Merrill Fire Sale Just Another Ponzi Scheme
Wednesday, July 30, 2008 2:38 PM
By: Hans Parisis
Media reports say that big global banks like Citigroup and UBS
will be under renewed pressure to write down or sell billions of dollars in
so-called toxic assets.
This the result of Merrill Lynch's decision recently to dump $30
billion in mortgage-related securities at a huge discount.
Merrill is getting rid of collateralized debt obligations (known
as CDOs) for $6.7 billion, roughly 22 cents on the dollar. The buyer is Lone
Star Funds.
We all know that today the secondary market for CDOs is
extremely illiquid. Investors need to keep in mind that Merrill will provide
financing for 75 percent of the heavily discounted (78 percent off) purchase
price. But does even that discount wash? Not really.
The financing will amount to $5 billion. This implies that these
CDOs are worth much less than 22 cents on the dollar.
It's nothing new. These kind of "sales" transactions, that is,
broker-dealers "selling," is a way of liquidating toxic waste at a discount
while providing hedge funds and private equity funds heavily subsidized
financing for it.
So, investors should understand that the "real" discount value
is frequently (these days, anyway) much higher than the announced discount.
As a result, the writedown of these assets is seriously
misleading to the common investor.
Here's a breakdown: The writedown is smaller than it really
should be because Merrill is providing most of the financing for the
transaction. This market is totally illiquid and literally nobody could sell
$11.1 billion worth of these toxic CDOs.
Remember, the interest rate at which the financing occurs is
often significantly lower than the appropriate, risk-defined rate at which
this risk financing will occur. As Merrill has not announced the terms of
its financing, there should be serious suspicion of heavily subsidized
financing terms.
The collateral for this again-risky financing is the same toxic
waste that was sold to Merrill. Take into account that if this Merrill
transaction with a nominal market value of $11.1 billion tranche (now priced
at $6.7 billion) falls another 25 percent, the collateral for the 75 percent
financing (which is non-recourse, since 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 News, "the financing
is secured only by the assets being sold, meaning Merrill would absorb any
losses on the CDOs beyond $1.68 billion."
In understandable English this means that, 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.
The investor should ask himself, Is this toxic junk even worth
22 cents on the dollar? In reality (and that's what all investors are asking
for!), the true market value of this garbage is closer to zero than to 22
cents.
So don't get fooled when Wall Street is now shouting that 22
cents on the dollar sets a market benchmark for writing down these kind of
CDOs. (And don't forget the good old Citi is still carrying CDOs on their
books at a value of 53 cents.)
Many other firms will now have to use this benchmark. So, the
ongoing farce of pretending to "mark down to market" the value of this junk
will continue for a few quarters with continued bleeding of earnings.
It would be more honest for the financial firms to write down to
zero the value of these assets and leave open a possible positive
revaluation if they turn out being worth more than zero. They should also
keep them on the balance sheet rather than pretending to "sell" them via
greater debt, which only massively adds to the credit risk that these firms
are taking at the time when they should be de-leveraging rather than
re-leveraging further.
The investor should really put into question if this is sound
financial balance sheet restructuring or another Ponzi scheme of a house of
debt-upon-debt cards.
To me, when you sell your worthless junk and provide financing
for it, this cannot be considered a "sale" but rather another accounting
scam whose purpose is hiding the full extent of the losses.
If this is the way to run finances today, then it is no wonder
that the system is totally broken.
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