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.