Super-Senior Tranches of CDOs are Worth Much Less than 22 Cents on the Dollar: Another Ponzi Scheme of “Selling” Toxic Garbage with More Leverage

 Nouriel Roubini | Jul 29, 2008

Merrill Lynch decision to “sell” a good chunk of its remaining CDOs at 22 cents to the dollar has been widely praised as the firm finally recognizing the full extent of its losses on these toxic instruments. This batch of $30.6 billion of CDOs was already marked down to $11.1 billion. Now with the “sale” of it to Lone Star at a price of 6.7 billion Merrill Lynch is taking another $4.4 billion writedown and “selling” it at 22% of the original face value.

But is this a market-based “sale”? No way as calling this transaction a “sale” is a joke.

Let me explain next why…

First, note that the secondary market for CDOs is now extremely illiquid and Merrill will provide financing for 75% of the purchase price, or a financing of $5.055 billion. That implies that these CDOs are worth much less than 22 cents of the dollar. These type of “sales” transactions – broker dealers “selling” their toxic waste at a discount and providing hedge funds and private equity funds with heavily subsidized financing for it – has going on for a while. That discounted “sale” price often ends up being much higher than the true value of the assets (and the ensuing writedown of the assets is smaller than the correct one) because of three reasons:

• the selling broker dealer is providing most of the financing for the transaction as this market is totally illiquid and no one could dump $11.1 billions of toxic and illiquid CDOs in such a market;
• the interest rate at which the financing occurs is often significantly lower than the appropriate rate at which this risk financing will occur. Merrill has not announced what are the terms of its financing of this deal and this leaves the serious suspicion of a heavily subsidized transaction;
• the collateral for this risky financing is the same toxic waste that was sold to a fund. In the case of the Merrill transaction if the market value of this $11.1 tranche (now priced at $6.7 billion) falls another 25% the collateral for the 75% financing (that is non-recourse as it is secured only by the collateral) will be worth less than the underlying assets and thus additional losses will be incurred by Merrill. In other terms, as pointed out by Bloomberg since “the financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion”. Thus, in a extreme scenario in which the CDOs actually end up being worth zero Merrill will end up having sold them to Lone Star for 5.5 cents on the dollar rather than 22 cents. I.e. leaving aside the first loss of 25% taken by Lone Star all of the remaining credit loss is borne by Merrill.

So, based on the above consideration, is this toxic junk worth 22 cents on the dollar? No way and one would have to assume that the true market value of this garbage is closer to zero than 22 cents. So the street is now arguing that 22 cents on the dollar sets a market benchmark for writing down CDOs (Cit is still carrying them at a value of 53 cents rather than the 22) and many other firms will now have to use this benchmark; but the reality is that this toxic garbage is worth much less than 22 cents. So the charade of pretending to mark down to market the value of this junk will continue for a few quarters with continued bleeding of earnings.

At this point it would be more honest for the financial firms to write down to zero the value of these assets (with possible positive revaluation if they turn out being worth more than zero) and keep them on balance sheet rather than pretending to “sell” them via greater debt that massively adds to the credit risk that these firms are taking at the time when they should be deleveraging rather than releveraging further.

What is the sense of taking on another $5 billion of risky debt that has toxic garbage as collateral? Is this sound financial balance sheet restructuring or another Ponzi scheme of a house of debt-upon-debt cards? Selling worthless junk and providing financing for it is not a “sale”; it is another accounting scam whose purpose is hiding the full extent of the losses on garbage, not coming clean on them. So beware of the cheerleading chorus of banking “analysts” praising Merrill and this transaction. The entire episode stinks with the Merrill CEO making a series of misleading statements on Q2 earnings and on no need for further capital and now coming out of the blue with this new surprise and a new large capital injection that will massively dilute current shareholders a few days after the dismal Q2 results were reported. Add to this charade the fact that what will be raised in this new round of recapitalization be much less than the announced $8.5 billion once Temasek and other shareholders who participated in the previous recap will be compensated for the massive losses they incurred in that round of recapitalization of Merrill.

If this is the way to run the finances of one of the largest broker dealers in the most advanced financial system in the world it is not wonder that this system is totally broken. The smart and very savvy Mohamed El-Erian (co-CEO of Pimco) put it in polite terms when he recently said while commenting on this financial crisis: “What has suffered most is the credibility of the most sophisticated financial systems in the world.” Or as Bill King (a senior financial analyst) put it: “Eventually a critical mass of investors and traders will become cognizant of the obvious scheme and distrust of financial firms’ results, guidance and motives will increase substantially. John Thain’s credibility is now an issue”. It is both the credibility and viability of the most sophisticated financial system that is at stake now as most of this financial and banking system is on its way to substantial and formal insolvency and bankruptcy.

Or, as Barry Ritholtz aptly put it in much less polite terms than El-Erian and King in his latest blog:

How Screwed are the Investment Banks?

A brief review of recent Merrill (MER) CEO statements:

1. We don’t need capital;

2. We could use some capital, but we won’t sell shares, we’ll just sell some assets;

3. We need to sell shares and raise capital right away;

Where is Ken* when you need him?

The financial firms obviously think investors are utter fools. And for a while, they were correct. They suckered people into buying into this mess the whole way down. Bottom calls each and every level — all of which failed. Some analysts even called iBanks a “Generational Buys” — 30% higher.

Only not so much.

Release earnings. Issue guidance. A few weeks later, lower earnings. A few weeks after that, take more write-downs. Raise more capital. Start it all over again next quarter.

Rinse. Lather. Repeat.

The banks have adopted a Chinese water torture approach — dribbling out the bad news in small doses over time. Its been working up until now, but I doubt it will keep working much longer. Can they keep fooling people much longer? Merrill issued quarterly earnings on July 17th, and then dropped this bomb shell on July 28th? They must really think we are idiots, and that the SEC is in their backpockets to even attempt getting away with this crap.