Two days ago Merrill Lynch sold some of its toxic waste CDOs to Lone Star Funds. The original value of these C.D.O.s were $30.6 billion. Merrill sold them for $6.7 billion, 22% of their original value, but at the same time made a loan of $5 billion to Lone Star. The collateral for that loan are the CDOs now owned by Lone Star. As Roubini and others point out that if the value of the CDOs sinks further and ends up below $5 billion, Merrill Lynch will again have to bear losses.

Other banks, Citigroup, Deutsche Bank, UBS,  have used the same ‘trick’ of lending to the buyer of their toxic waste. The method has two purposes.

For one, the banks can obfuscate their risk position. Merrill Lynch is now officially free of further risk of write downs of that CDO bundle and has only the risk of a well covered loan to a well regarded Lone Star Fund.

Another purpose of this trick is to keep the market value for these
CDOs artificially high. Bank accounting regulation demands that such
papers be valued ‘to market’. Other CDOs Merrill still holds would have
to be written down further if the sold tranche would have gone for less
than 22% of its face value. By making that loan, likely to quite
preferable conditions for the buyer, Merrill propped up other CDOs book
value.

This is not only important for Merrill Lynch. The NYT DealBook points out:

Still,
Merrill’s price of 22 cents on the dollar was held up as the new
measuring stick on Tuesday, as analysts whipped out predictions for
Merrill’s peers. Several focused on Citigroup, a bank with large
exposure to C.D.O.’s.

Following the deal, executives at Citigroup, JPMorgan Chase and Bank
of America began reviewing the C.D.O.’s that their companies hold on
their books. Those companies may have to lower their valuations, and
take additional charges, if their assets are similar to those sold by
Merrill.

Citibank
owns CDOs it currently values at 61 cent on the nominal dollar. Those
will have to be written down to 22 cents on the dollar. Ouch.

Or even further. The National Australia Bank wrote down
its AAA rated U.S. real estate backed CDOs to 10% of their face value.
If that is the real fair price of such ‘assets,’  Merrill is set to
book $2 billion additional losses on the CDOs it ‘sold’ to Lone Star.

But there is a much bigger bank that will be concerned with this. The
Fed lent out over $400 billion in treasury bills to banks in trouble
and it took CDOs and other junk paper as collateral. The value of that
collateral has now significantly declined. The Fed will have to ask
these banks to put up more papers as collateral or the tax payer will,
one way or another, have to cover these losses. The collateral is damaged with the U.S. taxpayer being the collateral damage.

The Fed also owns
(see point 2) Maiden Lane LLC, a holding company for Bear Stearns’
toxic waste the Fed took over when Bear Stearns was ‘rescued’ by
JPMorgan. As of June 30 the Fed estimated the ‘fair value’ of the
Maiden Lane ‘assets’ at $29 billion. After the Merrill Lynch and NAB
write downs that estimate is likely wrong.