Is Merrill Lynch Throwing in the Towel on CDOs?

From a press release yesterday from Merrill Lynch (MER)…

On July 28, 2008, 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

One consistently echoed sentiment the last several months is that financial institutions need to deleverage and get their losses out of the way before some light can be seen at the end of the tunnel. Selling these CDO assets at 60% of carrying value is a step in the right direction - and it offers a great proxy to see which of the banks out there might have more writedowns to bring to light. While 20% of original notional value is an enormous hit to take on the bottom line, that’s the kind of discount - and this is the kind of sizable deal - that shows where the buyers are. As with most markets, there is liquidity; the major caveat is that the liquidity is a function of price.

Another good point to be drawn from Merrill is that there are still big backers of the investment banks - Merrill says it is able to raise another $8.5 billion in various forms of equity capital. As long as that source of funding exists, the banks themselves should be fine, even if their existing stockholders aren’t. Last week, the debt and CDS markets were saying that Merrill wasn’t investment grade; the market action today should be revealing as to whether the debtholders feel that Thain, et al., are righting the ship with their big moves.

The most speculative takeaway from this transaction is that it does give some idea as to what percentage of par value big bids will emerge for super senior CDO tranches. Note that Merrill was carrying these at roughly 36% of gross value on the balance sheet at mid-year, and it ended up selling at 21% of gross value yesterday. Compare this with, say, Citigroup (C) - on Page 5 of its July 18th press release, it says:

On June 30, 2008, these exposures were comprised of approximately $4.3 billion of gross lending and structuring exposures and approximately $18.1 billion of net ABS CDO super senior exposures (ABS CDO super senior gross exposures of $27.9 billion).

While I understand there are many potential reasons for differences in carrying value, Citi has these at 65% of par when Merrill has assets of the same classification at 36%. Um hm. While I’m not auditioning to join the Meredith Whitney fan club, but 21% of Citi’s remaining gross exposures to super senior CDOs implies a value of $5.86 billion - put another way, that leaves $12.24 billion in further writedowns or losses to be recorded upon sale. Hopefully, for Citi’s sake, their marks are accurate and they have the balance sheet strength to hold these assets to realize something close to their current value - and Merrill’s housecleaning will contribute to some form of a bottom (or at least floor) in the market for CDOs.

Although I have a large position in one aggressive financial name, I was (and continue to be) suspicious of this rally, and think there are only two big banks worth owning.

Comments

[raja:]

This is like slow poisioning, week after week. If they all tell us the truth, all these financial stocks will be in single digits. Look at Thain playing the market as he repeatedly has been saying once every month that they have adequate capital, only to raise more and more.

This is not over yet ! Dont let the size of the write downs fool you. Instead of writing down 40 billion at once (and you can imagine what that can do to the stock price) they are splitting it by giving us so-called lower write downs on a monthly basis. Talk of playing the market

2008 Jul 29 09:22 AM