Merrill Lynch CDO Sale Proves Investment Bank Balance Sheets Can’t Be Trusted
filed in financial services on Jul 29, 2008
Trying to value the investment banks based on book value is not an idea I would suggest if investors want to have any confidence in their valuation work. Today we learned that Merrill Lynch (MER) is selling $30.6 billion in nominal value CDOs for $6.7 billion, or 22 cents on the dollar, but that price is not all that surprising. What is surprising is what level Merrill valued those CDOs on their balance sheet when they reported second quarter earnings 12 days ago on July 17th.
That number was $11.1 billion. In less than two weeks, the CDOs lost 40% of their value? Highly unlikely. Of course, some will say the $11.1 billion value was supposed to be as of June 30th, so it was really four weeks of time that had passed. At the very least, we know that Merrill had no idea what the CDOs were worth, on June 30th, July 17th, or perhaps even today (we won’t know that for a long time).
There are some who think these ABS are being marked down too low and will eventually be written up. This could certainly happen in several years time as the underlying mortgages are repaid, but today’s news from Merrill certainly should not give anyone confidence in that thesis. Beware of using book values when trying to value portfolios of ABS. The company might come out and sell the things for 40% less than they thought they were worth less than two weeks before.
Full Disclosure: No position in MER at the time of writing
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July 29th, 2008 on 9:58 am
Couple of thoughts here…if the stock of MER can be up and down 20% in a week, why can the underlying assets not be? The market is not completely rational right now especially as it relates to the financials. The other is, what is MER actually receiving for the sale? 22 is the face but they are also getting a spread on the financing so the “deal” is going to make more than the 22.
July 29th, 2008 on 10:27 am
I would agree that the assets could certainly vary that much in value, if in fact they traded on a market, but that is because investors don’t really know what they are worth, and their estimates are all over the place. Nothing has happened to warrant a 40% drop in value in less than 1 month, so it is irrational as you point out.
That line of thinking goes to my point that we can’t just look at Merrill Lynch’s stated book value and value the stock. After all, two weeks later their book value looks a whole lot different even though financial asset prices have actually increased recently after firms reported Q2 earnings.
As for the CDO sale itself, the fact that Merrill is loaning the buyer $5.0B out of the $6.7B purchase price means they are actually getting less than 22 cents on the dollar, not more, due to the time value of money.
They might be earning some interest (terms of the loan weren’t disclosed), but that won’t make up for the fact that Merrill is lending the buyer money to buy its own assets.
July 30th, 2008 on 5:02 pm
My understanding is that there are numerous valuation models that can be applied to illiquid securities, only one of which is the current mark to market. With CDOs you can have a relatively short “deal life” compared with other ABS, so that you can credibly make an argument that if you intend to hold onto them and they’re performing reasonably well, then they’re worth more than they are at a current fire sale prices. When Merrill decided to offload them, they had to use a much less favorable valuation model.
Of course, investment banks aren’t the only ones holding on to such securities. A good deal of corporate treasury cash is tied up in them as well…Bristol Meyers comes to mind.
I’d be curious as to what you thought of the structure of that deal. It seems strange to exchange one kind of loan for another. Why would they do that?
July 30th, 2008 on 5:06 pm
In case you’re interested, I thought I’d add that Pluris publishes a state of ARS which gives you a good idea of the companies holding some of this stuff. (No, I don’t work for Pluris).
http://www.plurisvaluation.com/ars/holders_survey.htm
July 31st, 2008 on 5:08 am
It appears that they swapped CDO’s for a corporate loan simply to rid their balance sheet of much of the worst CDO exposure they had, even if it was for a firesale price. Thain is just trying to clean out as much toxic stuff as possible.
The press release noted that their remaining CDO exposure is mostly 2005 vintage and earlier. This means they sold lots of 2006/2007 vintage, which is when underwriting standards were the loosest and defaults have been highest.
July 31st, 2008 on 1:46 pm
Then they were valuing 2006/7 CDOs at par? Wow.
Thanks for the answer.
July 31st, 2008 on 1:51 pm
As of 6/30, I believe they had them marked at $11.1B, versus par of $30.6B, so ~ 36 cents…
August 3rd, 2008 on 11:33 am
Looking to purchase CDO’s? Specifically non performing assets.
I represent a group of prive investors and we are prepared to pay 10cents to 20 cents on a dollar. 300 Million – 400 million CDO’s to start.