Merrill Lynch CDO Sale Proves Investment Bank Balance Sheets Can’t Be Trusted

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