Merrill CDO Deal: How Can It Book a 'Sale'?

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 |  About: Merrill Lynch & Co. Inc. (MER)
by: Whitney Tilson

STOP THE PRESSES! This part of Merrill's (MER) press release caught my eye:

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.

Lone Star Funds presumably has other assets, so what explains this line: "The purchaser will not own any assets other than those sold pursuant to this transaction."? I went to Lone Star's web site and here's the description of what they do:

Lone Star Funds (Lone Star) are closed-end, private-equity limited partnerships that include corporate and public pension funds, university endowments, foundations, bank holding companies, family trusts and insurance companies. Since 1995, the principals of Lone Star have organized private equity funds totaling more than $13.3 billion to invest globally in secured and corporate unsecured debt instruments, real estate related assets and select corporate opportunities.

Lone Star is a group of funds, so what it's doing here is setting up a special fund solely to purchase Merrill's CDOs (the fact that they are called "super senior" CDOs is so hilarious -- that phrase will go down in the oxymoron hall of fame). If so, what an incredible deal for Lone Star (and horrible deal for Merrill)! By putting up only $1.675 billion (25% of the purchase price of $6.7 billion and only 5.47% of the $30.6 billion gross notional value of the CDOs), Lone Star is getting 100% of the upside above $6.7 billion, but Merrill is on the hook for every penny from $6.7 billion down to $1.675 billion.

The Dow Jones story reaches the same conclusion:

As part of the deal, Merrill is funding three quarters of the purchase price. If Lone Star defaults on that loan, the only recourse Merrill has is to the CDOs it sold Lone Star. That means the fund is only putting up about 5.5 cents of its own money for every dollar of face value.

Here's what I want to know: HOW ON EARTH IS MERRILL ABLE TO BOOK A $6.7 BILLION SALE HERE?!?!?! Did its auditors really sign off on this?! I'm not an accounting expert, but it seems obvious to me that Merrill should book a $1.675 billion sale and then have an account receivable of $5.025 billion, on which they would have to take an allowance for doubtful accounts (presumably a large allowance, given that nobody has the foggiest notion of what these CDOs will eventually be worth).

Sean Dobson from Amherst Securities notes:

If the financing is non-recourse to Lone Star Funds, then they only invested ~5 basis pts in the trade, which is likely the interest payments they will receive even if the CDOs go bad.

If after that the CDOs are worthless, they boomerang back to MER.

We've heard the same for the UBS/Blackstone trade.

It's hard to believe they can get true sale opinions on these deals.

The only silver lining I can see for Merrill is that they're smart to see the writing on the wall and get in front of this problem -- forced to buy a company in a distressed sector, you want to buy the one that's first to acknowledge and address its issues. Keep in mind, however, that one could have had this thought earlier this year and bought MER at twice today's price. Fortunately we're not forced to buy anything -- as David Einhorn said at last November's Value Investing Congress: "You don't have to be a hero" here.

So what is the market, in its infinite wisdom, doing? Knocking down MER and running up the stock of every other financial company -- the ones that haven't admitted that they're totally mismarking their assets and will need to raise more money on highly dilutive, distressed terms. Go figure...

Disclosure: No position in MER