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Merrill CDO Deal: How Can It Book a 'Sale'?

by: Whitney Tilson July 29, 2008 | about stocks: MER    

Whitney Tilson

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STOP THE PRESSES! This part of Merrill's (MER) press release caught my eye:

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction.

Lone Star Funds presumably has other assets, so what explains this line: "The purchaser will not own any assets other than those sold pursuant to this transaction."? I went to Lone Star's web site and here's the description of what they do:

Lone Star Funds (Lone Star) are closed-end, private-equity limited partnerships that include corporate and public pension funds, university endowments, foundations, bank holding companies, family trusts and insurance companies. Since 1995, the principals of Lone Star have organized private equity funds totaling more than $13.3 billion to invest globally in secured and corporate unsecured debt instruments, real estate related assets and select corporate opportunities.

Lone Star is a group of funds, so what it's doing here is setting up a special fund solely to purchase Merrill's CDOs (the fact that they are called "super senior" CDOs is so hilarious -- that phrase will go down in the oxymoron hall of fame). If so, what an incredible deal for Lone Star (and horrible deal for Merrill)! By putting up only $1.675 billion (25% of the purchase price of $6.7 billion and only 5.47% of the $30.6 billion gross notional value of the CDOs), Lone Star is getting 100% of the upside above $6.7 billion, but Merrill is on the hook for every penny from $6.7 billion down to $1.675 billion.

The Dow Jones story reaches the same conclusion:

As part of the deal, Merrill is funding three quarters of the purchase price. If Lone Star defaults on that loan, the only recourse Merrill has is to the CDOs it sold Lone Star. That means the fund is only putting up about 5.5 cents of its own money for every dollar of face value.

Here's what I want to know: HOW ON EARTH IS MERRILL ABLE TO BOOK A $6.7 BILLION SALE HERE?!?!?! Did its auditors really sign off on this?! I'm not an accounting expert, but it seems obvious to me that Merrill should book a $1.675 billion sale and then have an account receivable of $5.025 billion, on which they would have to take an allowance for doubtful accounts (presumably a large allowance, given that nobody has the foggiest notion of what these CDOs will eventually be worth).

Sean Dobson from Amherst Securities notes:

If the financing is non-recourse to Lone Star Funds, then they only invested ~5 basis pts in the trade, which is likely the interest payments they will receive even if the CDOs go bad.

If after that the CDOs are worthless, they boomerang back to MER.

We've heard the same for the UBS/Blackstone trade.

It's hard to believe they can get true sale opinions on these deals.

The only silver lining I can see for Merrill is that they're smart to see the writing on the wall and get in front of this problem -- forced to buy a company in a distressed sector, you want to buy the one that's first to acknowledge and address its issues. Keep in mind, however, that one could have had this thought earlier this year and bought MER at twice today's price. Fortunately we're not forced to buy anything -- as David Einhorn said at last November's Value Investing Congress: "You don't have to be a hero" here.

So what is the market, in its infinite wisdom, doing? Knocking down MER and running up the stock of every other financial company -- the ones that haven't admitted that they're totally mismarking their assets and will need to raise more money on highly dilutive, distressed terms. Go figure...

Disclosure: No position in MER

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This article has 18 comments:

  •  
    Jul 29 12:57 PM
    I'm not an accounting expert either... but that certainly doesn't look right. Obviously somebody had to sign off on this... I'd love to know the rationale.

    Keep your reading audience posted...
    Reply
  •  
    Jul 29 01:03 PM
    It seems ridiculous, but Merrill appears to have satisfied the requirements for sale treatment under FAS 140. A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

    a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. {Yep, the CDOs are bankruptcy-remote SPEs.}

    b. Each transferee has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. {The CDOs now belong to Lone Star, who may pledge them or sell them at will.}

    c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. {Condition 1 is satisfied, as Merrill is not obligated to repurchase the CDOs. Condition 2 is the tricky part. I guess by not funding the full purchase, Merrill doesn't have the ability to UNILATERALLY cause Lone Star to return the CDOs. Something to that effect.}

    It's definitely a sale in accounting terms only. Economically, it's nothing more than a reverse repurchase agreement.

    Reply
  •  
    Jul 29 01:09 PM
    Sounds like MER just underwrote another subprime loan to get rid of one! Creative financing at its best. Is it me...or does anyone else smell desperation in the air?
    Reply
  •  
    Jul 29 01:28 PM
    SFAS 140 is dead. Also MER is not securitizing its CDO portfolio.
    Reply
  •  
    Jul 29 02:07 PM
    It is hard to understand how so many highly paid, smart people (at the big investment banks) can make such horrid investments. I can understand a few random traders losing it here and there, but to have so many accross-the-board large scale blunders can not be a statistical abberation. There must be a systemic reason. Perhaps it is due to a cultural flaw at these firms. I just don't get it.
    Reply
  •  
    Jul 29 02:32 PM
    The accountants HAVE BEEN BOUGHT AND PAID FOR.

