Merrill Writedowns: The Plot Thickens

An interesting tidbit in the Financial Times: Bank of America was not blindsided by the Merrill writedowns (although Ken Lewis no doubt still wanted to walk from the deal). Its CAO was deeply involved in making them (boldface ours):

Bank of America was directly involved in markdowns that contributed to Merrill Lynch’s $15.3bn loss in the last quarter of 2008, its final reporting period before the Wall Street bank was acquired by BofA, sources familiar with the matter say.

Mounting losses at Merrill during December almost derailed the acquisition. Ken Lewis, BofA’s chief executive, threatened to walk away from the deal unless the US government provided $20bn in extra capital. The deal closed on January 1 after federal officials pledged their support.

People familiar with the matter said BofA had dispatched Neil Cotty, its chief accounting officer, during the fourth quarter to work with Merrill’s finance team. They said Mr Cotty played an active role in preparing accounts, wielding influence with Merrill executives who were set to report to him and other BofA officials after the deal closed.

With Mr Cotty’s involvement in December, the people familiar with the matter said, Merrill took a fourth-quarter writedown of $1.9bn in leveraged loans and a $2.9bn reserve against an exposure to derivatives linked to asset-backed securities.

Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m….

Mr Cotty said: “While BofA had access to Merrill’s financial information in the fourth quarter and had input into many accounting policy and valuation issues, Merrill management was responsible for these decisions regarding the marks and other valuations.”

There are two ways to look at this, neither of them pretty.

One is that Bank of America pushed for the most aggressive (meaning least favorable) writedowns on positions so that when it closed the deal, Merrill would be as clean as possible. The problem is that writedowns sufficient to do that (presuming that was BofA’s plan all along) left the bank looking like it had badly overpaid. Thus the threat to walk from the deal was a bit of a ruse, since the losses were at least in part the result of over-reserving (or hedging against positions BofA could not assess).

The second is that many (most? all?) of the BofA imposed writedowns were legitimate and called for. The implication would be that Merrill for some time had been making overly optimistic marks on its dodgy positions. And it might also imply that Merrill’s practices were not out of line with the industry (remember, Bank of America, unlike JP Morgan and Citigroup, is not a big player in exotic debt products). That in turn would suggest the financial reports of other big capital markets players (Goldman, Morgan Stanley, JPM, UBS) could also be more than a tad generously valued.

Of course, these possibilities are not mutually exclusive.

Informed reader comment encouraged, particularly on “high vol 4” index.

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  1. John Liberty

    ‘high vol 4 = high volatility series 4 investment grade credit default swap index ‘ its a specific tradeable index swap made by either dow jones or itraxx. the series is becuase cds indicies are rolled over in order to keep up with the contract time parameters. a series 4 would mean it was older.

  2. Anonymous

    (posted this in the guest post accidentally – not entirely on topic, but..)

    1st inaugural address: “the money changers have fled from their high seats in the temple of our civilization. … those unscrupulous money changers stood indicted in the court of public opinion, rejected by the hearts and minds of men.”

    First fire side chat, he promised to pursue a final reckoning with the illegitimate and overbearing financial aristocracy that had shadowed the nation since at least the days of Andrew Jackson.” the days of great promoter or the financial titan to whom we granted everything, if he will only build or develop is over.”
    and also wrote ‘The fundamental trouble with this whole stock exchange crowd is their complex lack of elementary education. I do not mean lack of college diplomas, etc. but just inability to understand the country or public or their obligations to their fellow men. Perhaps you can help them acquire a kindergarten knowledge of these subjects. More the power to you.”

  3. doc holiday PI

    In addition to what John has said:

    5-Year Credit Default Swap


    iTraxx High Vol

    iTraxx indices are a family of credit default swap (CDS) index products. The spread numbers are a good proxy for
    the yield premium over market swaps offered by non-government entities of different credit ratings. For example the
    iTraxx Europe index is the most widely traded and is composed of the most liquid 125 CDS on investment grade

    >>> HiVol represents a subset of the main index comprising the most risky 30 names within the main index. The
    Crossover index is typically composed of 45 sub investment grade credits.

  4. dh

    See additional examples here:
    CDO/CDS Update 2/27/07

    Since the start of 2007, the CDX indices continue to display a tightening bias. The CDX.NA IG 7 index tightened just under 1bp last week to 29.7 bps, marking the first time spreads for the index ended the week below 30 bps. The high volatility series 7 index also performed well with tightening of almost 3 bps to 69 bps, bringing spreads under 70 bps for the first time.

  5. Anonymous

    Sorry, I'm obsessed:

    Fitch Releases Analysis on DJ.CDX.NA.IG Series 4 CDS Index
    Business Wire , April 26, 2005

    Fitch Ratings announced today the release of its analysis on the most recent roll of the DJ.CDX.NA.IG credit default swap (CDS) index from Series 3 to Series 4. Fitch has conducted the current analysis using the latest version of Vector V2.2, which was released on April 15, 2005. Consisting of 125 reference entities, the DJ.CDX.NA.IG Series 4 index allows investors to gain exposure to various tranches of a diversified portfolio of the most liquid investment-grade North American corporate reference entities. Credit assessments of various risk tranches and supporting analytics are available exclusively on Fitch's credit derivatives web site at ''

    The new roll was effective on March 15, 2005 with 5 1/4- and 10 1/4-year maturities. The credit risk of the DJ.CDX.NA.IG Series 4 index is broadly similar to that of the Series 3 index as the same weighted average rating of 'BBB+/BBB' has been maintained in the Series 4 pool as in the Series 3 pool. There have been three reference entity deletions and three additions which have been made to reflect recent dealer liquidity polls.

