After speaking with the mechanic, still not sure what caused the wire meltdown or the bad compression in middle cylinder, but the electrical problem seems to have been resolved with a new stator and rectifier. My father was able to track down another message board that had a similar situation with the same motor --
http://forums.iboats.com/showthread.php?t=133622
seems that poster had a wire meltdown, but no compression loss afterwards! I am sure that the electrical gremlins have been silenced (at least for now), so its on to a larger problem.
The situation now seems to be more focused on the low compression on the middle cylinder (I am not sure that I stated before that it was a 3 cylinder). The mechanic has been speaking with Mercury over the phone regarding this issue and he said that Mercury would replace the powerhead for free and he would just charge labor to install. I asked how he knew that the powerhead was bad (ie what tests had he performed) and his reply was since it was the middle cylinder, that was for sure the culprit - a bad powerhead. That plus the Mercury customer claims people were so readily willing to replace the powerhead even though the engine has been out of warranty for just about a year. Something like they want to keep people happy and that this might be a reoccurring problem. Seems kind of odd to me, but I wanted to pass this one by everybody before going any farther.
Hearing this news I am inclined to head over to the mechanics and remove the head to see what has gone on. I have heard that I will see damage to the head gasket or the cylinder walls. The explanation for possiblity of head gasket damage is that a bad detonation (bad electrical) could have caused the cylinder not to compress the fluid and the path of least resistance would have been the head gasket or maybe a ring. The carberator is another place I would like to look at for the possibility of finding a reed valve issue.
What do you think? Are there any tests for diagnosing powerhead issues? I keep hearing about leakdown tests, but not sure what or how that is done. Last year I was on a 40HP Yamaha that blew the head gasket and there was a bunch of steam comming off the motor, I am sure from the cylinder and the block, so that might not be my problem either as I never saw that heppening in my case. I know that pulling the head is fairly easy and think that should be done to ensure the powerhead is shot before going ahead. On the other hand, I dont want to get in the way or obstruct a somewhat free powerhead replacement. I am really at a loss and would really apprectiate your advice.