Now that Merrill Lynch (MER) has sold a raft of CDOs at 22 cents on the dollar, every CDO everywhere needs to be marked down to 22 cents, too, right? David Reilly at the Wall Street Journal seems to think so , as does Deutsche Bank’s (DB) Mike Mayo . Lex at the FT says so, too .
Wrong. Can we go back to basics for a minute? A CDO, recall, is simply an asset structure. In this case, it’s essentially a portfolio of debt instruments. The value of the CDO, therefore, is driven by what those debt instruments are, their credit quality, and how much they’re worth.
Which means the value of instruments called “CDOs” can vary all over the place. The paper (sorry, make that “toxic paper”) Merrill Lynch sold to Lone Star Tuesday was the worst of the worst. In a note to clients that night, Buckingham’s Jim Mitchell points out that it consisted mainly of super-senior CDOs comprised of subprime mortgages originated in 2006 and 2007—by which time most originators had gone completely out of their minds.
But, again, not all CDOs are packed with that stuff. Citigroup (C), with $18 billion of subprime CDO exposure still on its books, is said to be next in line to take a big hit as a result of the Merrill sale. But Mitchell points out that the bulk of Citi’s paper has protections that Merrill’s didn’t (it’s in an asset-backed structure, for instance). And something like 80% of it is 2005 vintage and earlier. That makes a huge difference. Mitchell is absolutely right to note those distinctions. More analysts should.
For that matter, don’t forget that John Thain likely decided to part with the paper for reasons that weren’t entirely economic. He’s the new broom at Merrill—and is having to deal with (among others) regulators and rating agencies as he sorts through the prior regime’s mistakes. He’d probably rather fix the problems he inherited sooner rather than later; if that means accepting a less-than-optimal price on the sale of troubled assets, so be it. Other CEOs, who might hypothetically own the exact same paper, but under different circumstances, might not make the same decision Thain did.
Will more banks take more hits on their subprime holdings in coming quarters? I have no clue. But people who think Merrill’s news yesterday means automatically that more hits are inevitable, and must be huge are being way, way too simplistic.
Tom Brown is head of BankStocks.com.