Patrick Harden

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

Just balance sheet sleight of hand at this point. Merrill gets to record a $6.7 billion loan receivable from Lone Star, which requires no reserve until the underlying assets fail to perform and the loan to Lone Star goes delinquent. It's basically a refinancing of troubled debt structured to achieve the best possible accounting treatment.

It is certainly ridiculous to allow Merrill to remove $6.7 billion in toxic assets yet simultaneously provide non-recourse funding to the purchaser. Certainly the $5.025 billion seems to be a contingent asset, but GAAP is awfully flexible at times.

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

It seems ridiculous, but Merrill appears to have satisfied the requirements for sale treatment under FAS 140. A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met:

a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. {Yep, the CDOs are bankruptcy-remote SPEs.}

b. Each transferee has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. {The CDOs now belong to Lone Star, who may pledge them or sell them at will.}

c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. {Condition 1 is satisfied, as Merrill is not obligated to repurchase the CDOs. Condition 2 is the tricky part. I guess by not funding the full purchase, Merrill doesn't have the ability to UNILATERALLY cause Lone Star to return the CDOs. Something to that effect.}

It's definitely a sale in accounting terms only. Economically, it's nothing more than a reverse repurchase agreement.