    >> I want my money back!

  6. John Liberty

    i cant believe merrill would be holding that stuff for 2 years – the fitch report says they are up to series 7 and also that they dont have to book losses until bank of america came along. does anyone know why if credit events occured they didnt have to book losses? look at some of the names in the contract!:

    * Comcast Cable Comms LLC
    * Eastman Kodak Co.
    * Ford Motor Credit Co.
    * FirstEnergy Corp.
    * Sprint Corp.
    * General Motors Acceptance Corp.
    * Kerr McGee Corp.
    * Liberty Media Corp.
    * Lear Corp.
    * Southwest Airlines Co.
    * McKesson Corp.
    * Maytag Corp.
    * News America Inc.
    * Sears Roebuck Acceptance Corp.
    * Tyson Foods Inc.

  7. doc holiday

    This is such a stupid game to play and it makes me wonder why we have a person like Obama that is unwilling to use his Executive Powers to shut this shit down: CDX.NA.IG.HVOL

    America will remain in The Dark Ages, until this mafia casino shit is shut down!

  8. Anonymous

    just FYI – BofA was as much involved in these instruments as any of the other big dealers and HVOL is not an exotic instrument. It is/was one of the most vanilla CDS indices that trades today.

  9. Anonymous

    Please – all of you who have no concept of how IG and HVOL trade and why stop making accusations from a perspective of ignorance. HVOL4 was a sub-index of the last IG index to contain Auto exposure when Autos were Investment grade! Therefore, dealers hedl this index position to hedge bespoke CDOs, or just to run down to money good (hopefully) given how wide they traded…in this case we have recently seen a major swing to more recent indices such as IG9 (most liquidi tranche market currently) and IG11 (series 12 starts tomorrow). This caused the roll (the differential between old and new indices) to compress as the dealers derisked in HVOL4 and rerisked in more recent vintages. This was well known and everyone knows that HVOL4 was an ugly one for most dealers. The fact that it was not marked down is clearly malfeasance on their part in my view and should be an eye-opener for many because this index is relatively liquid compared to the bespoke CDO deals they carry which are likely marked massively wrong!!!

  10. Doc Unhappy Holiday

    This is just a great little circle jerk at Markit, that spins money in circles in a casino that is a casino like CBOT and all the fu-kers that want derivatives to be used to help make risk disappear… I say we make them all disappear, by putting them in prison for fraud!

    More than 85 dealing firms have data contribution relationships with us (Markit) including:

    Bank of America
    Barclays Capital
    BNP Paribas
    Commonwealth Bank of Australia
    Credit Suisse
    Dresdner Kleinwort
    Deutsche Bank
    Goldman Sachs
    J.P. Morgan
    Merrill Lynch
    Morgan Stanley
    National Australia Bank
    Rabobank International
    Royal Bank of Canada
    Royal Bank of Scotland
    Societe Generale
    TD Securities

    Also see: AIG, Maiden Lane Will Pay $62 Billion to Settle Derivatives
    American International Group Inc. and a U.S. Federal Reserve financial vehicle agreed to pay $62 billion to settle derivative transactions with 16 investment banks, getting in return securities whose market value had fallen below $30 billion, according to a regulatory filing.

    The insurer and Maiden Lane III, a Fed vehicle created to bail out AIG, had previously disclosed their plan to settle AIG’s credit default swaps, but hadn’t disclosed details related to the derivatives’ value and the amounts paid to settle obligations to each counterparty.

    Screw these pirates man, they need to be shut down and obviously with Timmy being pumped on Leno by Obama, we have a long fuc-ing way to go, before we see change!

  11. Anonymous

    anonymous: does not make sense about ur time compression theory, they could/should have had someone take their spot as a seller is whats amazing.

    liberty: the answer is FAS 133

  12. Anonymous

    Inexcusable…HVOL4 isn’t nearly as liquid as the more recent vintages, but ML itself has always provided a daily level on the index. Understood it was used to hedge bespoke instruments which had limited pricing clarity and they probalby held it at cost…but still. How it could be marked so incorrectly is beyond me.

  13. doc holiday

    Also see: Ruse: French, from Old French, roundabout path taken by fleeing game, trickery, from reuser.

    > While Congress and Obama appear to be amazed by AIG giving out a few million bucks in fraudulent bonuses, the real threats remains under the rug and out of sight, not discussed or hinted at, e.g, the obvious, general accountability issues related to fraud, but even more so, is the lack of regulation for derivatives markets and the security instruments that are still being played with by money market managers.

