Wednesday, July 30, 2008

Rethinking Merrill's Purge Cycle

(Housing Wire) Maybe the good news on Merrill Lynch & Co. (MER: 26.22 -0.11%) yesterday wasn’t really all that good, after all.

That’s the consensus that seems to be creeping into the Street’s collective psyche Wednesday morning, as analysts scrutinize the details of the deal to sell $30.6 billion in gross notational amount of ABS CDOs to an affiliate of Lone Star Funds. Merrill suggested in its press statement that it sold the securities for roughly 22 cents on the dollar, a figure that major financial press immediately hooked onto as establishing a price point in the battered secondary market.

That figure, however, has quickly come under fire, as details of the sale have been digested by market participants.
In particular, the fact that 75 percent of the deal is financed by Merrill itself meaning Merrill only received $1.7 billion in cash for the deal had more than a few market pundits, including the Financial Times’ Lex, suggesting that the implied sale price was actually much lower.

“In putting up three-quarters of Lone Star’s funding, secured only on the assets it is shedding, Merrill gets about $1.7bn in cash, and effectively swaps $5bn of direct exposure to CDOs for credit exposure to the buyer,” according to the Lex column. “A fall of 25 per cent could see this risk return to Merrill, hardly a comfort when the assets have apparently dropped 40 per cent since the end of June.”

For the record, a 25 percent drop translates into a drop of just another 5 cents or so.
Analysts at Bank of America reversed course Wednesday morning after calling the deal “the endgame” for CDO risk on Tuesday; Bloomberg News reported that the same BofA analysts said they had originally “overstated the positive implications” of the CDO deal.

“Merrill must be hurting worse than we thought,” one analyst told HW via email yesterday afternoon.
Citi’s woes, speculation grows
All of the analysis over Merrill’s deal is proving to be rather problematic for firms like Citigroup Inc. (C: 18.57 +0.65%), which holds a lot of these sort of securities none of which are really marked anywhere close to the implied value here of 5.5 cents. Or even 22 cents, for that matter.

Mike Mayo, an analyst at Deutche Bank, was among the first to sharpen his pencil and said Tuesday that Citigroup could face a write-down of $8 billion on its ABS CDO portfolio, cutting his earnings estimates for the bank, as a result. Mayo suggested that Citigroup has its CDOs valued at 53 cents on the dollar in his report.

William Tanona at Goldman Sachs & Co. (GS: 183.19 +0.86%) went even further, suggesting a $16 billion write-down.
Rating agency DBRS downgraded long-term ratings for Merrill, suggesting that the deal limited Merrill’s future prospects for capital.

“While successful in lowering the company’s risk profile, this combination of actions continues to draw down the company’s potential resources,” the agency said in a press statement.

And, of course, there’s the not-so-little issue of Merrill CEO John Thain’s credibility on Wall Street and among investors or, more appropriately, what’s left of it. The fact that Thain had so recently said fresh capital wouldn’t be needed, and that the company recently reported earnings on July 17 without so much as a peep about the asset sale or its terms, left more than a few market commentators and HW sources either scratching their heads, or incensed.

“Existing shareholders have been diluted 38 percent by this,” said one source, who asked not to be named. “And that’s after Thain swore up and down no more capital would be needed.”

There are those that have said the market’s malaise is as much about investor sentiment as it is about market fundamentals. If true, it’s clear that Merrill Lynch did little yesterday to clear up the picture on either front.

And from Felix Salmon's blog... The most important and most ignored sentence in Merrill's press release: "The sale will reduce Merrill Lynch's risk-weighted assets by approximately $29 billion."

How is this possible? After all, last month the CDOs being sold were valued at $11.1 billion, and indeed "Merrill Lynch's aggregate U.S. super senior ABS CDO long exposure" has been reduced by precisely that amount.

A CDO is not, in itself, a leveraged instrument: you can't lose more than you invested in it. If you're carrying a CDO on your books at $11.1 billion, there's no way that CDO can be responsible for $29 billion in losses, since its value can't fall below zero.

But there's more: since Merrill is lending Lone Star $5 billion to buy the CDOs, and the loan is non-recourse to Lone Star itself, the maximum that Lone Star can lose is its equity investment of $1.7 billion. If the CDOs went to zero tomorrow, then Merrill would suffer a further $5 billion of losses, and that contingent exposure should appear on the bank's balance sheet somewhere, as the risk associated with the loan to Loan Star.

Maybe that's where the $29 billion number comes from? Up until the sale, Merrill owned the CDOs outright, and if the CDOs all performed then those assets would have more or less their face value of $30.6 billion. Merrill took mark-to-model losses of $19.5 billion on those assets, but it still owned them, and kept them on its balance sheet under risk-weighted assets, valued at face.

Now, however, the CDOs have now been moved off Merrill's balance sheet, and Lone Star gets all of the upside (minus the interest it's paying on its $5 billion loan, of course). The $1.6 billion difference between $30.6 billion and $29 billion would then be Merrill's risk-weighted exposure to the final $5 billion of possible losses: after all, the $5 billion loan to Lone Star is surely now a Merrill Lynch risk-weighted asset of some description.

Let's say that Merrill considered the CDOs to be $30.6 billion of risk-weighted assets before the sale, and $0 afterwards. Then risk-weighted assets will have fallen from $30.6 billion in CDOs, to $5 billion in loans to Lone Star: a drop of $25.6 billion, not $29 billion.

So the only way I can see that Merrill could have got to $29 billion would be by risk-weighting the loan to Lone Star at just 32%: the $5 billion loan, once risk-weighted, would be counted as entailing risk of just $1.6 billion.

But even that doesn't make sense. Before the sale, Merrill would have been counting 100% of the CDO assets as risk assets; after the sale, Merrill would be determining that $3.4 billion of the assets are essentially risk-free. It seems to me there's some kind of weird remarking going on; if anybody could help me out, I'd be much obliged.

Oh, and one other thing from the press release: there was some commentary yesterday saying that the sold-off CDOs were mostly of 2005-and-older vintage. That's not true: it's Merrill's remaining $8.8 billion of CDO exposure which is the older stuff.

Comment from "JCK": the super senior abs cdo were downgraded and so were the insurers/monolines/hedges counterparties, this means under basel II ( the IBs are subject to basel II) they have to risk-weight to 100% of notional value hence they had a charge of $30.7bn to carry that stuff.

After the sale they have a simple loan to loan star credit enhanced by an equity tranche, that cuts the risk-weight assets by $29bn since ML no longer carries any risk for the super senior. the deal is very clever if i interpret it correctly [ not guaranteed...

I suspect they sold mostly post june 2005 mezz abs cdo, these have high attachment points in the 30s. suppose it is 30, then lone star equity attach at 85 and the merril loan attach around 88.5, the portion 30 to 85 having been written down by ML. This means that 85% of the cdo has to be wiped out by credit losses [ as opposed to mtm losses] before touching the lone star attachment point. If it doesn't happen I believe but am not sure that ML can recover some of the writedowns.

In any case this is no way near as bad as some of the permabears would have us believe. it's just catching up with reality.

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