Loading...
Symbols:
Authors:

Why Merrill's CDO Sale Doesn't Mean Big Writeoffs Elsewhere

by: Tom Brown July 31, 2008 | about stocks: BAC / C / LEH / MER / WB / XLF    
Tom Brown

Tom Brown

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print

Now that Merrill Lynch (MER) has sold a raft of CDOs at 22 cents on the dollar, every CDO everywhere needs to be marked down to 22 cents, too, right? David Reilly at the Wall Street Journal seems to think so , as does Deutsche Bank’s (DB) Mike Mayo . Lex at the FT says so, too .  

Wrong. Can we go back to basics for a minute? A CDO, recall, is simply an asset structure. In this case, it’s essentially a portfolio of debt instruments. The value of the CDO, therefore, is driven by what those debt instruments are, their credit quality, and how much they’re worth.

Which means the value of instruments called “CDOs” can vary all over the place. The paper (sorry, make that “toxic paper”) Merrill Lynch sold to Lone Star Tuesday was the worst of the worst. In a note to clients that night, Buckingham’s Jim Mitchell points out that it consisted mainly of super-senior CDOs comprised of subprime mortgages originated in 2006 and 2007—by which time most originators had gone completely out of their minds.

But, again, not all CDOs are packed with that stuff. Citigroup (C), with $18 billion of subprime CDO exposure still on its books, is said to be next in line to take a big hit as a result of the Merrill sale. But Mitchell points out that the bulk of Citi’s paper has protections that Merrill’s didn’t (it’s in an asset-backed structure, for instance). And something like 80% of it is 2005 vintage and earlier. That makes a huge difference. Mitchell is absolutely right to note those distinctions. More analysts should.

For that matter, don’t forget that John Thain likely decided to part with the paper for reasons that weren’t entirely economic. He’s the new broom at Merrill—and is having to deal with (among others) regulators and rating agencies as he sorts through the prior regime’s mistakes. He’d probably rather fix the problems he inherited sooner rather than later; if that means accepting a less-than-optimal price on the sale of troubled assets, so be it. Other CEOs, who might hypothetically own the exact same paper, but under different circumstances, might not make the same decision Thain did.

Will more banks take more hits on their subprime holdings in coming quarters? I have no clue. But people who think Merrill’s news yesterday means automatically that more hits are inevitable, and must be huge are being way, way too simplistic.

Tom Brown is head of BankStocks.com.

Related Articles

This article has 15 comments:

  •  
    Jul 31 03:51 AM
    22 cents on the dollar? Biggest lie on the Street. They only got 5 cents cash. They loaned the rest to the buyer. If defaulted they can only get the securities back. So if all goes really well they will get the 22 cents. Tell me another one.
    Reply
  •  
    Jul 31 04:04 AM
    What the man has to say makes sense and may I add - logical. It sure is refreshing to see someone take the time to articulate the difference in CDO's.. thanks Tom
    Reply
  •  
    Jul 31 06:07 AM
    Absolutely agreed Tom. Saying every CDO needs to be written down to 22c (or 5c depending on how you view it) is like saying every stock needs to be marked down to $2 (or $10) because that's where BSC went. Ok, not the same .. but u get the idea ..
    Reply
  •  
    Jul 31 06:08 AM
    To all Banks and Broker agencies: just FIRE SELL all your structure finance vehicles i.e.: CDO-ABS-MBS-SIVs if you want to live period!
    Reply
  •  
    Jul 31 08:39 AM
    sadly when your house is on fire it dosent make a differance how it started, the same with these mark to market rules, if someone sells everybody has to do the same.
    Reply
  •  
    Jul 31 09:27 AM
    I like this guy. He knows the business of banking. After forty years in the financial world I enjoy hearing from someone who actually can articulate a position and support it with sound financial logic. Well said Tom, I'm a new fan.
    Reply
  •  
    Jul 31 10:04 AM
    Tom I appreciate your perspective and always listen carefully to your comment here and on television. Do you not think" less than optimal " is an understatement? More importantly, can you generalize on the level, on average, that the big banks have already marked their subprime assets/ 15% ? 30%?. Also do you think the Regionals are understating their construction ans development losses or no. I live in the Southeast( Atlanta) and there are frozen development everywhere?
    Reply
  •  
    Jul 31 11:25 AM
    recall that these CDO's were supposed to be "super senior." sure there are many kinds of CDO's, just as there are many kinds of portfolios of anything. But if the "super seniors" are being marked down to 22% of par, wouldn't it stand to reason that less senior tranches would be perhaps marked even lower?

