What Hath Merrill Wrought? Tally of Likely Fallout from CDO Writedown Rises (Updated)

Merrill’s surprising, mere ten days after its last investor combo writedown/fundraising announcement still has financial analysts toting up the collateral damage. Remarkably, the US stock market staged a peppy rally, clearly choosing to ignore the implications.

The cause for pause was the sale of $30.6 billion in face amount of super senior CDOs at a ostensible price of 22 cents on the dollar. But the sale was 75% financed, non-recourse, and could almost be characterized as a call rather than a sale. Worse, the CDOs were mainly 2005 vintage, and thus should have better quality underlying assets than 2006 and 2007 deals.

Barry Ritholtz argues that the real sales price was 5.47%, the amount paid in cash. That’s debatable (you’d need to look at the financing terms and do a bit of math), but the general point is well taken: the real number is lower than 22%. But even that figure has knock-on consequences.

Reader Saboor was so kind as to provide links to stories that discuss the broader ramifications. The Financial Times cites Goldman Sachs analyst William Tarona saying that if Citi were to mark its $22.7 billion of CDOs on the same basis, it would take a $16.7 billion writedown (note this is nearly twice Michael Mayo’s estimate earlier today),

However, the low price paid by Lone Star Funds, a distressed debt investor, to buy Merrill’s CDOs sparked fears that the financial system could enter another spiral of huge writedowns followed by highly dilutive capital raisings…

Mike Mayo, Deutsche Bank analyst, said Merrill’s action, a fortnight after John Thain, chief executive, said that it did not need more capital, “raises ongoing credibility issues for the industry”.

William Tanona, Goldman Sachs analyst, said that if Citi were to write down its $22.7bn of CDOs to the levels implied by the Merrill deal, it would have to take a $16.2bn writedown. Citi said this month that it valued its CDOs at about 61 cents on the dollar. Citi declined to comment. However, people close to the company said that the bulk of its CDOs dated to years prior to 2005 – before the onset of the housing crisis. As a result, they said that Citi was comfortable valuing them at current levels.

I find the claim about Citi’s CDOs hard to swallow. The CDO market grew explosively starting in roughly 2003; the vast majority of the deals were closed in 2005 or later. Why would they have kept the paper on their books if it was any good? The reason most banks wound up stuck with CDOs was that the market started getting indigestion as underwriters kept churning out paper in the face of weakening demand for certain tranches. The retained super senior slice was reported unsold underwriting inventory. And my impression further was that most CDOs had lives of five years or less, that the underlying assets matured or were paid off (for instance, mortgages were paid off via sales or refinancings).

The Times had a dire article, featuring Michael Mayo’s forecast of an $8 billion writedown for Citi and another grim perspective:

Sean Egan, of Egan Jones, called the sale a watershed moment, with implications that would trigger huge additional writedowns on CDOs and related assets worldwide. “This sends a loud and clear signal that the issue with CDOs is not liquidity in the market but problems with the value of their underlying assets,” he said.

Many owners of CDOs have marked down their value insufficiently, believing that such assets were sound and that the market’s appetite for them had dried up temporarily amid nervousness about all but the safest forms of debt.

Mr Egan said that Monday’s sale indicated that the problems were not temporary and that there needed to be widespread devaluation of CDOs. Mr Egan said: “The accountants will have to put significant pressure on their clients to write down these assets — Fannie Mae and Freddie Mac in particular — as this high-profile transaction has underscored the losses that are inherent in these kind of asset-backed securities.”

Freddie Mac disclosed at the end of March that it had $32 billion of losses on various securities that it deemed “temporary” and which were not reflected in its accounts. Fannie Mae reported $9 billion of similar losses at the same time. However, the writedowns will need to be much greater than that, Mr Egan said, in part because the market for CDOs has deteriorated significantly since March….

The extra losses that Mr Egan forecasts could double writedowns that financial institutions have taken so far in relation to the credit crisis, which stand at $400 billion.

It seems noteworthy that, at least of this hour, the UK press is taking keener interest in the downside that its US counterparts.

Update 1:20 AM: One important point I failed to make, A reason that Citi and others might legitimately have CDOs that could e marked higher (or lower) is that the structure of each deal is custom, and there is a very high degree of variability among deals. Since each is pretty much sui generis, Merrill’s trade can only be used as a mark in a very general sense. While it does call valuations of, say, 50 cents on the dollar and higher very seriously into question, there is still a good deal of artwork in determining what the Merrill sale means for other firms.

That clearly implies they probably have ample wriggle room to fudge if they wanted to…..the open question is how hard a time will the analysts give them? So far, some seem to be saber-rattling, but if a bank could tell a persuasive story as to how their CDOs were better than Merrill’s, they’d probably back down.

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  1. Eric

    Geez, and the housing price decline has not bottomed yet.
    “Sell’em all, they ain’t worth a thing”

  2. sinic

    Sayin Merrill’s action “raises ongoing credibility issues for the industry” must be a euphemism for “they’re a bunch of f..ing liars,” and of course they are!