    They will sign off on ANYTHING.
    Reply
  •  
    Jul 29 04:32 PM
    I understand what they did however convoluted and I admit this is a good attempt to rid themselves of the albatross around there corporate neck. But how much this junk is left in the basement and is this the first of many such deals for them? I'm sure John Thain is back out there saying this is it and Merrill doesn't need anymore capital. Yeah sure it is.
    Reply
  •  
    Jul 29 05:19 PM
    I am NOT an Accoutant, and neither rooting for MER but:
    When I buy a car from GM for $20,000
    I pay $2000 down and they finance the $18,000
    I have full control on the Car, but if I don't pay back the loan they can take away my car (which will be worth a lot less than $18,000 then)
    For now, they have taken a loss and removed the stuff from their books. I guess they are estimating that the CDO's won't go down to zero.
    Reply
  •  
    Jul 29 08:11 PM
    To Patrick1980SC's thoughtful comment that Merrill's action DOES qualify as a sale: I agree. My point relates to how the proceeds from the sale are accounted for. MER sold some assets and is getting $1.675 billion for them, PLUS the first $5.025 billion above this, IF the assets are worth this, and then Lone Star gets everything above this. How this is booked as a $6.7 billion sale is beyond me...
    Reply
  •  
    Jul 29 09:08 PM
    There is only ONE question. Is this the bottom for financials? SKF or UYG. I vote UYG
    Reply
  •  
    Jul 29 09:30 PM
    I'm not an accountant ,but the point of all this "jibberish" is clear enough . ML pulled a fast one on investors .Never the less how do you value these financials going forward when they can no longer perform these exotic financials products to bring in "gobs" of money . They'll have to make money the old fashion way , earn it . their profits should be considerably less therefore how can you know until these banks finally make money (which could be 2 yrs) is worth . You have be have "brain damage " to buy stock in any of these financials .
    Reply
  •  
    Jul 29 09:52 PM
    WT, great point on the valuation allowance. I think they will argue that the 4.4bn write down to 'fair value' took care of the loss provision. They could have sold the bonds for 11.1bn, financed 9.4bn and taken a valuation allowance of 4.4bn against the loan. Same balance sheet result.
    Reply
  •  
    Jul 29 10:39 PM
    Just balance sheet sleight of hand at this point. Merrill gets to record a $6.7 billion loan receivable from Lone Star, which requires no reserve until the underlying assets fail to perform and the loan to Lone Star goes delinquent. It's basically a refinancing of troubled debt structured to achieve the best possible accounting treatment.

    It is certainly ridiculous to allow Merrill to remove $6.7 billion in toxic assets yet simultaneously provide non-recourse funding to the purchaser. Certainly the $5.025 billion seems to be a contingent asset, but GAAP is awfully flexible at times.
    Reply
  •  
    Jul 30 04:46 AM
    Whats MER monthly payroll?
    Reply
  •  
    Jul 30 12:49 PM
    I guess Merrilll is betting on Lone Star's credibility. What are the chances that Lonestar would default? If it is less than the probability of CDO's losing its value below the already discounted 22 cents to a dollar, this deal seems fair.
    Reply
  •  
    Jul 30 01:43 PM
    Y'all are talkin' around one of the oldest tricks in accounting, namely: "suppressed profits." Which means by valuing the CDO's at the sale price, which obviously will be greater than the total loss price, allows MER to record this sale as a "gain" by releasing the suppressed profits. CDO's and all other sliced and diced pooled assets are treated the same way upon sale. So MER's loss actually becomes a gain on the balance sheet which placates its shareholders and the SEC. All in all, it's an accounting trick! But allowable. Look closely at annual reports and y'all will see it being done all the time. Ya gotta look to find it.
    Reply
  •  
    Jul 31 12:10 AM
    A friend just emailed me what sounds like a reasonable answer:

    I see the Merrill CDO sale to Lone Star differently. The financing was non-recourse, so Lone Star effectively bought a call option on the assets with a strike of $5.025 billion and a premium of $1.675 billion. Depending on the volatility assumption, that implies a value of the assets around $4 to $5 billion. So Merrill should have marked the assets down from $11.1 billion (the mark prior to the sale) to (say) $4.5 billion, showing an additional $6.6 billion loss (not the $4.3 billion they reported). The sale of the call option to Lone Star is presumably at the arm’s length price of $1.675 billion, leaving Merrill with $2.825 billion remaining equity in the asset. So that’s sale proceeds of $1.675 billion, remaining asset value $2.825 billion and $6.6 billion loss; instead of sale proceeds of $6.8 billion, remaining asset value of zero and $4.3 billion loss.
    Reply
  •  
    Jul 31 03:13 AM
    The option analysis is an interesting angle.

    For Lone Star, this deal is oddly similar to the deal the Fed gave to JPM for Bear Sterns .. The Fed took all the downside risk after a small sliver of risk taken by JPM and JPM retained all the upside equity.

    Additionally, a little noted consideration is that Lone Star is identified in ML's press release as an "affiliate", which usually means that ML has more than a 20% but less than a 50% stake in Lone Star. So a) this means it certainly wasn't an "arms length" price and b) ML may retain a small portion of the equity.
    Reply
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