Tuesday, July 29, 2008

Merrill Gives Away Its Toxic Waste


The market reacted favorably today to Merrill Lynch's announcement that it is selling its CDOs to Lone Star Funds, a Dallas private equity firm, for the basement-level pricing of 22 cents on the dollar. Most market analysts viewed this move as 'constructive' or a 'watershed for banks' , but investors better scrutinize this deal before jumping to any conclusions.

I read two important articles that critically examined this deal. The first, Merrill’s Latest Misfire, was written by Elizabeth MacDonald of Fox Business News. Ms. MacDonald states the following:

Merrill Lynch’s shocking announcement after the market’s close yesterday that it will book a huge pre-tax $5.7 bn writedown in its upcoming third quarter from its toxic securities and hedges with bond insurers, plus raise another $8.5 bn in new stock, should make investors who piled into the shares just last week at $31 thinking the worst was over after Merrill reported its disastrous second quarter results feel totally blindsided.

It defies reason that Merrill did not know about this massive problem in its book of business, that it didn’t see this freight train of a writedown coming when just last week it disclosed $4.9 bn in second quarter losses due to $9.4 bn in writedowns for the period. Wall Street had expected lesser sums here, $1.8 bn in losses due to $6 bn in writedowns.

At minimum, do you really think it takes only about a week to convince foreigners to invest even more money at a time when the stakes they’ve already bought in Merrill earlier this year are now drastically under water?

Ms. MacDonald goes on to add:

Investors in Merrill should be notably concerned with what is happening at the country’s largest brokerage. Merrill was a repackaging factory for some truly toxic subprime debt, including those pumped out by Countrywide Financial. Countrywide pointed its conveyor belt of nasty loan products at Wall Street, and Merrill was first in line to gin them up into asset-backed securities.

Merrill’s latest writedowns resulted from the sale of a huge $11.1 bn slug of its asset-backed securities, helping to create the latest $5.7 bn pre-tax writedown. It also pulled the plug on hedges with troubled bond insurers, the two white hot zones on many financials’ balance sheets.

Watch how this deal to unload a whopping slug of Merrill’s distressed debt breaks down. Merrill said it sold $30.6 bn worth of distressed debt in the form of super senior asset-backed debt for just $6.7 bn. Merrill had just said at the end of its second quarter these assets were worth $11.1 bn, or just 36 cents on the dollar.

So, being that it has sold this distressed debt, called collateralized debt obligations, for just $6.7 bn to a unit of Lone Star Funds, a Dallas private equity firm, when you do the math, that’s about 22 cents on the dollar. That’s a writedown of 78%. Gasp. That created $4.4 bn of the writedown.

Moreover, Lone Star only has to pony up $1.7 bn to seal the deal, borrowing the rest, or 75%, from Merrill. So Lone Star is effectively putting up just 25% of the deal, about six cents on the dollar, for the gross value of the deal. “That does not sound very good for the about-to-be diluted shareholders, now does it?,” says Jill Schlesinger, executive vice president and chief investment officer for StrategicPoint Investment Advisors.

One of the sharpest minds on Wall Street, Whitney Tilson, points out that Merrill’s announcement said Lone Star ” will not own any assets other than those pursuant to this transaction.” Tilson says that means Lone Star is setting up a special unit to house Merrill’s toxic CDOS, sheltered away from the pension, family trusts, endowment assets and insurance company portfolios Lone Star manages. That means if Lone Star defaults on its loan from Merrill, the only assets Merrill has recourse to are these CDO assets, Tilson notes.

So Tilson asks whether Merrill got to book this deal as a $6.7 bn sale, or as a $1.7 bn deal, with an account receivable on its balance sheet of $5.0 bn.

Does anyone at Merrill or on Wall Street know what these assets are really worth?

Apparently not and keep in mind that these Wall Street "geniuses" are the same people who sold this toxic garbage to institutional pension funds around the world.

The second must read article, Super-Senior Tranches of CDOs are Worth Much Less than 22 Cents on the Dollar: Another Ponzi Scheme of “Selling” Toxic Garbage with More Leverage, comes from Nouriel Roubini's Global Economonitor.

Given its importance, I quote the entire article below:

Nouriel Roubini | Jul 29, 2008

Merrill Lynch decision to “sell” a good chunk of its remaining CDOs at 22 cents to the dollar has been widely praised as the firm finally recognizing the full extent of its losses on these toxic instruments. This batch of $30.6 billion of CDOs was already marked down to $11.1 billion. Now with the “sale” of it to Lone Star at a price of 6.7 billion Merrill Lynch is taking another $4.4 billion writedown and “selling” it at 22% of the original face value.

But is this a market-based “sale”? No way as calling this transaction a “sale” is a joke.