  3. Phil

    If you believe that the writedowns are going to be over $1,000,000,000,000, we still got a long way to go. Imagine if the pundit that said $1,600,000,000,000
    is correct. It numbs the mind.

  4. Elizabeth

    Lone Star bought the bonds and a put at 16% for a total of 22% of face. Assume the put is worth 4% – they paid about 18% for the bonds. The question I have is why on earth did they do this transaction?

    –They got next to nothing for the bonds.
    –They traded 6% downside protection for all the upside.
    –The non-recourse financing means that the boil is just oozing, not lanced.

    I’d like to know more about underlying collateral to understand how super senior could be at 18%.

  5. Tom Lindmark

    If Merrill takes this hit, bites the bullett,successfully sources new capital and pays the Temasek penalty can we start to possibly look at this as a turning point. After all if they can pull this off, someone is going to ante up for a piece of the arguably better Citi franchise.

    Everyone may be making too much of the financing aspect of the sale to Lone Star. Yes it’s a non-recourse loan but they do have about $1.6 billion in the deal. Not insignificant. Instead of focusing so much on Merrill maybe we all need to look at Lone Star since this is their second deal (picked up a pile from from CIT a week or two ago). Maybe they see something the rest of us don’t.

    Bottoms and pivot points often come when things seem to be spiraling to the bottom. When the bottom fishers (Lone Star) start buying for real you need to take a step back and examine your assumptions.

  6. Anonymous

    Tom, good thought. I think you are definitely on the right track (at least for the US).


  7. doc holiday


    Thank you for staying on top of this and posting so many great stories — in a time when people are ignoring the implications of this insanity; it seems that more news just makes people numb. You really have THE best economic blog out there! If you burn out, not many can take your place, so THANKS!!!

  8. Anonymous

    Yeah but what if Housing Prices continue to decline? If the problem is essentially too much debt on assets that are declining in value, won’t the problem continue to worsen?

    I guess if you can say, “MER has cleared it all out, they have no more exposure, they are done.” that would be one thing.

    But what about the load FNM/FRE are carrying? How much clarity do we have to that?? So this talk of “steps in the right direction” isn’t that premature?

  9. wintermute

    There is confusion between CDOs and MBSs even amongst alert followers of the credit crisis.

    CDOs, as tranches of securitized loans, can quite easily go to 22c in the dollar. Credit cards, student loans, car loans, 2nd (unsecured mortgages) etc are eminently defaultable in a downturn.

    MBSs (which I imagine are the bulk of FNM/FRE holdings) *should* have a floor under them based on real-world house-building costs and demand/affordability. So 50c to 80c in the dollar would be reasonable valuations.

    How much each bank holds should also be in the public domain but with all the smoke and mirrors – it is still a guesstimate…

  10. Anonymous

    what triggered this writedown– besides the NAB connection? cnbc is trying to claim that merrill did it out of concern for its retail clients. supposedly retail clients felt merrill wasn’t writing down quick enough and this bore heavily on merrill’s conscience– absolutely risible!

    i’m thinking it was merrill given $500mm to rip up $3.75billion worth of protection it thought it had in CDS’s as insurance against the toxic waste. why isn’t anyone focusing on this renegue– i mean, renegotiation– by SCA/XL? the “WSJ’s” article yday says:

    “According to a person familiar with the matter, representatives from Mr. Dinallo’s office went to SCA’s offices on July 7 to prepare for a takeover by regulators. A so-called rehabilitation had the potential to cause all its CDS contracts to be cancelled; it hence put added pressure on SCA and Merrill to reach an agreement. The bond insurer is also talking to 13 other financial institutions about similar settlements on about 80% of its CDO guarantees.”

    will it be merrills precipitating copycat writedowns, or will it be sca?

  11. Ginger Yellow

    Yves, Citi’s (remaining) CDOs weren’t retained at launch. These are the liquidity puts that came back on balance sheet when the market collapsed. Of course, you can well ask why they included a liquidity put if the assets were so good.

    As for Merrill, first off I’d like to pimp EuroWeek again and recommend that read our piece on the “sale” that went up yesterday. Non-subscribers can get a free trial.

    Second, Yves is right to note that there is huge variability between different ABS CDOs, not just by vintage. The biggest differentiator is whether the CDO is “high grade” or “mezzanine”. The latter are in most cases (post 2005, anyway) pretty much worthless. The former can probably justify much higher marks.

    Unfortunately for Citi, this might not work in their favour. I’ve seen some research (from Citi, ironically) which argues from pricing of triple-B RMBS that the Merrill portfolio was probably mainly high grade.

    Finally, on the XL/ML thing, there are a lot of interesting angles. First, the settlement came after a lawsuit. XL tried to terminate the CDS (without payment) earlier this year. Merrill sued to keep the protection. Merrill won.
    Second, from Merrill’s perspective, it seems that in light of XL’s precarious position (they would have been taken over by the regulator if they hadn’t been able to commute the CDS), they’d rather take cash upfront than hope for a bigger payout in future that might never happen.
    From XL’s perspective, the $500m payout is less than their expected losses on the CDOs and so is a no-brainer, now that they can’t wriggle out of the contracts. Combined with the restructuring announced this week, the removal of the liability saved them from regulatory takeover.

