Merrill’s CDO Sale—With A “Call” Option

Just what did Merrill Lynch do today? Did it actually sell something? Or just move something off its balance sheet for now? Welcome to the world of accounting.

Just what did Merrill Lynch do today? Did it actually sell something? Or just move something off its balance sheet for now? Welcome to the world of accounting.

As you know, Mother Merrill made an announcement after the markets closed yesterday (click here for the press release). Yes, Merrill is marking down another $5.7 billion in write-downs to come in the third quarter. That amounts to a pre-tax charge of $4.4 billion against third-quarter earnings.

Apparently, Merrill is eager to show that the bloodbath is almost over, because now, after the sale of this tranche of CDOs, it has less than $2bn net exposure to CDOs.

Okay, great. But did ML really get rid of the CDOs it just sold? Could those CDOs ever return to its balance sheet? The firm says it booked a sale of $6.7 billion for the sale of super-senior CDOs. (Whew! We wouldn’t want to know what the juniors or sophomore CDOs look like!) That works out to about $0.22 on the dollar—quite a haircut on what had a notional value of $30bn, marked-to-market at $11.1bn.

But here’s the catch: Merrill financed the deal with a non-recourse loan to Lone Star Funds, which creates private equity limited partnerships. ML, in fact, loaned Lone Star 75 percent of the money to buy the toxic CDOs. But Lone Star apparently created a vehicle to buy the loans, and paid Merrill just $1.675 billion. So, ML is owed $5.025 billion, which would return to ML’s balance sheet if the CDOs deteriorate.

A friend we know—he once worked at ML—asks, “This raises the question: Have they really sold it?” Our knowledgeable friend asserts that since it is a non-recourse loan, ML could be on the hook for the $5bn it is owed, although, for now, the CDO tranche in question is safely off its book. According to FAS 140, this is in fact a sale, since it meets FAS 140’s standards.

Still, our friend ponders, “It’s hard to understand why Merrill did this.” Well, other than to just capitulate, get it all behind it. On the other hand, why take such a bath on securities that are already so completely discounted? After all, if the CDOs go bad, it’ll be ML’s problem again.

For this reason, another hedge fund friend says, “It wasn’t a f****ing sale at all. Merrill just wants people to perceive it to be to stop a run on the bank. It’s a sale with a call option.”

In other purging, the firm is terminating, or working on terminating, its CDO-related credit default swaps it has with monoline guarantors. It also announced it is issuing 310 million shares at $27.52 per share in a secondary offering.

That would gross Merrill $8.5 billion in capital—a fact many commentators are having fun with since CEO John Thain’s public pronouncement in April that this wouldn’t be needed anymore. Financial blogger Barry Ritholz, author of financial blog, The Big Picture, is one of them. He’s posted an amusing review of Thain’s comments along with a timeline and corresponding chart of write-downs, titled “Rinse. Lather. Repeat.” Check it out here.

But if Thain spoke too confidently too soon, this action appears to be to the liking of the market—Merrill shares are up nearly 2.5 percent—and insiders. One of Merrill’s top private bankers said he bought shares this morning after the news, and likes that Thain is “biting the bullet and cleaning up as quickly as he can so that we can get on with business.”

As Bernstein analyst Brad Hintz puts it in a research report out this morning, “All of this is Mr. Thain’s attempt to wipe the slate clean by removing a large chunk of legacy assets from MER’s books.” Unfortunately for Merrill—and its shareholders—there is plenty left on the slate to wipe off: $8.8 billion of gross CDO exposures (net it’s $1.6bn), $5.9 billion of sub-prime related mortgage exposure and $4.4 billion of Alt-A mortgage exposure, according to Hintz. That could mean more write-downs, though not as large, are likely in the next quarter, but Hintz thinks the move is a positive for investors: “It appears that investors in this company can now begin to focus more on the firm’s underlying businesses and less on the firm’s exposure to troubled assets,” he writes.

And get this: Despite the sale of Bloomberg and other assets and the new issue of equity, ML’s book value will be about $22 per share in the third quarter, that’s down from $28 a share at the end of the second quarter, says Hintz. ML owed about $4.9 billion of the offering’s proceeds to Temasek, the fund run by the government of Singapore, because of anti-dilutive clauses from the prior capital raise in December. There were other investors with anti-dilutive clauses, who converted shares in convertible preferreds in the deal. Hintz says ML will be on the hook for $2.4bn in additional dividends in the third quarter.

Let’s put this debacle in perspective: In the third quarter of 2007, the notional value of ML’s CDO was a total of $46.1bn, according to Bernstein Research. That would be more than ML’s total stockholder’s equity of $38.8bn.

This caused us to ask our former ML employee friend, did the then-ML executives, in essence, bet the franchise on CDOs, however unwittingly? “Absolutely. This almost brought the firm down. [Of course] it’s hard to predict what happened. But, yes, they did [bet the farm].”

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