percentage point to an annual rate of 2.8 percent, according to broker Phoenix Partners Group. The drop indicates that fixed- income investors perceive a lower risk of default.

``While third-quarter results and the future capital raise would be yet another burden, we do believe there is light at the end of the tunnel,'' wrote Douglas Sipkin, an analyst at Charlotte, North Carolina-based Wachovia Corp., in a note to clients today. He rates Merrill ``market perform.''

Smith, the former Merrill executive, said he's buying the firm's stock. Merrill's own executives agreed to buy about 750,000 shares, or $17 million worth, in the offering, according to a statement released yesterday.

Temasek's Terms

Some analysts were less enthusiastic. UBS AG analyst Glenn Schorr predicted today that Merrill would report a third-quarter loss of $4.80 a share. Schorr, who has a ``neutral'' rating on Merrill, previously estimated the company would post a profit of 72 cents. The company still has commercial real-estate investments, mortgages and other holdings that may be vulnerable to further writedowns, he wrote today in a report to clients.

``We think the stock isn't overly attractive considering the remaining issues, lower earning power'' and a weak economy, Schorr wrote.

Temasek Holdings Pte., the Singapore-owned fund that became Merrill's biggest investor by acquiring shares in December, agreed to buy $3.4 billion of the new stock, Merrill said yesterday in the statement. The New York-based company is paying Temasek $2.5 billion to offset losses on its earlier investment. Merrill said it will also book $5.7 billion of writedowns in the third quarter.

Lone Star

Earlier this month Merrill sold its 20 percent share of Bloomberg LP, the parent of Bloomberg News, for $4.43 billion, 11 percent less than the $5 billion market value Thain placed on the stake in June. He also agreed to sell Financial Data Services, an in-house mutual-fund administrator worth $3.5 billion.

In yesterday's statement, Merrill said it agreed to sell $30.6 billion of collateralized debt obligations -- the mortgage-related bonds that have caused most of the firm's losses -- for $6.7 billion. The buyer is an affiliate of Lone Star Funds, a Dallas-based investment manager.

``Our consistent focus has been to opportunistically reduce risk, and in order to take advantage of this sizeable sale on an accelerated basis, we have decided to further enhance our capital position,'' Thain, 53, said in the statement.

Loss Estimate

Merrill will provide financing for about 75 percent of the purchase price, according to the statement. The financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion.

The sale will result in a third-quarter pretax writedown of $4.4 billion, Merrill said. Less than two weeks ago, the firm announced $3.5 billion of CDO writedowns for the second quarter that ended in June.

Bank of America Corp. analyst Michael Hecht estimated Merrill will report a full-year loss of $11.55 a share and he cut his price target for the stock to $40 from $47, according to a note to clients.

``Why these assets are written down when you're selling them and weren't written down in your earnings is a question,'' said Ralph Cole, a senior vice president in research at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which oversees $2.7 billion and doesn't own Merrill shares. ``This kind of announcement is surprising and a little disheartening.''

Thain declined to comment through Merrill spokeswoman Jessica Oppenheim.

Goldman Trader

Merrill had lost almost 55 percent of its market value this year through yesterday. Only Lehman Brothers Holdings Inc. had fallen more on the 11-member Amex Securities Broker/Dealer Index, dropping 77 percent.

Thain, who worked as a mortgage trader during his 25-year career at Goldman Sachs Group Inc., said July 17 that he was ``hopeful'' that Merrill could sell its CDOs, while adding he didn't ``want to do dumb things'' by selling them too cheap.

In yesterday's statement, Thain said, ``the sale of the substantial majority of our CDO positions represents a significant milestone in our risk-reduction efforts.''

The CDOs Merrill sold to Lone Star were carried on the securities firm's books at about $11.1 billion, indicating they already had been written down to about 36 cents on the dollar. The Lone Star sale values them at about 22 cents.

Merrill said yesterday in a presentation to potential buyers that it would sell as many as 356.5 million shares, a 36 percent increase over the number outstanding at the end of June. The share sale is Merrill's fourth since Thain took over following O'Neal's ouster last October.

Turned Away

Thain raised $6.2 billion in December -- when Temasek bought its initial 9.4 percent stake -- and an additional $6.6 billion in January. That month, he told investors Merrill had attracted more than it needed. Since then, he has repeated that the firm's capital was sufficient.

``We're very comfortable with our position,'' Thain said on Jan. 30. ``We could have raised substantially more money. We turned people away.''

Three months later he sold $2.55 billion of preferred stock. Then, after Standard & Poor's cut Merrill's credit rating to A from A+ on June 2, Thain announced he was considering a sale of Merrill's stake in Bloomberg.

When the firm reported a $4.65 billion second-quarter net loss on July 17, Thain said the firm's resources were adequate.

``We believe that we are in a very comfortable spot in terms of our capital,'' he said on a conference call with analysts.

CDO Underwriter

In yesterday's statement, Thain said the new capital became necessary because the completion of the Lone Star deal meant additional losses had to be booked.

Merrill was contractually bound to compensate Temasek and other investors who bought shares in the December and January offerings. The stock has since plummeted about 50 percent. So in addition to the new public offering, Merrill will pay $2.5 billion to Temasek and issue an additional 195 million shares to the other investors, according to yesterday's statement.

Losses on CDOs and the associated hedging contracts have accounted for about $27 billion of the total $41 billion of total writedowns taken by Merrill over the past year. The firm was one of the largest underwriters of CDOs before the credit crisis hit last year, and Merrill was stuck with more than $50 billion of them on its books when buyers fled the market.

XL Hedges

The remaining CDOs may be less worrisome to investors. About $7.2 billion of the $8.8 billion left are hedged with ``highly rated counterparties,'' the firm said in the statement.

In addition to the losses from the Lone Star sale, Merrill said it will record a $500 million loss related to the termination of hedging contracts on CDOs with XL Capital Assurance. It took another $800 million maximum loss related to the potential settlement of hedges with other bond-insurers.

Moody's Investors Service affirmed Merrill's A2 credit rating after the securities firm announced the asset sale.

``We think they have taken care of much of their troublesome exposure in structured finance and real estate,'' said David Hendler, a bank analyst at CreditSights Inc. in New York.

To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net

Last Updated: July 29, 2008 17:06 EDT