Let me explain next why…

First, note that the secondary market for CDOs is now extremely illiquid and Merrill will provide financing for 75% of the purchase price, or a financing of $5.055 billion. That implies that these CDOs are worth much less than 22 cents of the dollar. These type of “sales” transactions – broker dealers “selling” their toxic waste at a discount and providing hedge funds and private equity funds with heavily subsidized financing for it – has going on for a while. That discounted “sale” price often ends up being much higher than the true value of the assets (and the ensuing writedown of the assets is smaller than the correct one) because of three reasons:

  • the selling broker dealer is providing most of the financing for the transaction as this market is totally illiquid and no one could dump $11.1 billions of toxic and illiquid CDOs in such a market;
  • the interest rate at which the financing occurs is often significantly lower than the appropriate rate at which this risk financing will occur. Merrill has not announced what are the terms of its financing of this deal and this leaves the serious suspicion of a heavily subsidized transaction;
  • the collateral for this risky financing is the same toxic waste that was sold to a fund. In the case of the Merrill transaction if the market value of this $11.1 tranche (now priced at $6.7 billion) falls another 25% the collateral for the 75% financing (that is non-recourse as it is secured only by the collateral) will be worth less than the underlying assets and thus additional losses will be incurred by Merrill. In other terms, as pointed out by Bloomberg since “the financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion”. Thus, in a extreme scenario in which the CDOs actually end up being worth zero Merrill will end up having sold them to Lone Star for 5.5 cents on the dollar rather than 22 cents. I.e. leaving aside the first loss of 25% taken by Lone Star all of the remaining credit loss is borne by Merrill.

So, based on the above consideration, is this toxic junk worth 22 cents on the dollar? No way and one would have to assume that the true market value of this garbage is closer to zero than 22 cents. So the street is now arguing that 22 cents on the dollar sets a market benchmark for writing down CDOs (Cit is still carrying them at a value of 53 cents rather than the 22) and many other firms will now have to use this benchmark; but the reality is that this toxic garbage is worth much less than 22 cents. So the charade of pretending to mark down to market the value of this junk will continue for a few quarters with continued bleeding of earnings.

At this point it would be more honest for the financial firms to write down to zero the value of these assets (with possible positive revaluation if they turn out being worth more than zero) and keep them on balance sheet rather than pretending to “sell” them via greater debt that massively adds to the credit risk that these firms are taking at the time when they should be deleveraging rather than releveraging further.

What is the sense of taking on another $5 billion of risky debt that has toxic garbage as collateral? Is this sound financial balance sheet restructuring or another Ponzi scheme of a house of debt-upon-debt cards? Selling worthless junk and providing financing for it is not a “sale”; it is another accounting scam whose purpose is hiding the full extent of the losses on garbage, not coming clean on them. So beware of the cheerleading chorus of banking “analysts” praising Merrill and this transaction.

The entire episode stinks with the Merrill CEO making a series of misleading statements on Q2 earnings and on no need for further capital and now coming out of the blue with this new surprise and a new large capital injection that will massively dilute current shareholders a few days after the dismal Q2 results were reported. Add to this charade the fact that what will be raised in this new round of recapitalization be much less than the announced $8.5 billion once Temasek and other shareholders who participated in the previous recap will be compensated for the massive losses they incurred in that round of recapitalization of Merrill.

If this is the way to run the finances of one of the largest broker dealers in the most advanced financial system in the world it is not wonder that this system is totally broken. The smart and very savvy Mohamed El-Erian (co-CEO of Pimco) put it in polite terms when he recently said while commenting on this financial crisis: “What has suffered most is the credibility of the most sophisticated financial systems in the world." Or as Bill King (a senior financial analyst) put it: "Eventually a critical mass of investors and traders will become cognizant of the obvious scheme and distrust of financial firms’ results, guidance and motives will increase substantially. John Thain’s credibility is now an issue". It is both the credibility and viability of the most sophisticated financial system that is at stake now as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy.

Or, as Barry Ritholtz aptly put it in much less polite terms than El-Erian and King in his latest blog:

How Screwed are the Investment Banks?

A brief review of recent Merrill (MER) CEO statements:

1. We don't need capital;

2. We could use some capital, but we won't sell shares, we'll just sell some assets;

3. We need to sell shares and raise capital right away;

Where is Ken* when you need him?

The financial firms obviously think investors are utter fools. And for a while, they were correct. They suckered people into buying into this mess the whole way down. Bottom calls each and every level -- all of which failed. Some analysts even called iBanks a "Generational Buys" -- 30% higher.

Only not so much.

Release earnings. Issue guidance. A few weeks later, lower earnings. A few weeks after that, take more write-downs. Raise more capital. Start it all over again next quarter.

Rinse. Lather. Repeat.

The banks have adopted a Chinese water torture approach -- dribbling out the bad news in small doses over time. Its been working up until now, but I doubt it will keep working much longer. Can they keep fooling people much longer? Merrill issued quarterly earnings on July 17th, and then dropped this bomb shell on July 28th? They must really think we are idiots, and that the SEC is in their backpockets to even attempt getting away with this crap.

What remains to be seen is how these massive writedowns will affect the pricing of illiquid CDOs (and ABCP) at Canadian and global pension funds. If this trend continues into 2009 - and there is no reason to believe it won't - investors can expect more writedowns from banks and pension funds.

(Note: You can read more about Lone Star Funds and its founder, John Grayken, in this New York Times article and this clusterstock article.)

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