    Second, Thain was a new broom in mid January when he supposedly "kitchen sinked" the balance sheet. After multiple assurances that MER was well capitalized, and six months at the helm, it's a little late to say "oh what a surprise! how did this junk get here?!"
    Reply
  •  
    Jul 31 11:52 AM
    Vikram Pandit has a 'new broom' at Citi too - and probably bigger problems at the behemoth. Those 2005 CDOs are almost just as toxic as the 2006 & 2007 versions and its just a matter of time for their firesale value to be realized.
    Remember - those 06 & 07 versions were rated the same as the 05: AAA.
    Reply
  •  
    Jul 31 11:57 AM
    I was surprised that a super-seniors CDO sold for 22 cents on a dollar. I assume at worst, housing prices in the most affected areas would drop about 50% from the height, so I'm still puzzled on the significant markdown. If it were a lower tranche then I could understand.
    Reply
  •  
    Jul 31 01:37 PM
    tlc: Price is whatever a seller will pay and MER needed the cash bad. In this case it would appear 22 cents on the dollar is the best deal they could find.
    Reply
  •  
    Jul 31 01:39 PM
    To the OP: This is the first actual transaction of this stuff in a long time at an actual price. It would be unreasonable to dismiss the event as unimportant as it does have serious implications.
    Reply
  •  
    Jul 31 03:05 PM
    The "super senior" securities sold in the marketplace have no standard definition. The arrangers can structure the security any way they want. The only generalization you can make is that the "credit risk" of the security will be low. however because the credit risk is low the interest yield is also low. Arrangers get around this, and enhance the yield, by often building a lot of leverage, usually with low rate short term funding, into the structure. So, while the credit risk is "super senior" the securities can have a lot of interest rate risk and/or funding risk.
    Reply
  •  
    Aug 01 04:06 AM
    Tom, you are right of course - that mer esentially sold cdo-stuff for 5ct on the dollar says nothing about the CDOs held by others. It#s in fact not very hard to assume that they can't hold worse stuff but rather might hold better. BUT: what does it tell you about the true state of affairs at Merill? when they sell fpr 5 cents on the buck just to get some 6.7 bn in cash upfront (even if they might have to pay 5bn of that back over time). When they have to dilute their stock at a multiyear low by 38% and to basically issue new shares to Singapore at $7/share? What was all that bs said by Thain worth when he didn't have the balls to issue more new stock earlier while merill was trading much higher?
    What is does tell me at least (unlike you me being no banking expert ) is that mer sees very tough times ahead which they feel the need to get prepared for. Even with better cdo-stuff, these times may be as bad for anyone else.
    this is NO cyclical downturn for banks - this THE biggest financial services bubble ever deflating.
    There is more bad stuff to come - and I am pretty certain that over the next 6-12 months we will see one or more major banks (commerical or Investment) failing to raise fresh equity - leading to a true panic bottom for financial stocks.
    Reply
  •  
    Aug 02 07:24 PM
    Can you just see all the happy faces at Merrill Lynch when Lone Star bought the "worst of the worst". This has got to be a meeting of the liars club! This sounds like the hype when all the telecoms were booking these huge orders from clients to which they loaned all the money to buy the equipment. If Merrill Lynch is boasting the sale and pointing a finger at Lone Star for buying the "worst of the worst", AND Lone Star is not protesting the purchase of worthless assets, then this entire sale is a sham. Watch Lone Star turn out to be a shell corporation like Enron used.
    Reply
More Comments on MER ยป
More by Tom Brown

Investment Resources
Money Management 

Research 

Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Consumer Credit 

Insurance 

Investment Banks 

Major & Intl. Banks