Merrill Cleanses Itself, We Think

Well, there was an announcement from Merrill about some things:

  1. Selling CDO Assets
  2. Settling monoline issues
  3. Selling equity

Now, while all these are important, #2 is better covered elsewhere as I think reliance on insurers was stupid to begin with and #3 is what it is… best left for analyst reports for nuance, but very generally obvious. Let’s go to the release…

Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

… [The] sale will reduce Merrill Lynchs aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure…

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.

(emphasis mine).

Now, this is (via the WSJ via naked capitalism) 22 cents on the dollar. Wow! But, to be honest, this is sticker shock that comes from the massive liquidity being used here. The bid someone shows you on $30 billion versus $30 million is a very different proposition. This sounds like advice I gave before (see item #1 on that post). Now, what questions should the analysts be asking? Note the bold, italicized, underlined parts above. Seems as if the purchaser will be an entity, most likely formed for this transaction, that will only need 25% of the $6.7 billion, or $1.675 billion. Now, since the other 75% is financed, what happens if losses start flowing to these CDOs? The amount of equity decreases. From the Journal …

Many CDOs held by Merrill were viewed as highly likely to default and lose some or most of their principal value. Of around 30 CDOs totaling $32 billion that Merrill underwrote in 2007, 27 have seen their top triple-A ratings downgraded to “junk,” according to data compiled by Janet Tavakoli, a structured-finance consultant in Chicago. Their performance has been “dreadful,” she says.

(emphasis mine).

So now Merrill is in a race. Up to 78% of notional value can be written down, now, with no one taking a loss. Then the next $1.675 billion falls to Lone Star’s equity, and then the rest come out of capital Merrill has put up for the benefit of Lone Star. With the above downgrade statistics such losses aren’t completely out of the question. With this in mind, I would want to know the financing terms. The devil is in the details. Such financings could require only some margin up front in addition to the 25% equity, or none at all. The financing terms could limit Merrill’s ability to claw back more capital as the assets see further writedowns. In general, these terms could mean the risk is only cushioned, not removed. I’m sure these questions will be asked, and that Merrill anticipated such questions. This makes me think that these issues lead to the depressed price–price was the one protection potentially preventing Lone Star from having to have to cough up more money (you can’t owe money if the assets are performing better than their price implies). However, if these terms aren’t very favorable (Merrill was trying to get rid of these assets, after all) one might not ever see the financing terms. It’s also possible that Merrill retains some equity upside in these assets. I guess we’ll wait and see…

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6 Comments on “Merrill Cleanses Itself, We Think”

  1. Rahul Gupta Says:

    Nice analysis. Interesting structure, to say the least.

    BTW, you missed highlighting one crucial sentence in the announcement. You did emphasize the sentence “The recourse on this loan will be limited to the assets of the purchaser.”

    And then the very next sentence (which I think is also relevant) is — “The purchaser will not own any assets other than those sold pursuant to this transaction.” !!

    So what happens to Merrill’s recourse in case of price erosions in the said U.S. super senior ABS CDOs? They only have recourse to the U.S. super senior ABS CDOs sold by them, so wouldn’t they have to write off a further amount?


  2. Thanks for your kind words!

    As for the line you mentioned, I did see that too. However, there can be provisions that allow Merrill to extract assets from other Lone Star entities or require the SPV to get more money from the Lone Star funds. I’m not sure if that part was required to be in the press release as a disclosure requirement from a lawyer or some other technical requirement, but certainly it’s existence seems to point to something. We just need to know more…

  3. harry fabian Says:

    how do you reconcile

    “The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. ”

    with

    “However, there can be provisions that allow Merrill to extract assets from other Lone Star entities” ?


  4. Harry,

    Good question. The “purchaser” being a SPV can have some sort of agreement or ability to claw back money from a parent. This is likely limited if not totally optional. Consider this… the financing requires a periodic payment, usually monthly. If Merrill were to finance this entity, but the entity had no cash or access to cash then one month from now Merrill would just take back the assets when the interest on the borrowed 75% was due. Clearly this is illogical, so there must be some further consideration the SPV has access to. Also, for financing arrangements with SPV’s and other affiliates, like portfolio companies, it is usually the case that “cross default” provisions are in place allowing a broker-dealer such as Merrill to take other collateral being held against financing for related companies. I’m not 100% of the standards for these types of provisions, but I’m told they are universal with few exceptions (and have seen language for them to that effect).

    -DJT


  5. […] Seems obvious, then, that a decline in value will mean they take the assets back. Well, then why did I make the following statement (in the comments)? […]


  6. […] More on Merrill, from Dear John […]


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