    The real threat is to ignore why we have at least a $15 Trillion burden to deal with, a burden that will increase, as people like Obama show the same lack of understanding as to why we are in this mess. Bush, Paulson and Congress a year ago, had no clue what they were doing and now Obama and Timmy have stepped into those same exact shoes, which will provide us solutions to go down the same path, where regulation will take a backseat to political bullshit and games and all the Leno-like fashion model shit that will take precedence over the expansion of non-accountability in the derivative markets.

    I don't have time for this crap, but… IMHO, your retarded idiots if you do not read the fine print of your money market prospectuses and look at the casino chips that your being liked to!

    As a basic primer, this is a fine place to begin:

    Money-Market Funds May not Be As Safe As You Think

    But low-risk comes with different kinds of flavors. Among those investment options mentioned above, there truly low-risk investments, such as government securities and there are investments carrying a relative larger degree of risk, such as commercial paper. When looking carefully into the funds’ holdings, you will find that different money-market funds have different investments with different risk levels. For example, the Reserve Primary Fund has the following investments in the fund as of May 31, 2008 (fund annual report, PDF file):

    Commercial Paper: 53.9%
    Negotiable Bank Certificates of Deposit: 16.4%
    Floating Rate Notes: 14.9%
    Repurchase Agreements: 9.0%
    Euro Time Deposit: 2.2%
    Medium-Term Notes: 1.1%
    US Agency Bonds: 0.8%
    Promissory Notes: 0.8%
    US Corporate Notes/Bonds: 0.7%
    The largest investment RFIXX has is commercial paper (more than half of its assets), of which $535 million is issued by Lehman Brothers. The true safe heaven, US government bonds, is less than 1% in the fund’s total assets.

    Now, let’s look at another example, Vanguard Primary Money Market Fund (VMMXX). As of February 29, 2008, the fund has:

    US Government and Agency Obligations: 45.2%
    Certificates of Deposit: 26.9%
    Commercial Paper: 12.5%
    Eurodollar Certificates of Deposit: 10.6%
    Repurchase Agreements: 3.1%
    It’s quite clear that the two funds are taking two opposite approaches in seeking low-risk investments with Vanguard emphasizing on government securities.

    Also see: The instruments held by a Vanguard money market fund are valued on the basis of
    amortized cost. The values of any mutual fund shares held by a fund are based on
    the NAVs of the underlying funds (in the case of conventional share classes) or
    the market value of the shares (in the case of exchange-traded fund shares, such
    as VIPERs.

    Prior to the close of business on July 6, 2006, Vanguard ETF Shares were known as VIPER (R) Shares.

    Although ETF Shares represent an investment in the same portfolio of securities as Institutional Shares, they have different characteristics and may appeal to a different group of investors. It is important that you understand the differences before deciding whether to convert your shares to ETF Shares.

    Trust in God, because wall street aint gonna be your friend and you really need to do as much DD as you can, READ YOUR prospectus, and then pray very hard!

  14. Mike Dillon

    OK….I’m a little fuzzy in this department. Would the fact that either Merrill itself or one of its tranche servicers (Fairbanks/SPS) manufactures fraudulent assignments and has them recorded at county registries have anything to do with this process? What about selling “dead or non-performing loans into trusts a year after they have been declared “dead”?

    I should probably narrow down that statement and say that I know, factually, that this has happened with at least one note that Merrill claims to own.

  15. Anonymous

    OK! Let me introduce myself. I am one of the recipients of a fat AIG bonus. Got that? And you know what, I’ve had it with you people. I’m so tired of being bashed on the head like I am some kinda criminal or dope pusher or somethin. I ain’t no criminal and I ain’t no coke jock either. I’m just a hard workin dude, and I sold your stupid subprime junk like gold. You should thank me for that. I put all your trailer park trash in mansions. I made your American dreams come true. You owe me.

    And I can’t get my bonus now? Fuck you! I wanna my dough. I worked hard for it. I don’t give no shit if you borrow the dough for China, if you print it, or if you sell Hawaii. I just wanna my bread, bro! Got that?! Better get my fucking bonus, or else.

    A disgruntled British citizen working for AIG London.

  16. Anonymous

    anon @ 10:46

    Re: “I put all your trailer park trash in mansions”

    Don’t you really mean to say, “I put all you trailer park trash in mansions”, versus the reference to “our” trailer trash? I can see the point either way, but that strikes me as rather poor grammar coming from one who should speak The King’s English, yah know whad I mean punk, huh, huh, do yah?

  17. Anonymous

    Markit and Indexco are central to banking cartel’s rigged CDS casino.
    They have to keep referring to subprime borrowers as trailer trash to maintain their spin so no one will figure out these bets were placed with full knowledge of subsidiary mortgage servicers fraud on homeowners in which non-existent defaults were fabricated with bogus unwarranted fees and escrow malfeasance. Mortgage Servicing Fraud is epidemic and has been for some time. As to banking cartel and their ill gotten gains shorting subprime while subsidiary servicers acted as arsonists for them, they call that INSIDER TRADING.

  18. Anonymous

    Just look at the marks the prime brokerage divisions of these shops gave hedge fund customers and compare to where they marked the same positions held on the banks’ own books…voila la discrepancy, wide and clear.

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