    As to whether it will bring more writedowns, the answer is almost certainly yes. Banks have been negotiating with monolines about commutation for months, for the same reasons as Merrill. That said, the amount of the writedowns is likely to be relatively small (in a world where multi-billion marks are commonplace). Given that the strongest incentive for commutation (from both sides) is where the monoline is weakest, the CDS will already have been written down considerably. ML’s bought protection from XL on $3.7bn of CDOs but had already written it down to $1bn before the commutation.

    On the other hand Citi’s research argues that FSA is likely to be the only other monoline with enough cash in hand to unwind CDS in any volume

  12. Unsympathetic


    What self-respecting accountant would allow themselves to be “convinced” even in a dream that any CDO is worth more than Merrill’s? They all need to be written down to 5 cents on the dollar – and that’s a generous estimate for the post-2005 vintage. These gratuitously high estimates such as 22 cents can’t be substantively “about” anything other than saving Bill Miller’s (and other overpaid executives’) lost prestige.

  13. Bill

    One very interesting aspect of this that Ginger touched on is XL getting out of their CDS liabilities for a fraction of what they owed. MER took 500mm when they were owed 2.5bb. Turns out marking your liabilities to the market isn’t so crazy after all! How many articles have been written about the hypocrisy of discounting your liabilities at your own credit spreads? It turns out that is legitimate accounting when you can actually settle them there.

  14. Ginger Yellow

    Well, it’s important to remember that XL only “owed” what Merrill claimed for. They haven’t claimed anything – they only had a right to claim for losses up to a maximum of $3.7bn.

  15. Anonymous

    FNM and FRE own no CDOs. They own MBS’s- but no CDOs. They’ve got their issues, but CDOs are not one of them.

  16. bobn

    IMI, the write-down orgy this will inspire at Citi is what Citi was trying to avoid with Super-SIV last year – had that come about, Merrill would have sold to super-SIV at wildly inflated prices.

    Let the price discovery begin – time for heads to roll and blood to flow on Wall Street.

  17. Stuart

    I for one am sick and tired of the fudging. The true colors of the financial leadership have been shown, and they are shown to exemplify corruption and deceit as if they were modeled as measures of best practice. Sick and tired of regulators aiding and abetting the fudging and now FASB deferring rules aimed at stemming the fudging because pigmen lead banks cannot handle the truth. Thain was clearly lying, MER clearly fudging the books, again, like so many others. This latest fiasco is just another bullet in the whole nine yards to drive home why we should be sick of it all. No confidence left whatsoever in the political or financial leadership of this country. Now come along CNBC, time to pump why all this means it’s a great time to buy stocks. Time for another Paris Hilton story to lead off the 6:00 news, as that’s what’s important. How far we have fallen.

  18. Anonymous

    ginger@9:51. wasn’t MER claiming the $3.75billion in the lawsuit but through commutation accepted lower?

    how much do we have to worry about on the claims on the outstanding $50trillion CDS market?

  19. Ginger Yellow

    Anonymous – no. XL had tried to terminate the CDS on $3.7bn notional of CDOs, claiming breach (anticipatory breach, technically) of contract. Merrill sued to keep the protection in force, saying it had not and would not breach. Merrill won, so the contracts remained in force. Merrill has made no claims under the CDS yet (or at least not by the time the judge gave his opinion in July).

    “how much do we have to worry about on the claims on the outstanding $50trillion CDS market?”

    Depends on what you mean. There are many, many angles. My thoughts on monoline commutation are above (in brief, of course). But that’s hardly the only issue.

  20. Bill

    “Well, it’s important to remember that XL only “owed” what Merrill claimed for. They haven’t claimed anything – they only had a right to claim for losses up to a maximum of $3.7bn.”

    I was admittedly being very imprecise in my language. What I meant was that MER valued the contract at 2.5bb, but was carrying it at 1bb because of XL’s impaired credit. They were willing to tear it up for 500mm losing another 500mm to their mark.

    Any ideas of what XL was carrying the same liability at? Was their mark 1bb and they just made 500mm by commuting at 500mm? Or were they carrying it at 250mm in which case they just lost 250mm to their marks?

  21. Ginger Yellow

    Unfortunately I don’t, but I’m trying to find out. What I do know is that a few months back their expected loss was $429m and it had “substantially” increased by June 30, but I don’t have a precise figure. I think it’s safe to say that it was higher than $500m, and I suspect it was lower than $1bn, but I don’t know yet.

  22. Anonymous

    thanks so much for the wealth of info, GY!
    ok, here’s a naive question– would MER have been netting that right to claim losses at the maximum $3.7bill(less the $1bill writedown at some point) against a $2.7billion CDO holding to get a 0 exposure or are there haircuts on these things?

  23. Anonymous

    A follow up naive question-different anonymous. Could it be possible that Merrill has made private, under the table deals with smaller companies to take the fall for them? Loan them the money to buy their debt and then go bankrupt?

    “No matter how cynical I get, I can’t keep up!!” LT

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