Moon of Alabama Brecht quote
July 30, 2008

Collateral Damage - Damaged Collateral

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.

Posted by b on July 30, 2008 at 13:31 UTC | Permalink


Remember, banks only disclose those losses that they are no longer able to hide. For every billion in losses that they are forced to declare, there are several billions more buried in creative bookeeping mechanisms.

Posted by: ralphieboy | Jul 30 2008 13:46 utc | 1

We are broke, so we don't account our debt ... or something like that ...

This certainly doesn't generate trust into the companies and their regulators ...

Potentially Disruptive Lender Rule Is Delayed

The board that sets accounting rules for U.S. corporations yesterday postponed by a year a plan that could require banks and other financial services companies to raise mountains of new capital to protect themselves against financial exposures not currently reflected on their balance sheets.
The plan, which would require corporations to move onto their balance sheets what could amount to trillions of dollars of assets and liabilities, was intended to give the investing public a clearer view of companies' financial risks.

Financial institutions routinely pool assets including mortgages, car loans, student loans and credit card receivables into securities that are kept off their balance sheets.

The problem for such financial institutions is that moving the investments to their balance sheets could require them to maintain larger financial cushions, known as capital.

Imagine that catastrophe, banks would be required to have CAPITAL!

Posted by: b | Jul 31 2008 6:37 utc | 2

To the extent that this screws equity investors I would be encouraged, but you get the sinking feeling that continued socialization of the sector means equity holders r us.

As for Basel II implementation, everybody saw it would be procyclical, so you just knew that the industry's domesticated regulators would schedule it to goose earnings, i.e. not now, maybe later. Crap. I was really looking forward to one more big systemic credit constraint.

Posted by: ...---... | Jul 31 2008 16:52 utc | 3

July 31 (Bloomberg) -- The Federal Reserve Bank of New York expanded efforts to clean up trading in the privately negotiated derivatives markets to include contracts linked to interest rates, commodities and currencies.

JPMorgan Chase & Co., Goldman Sachs Group Inc. and 15 other banks committed to speed up processing and reduce errors in the $454 trillion over-the-counter derivatives market by putting more trading onto electronic platforms and improving the market's infrastructure, the New York Fed said today in a statement. They also committed to start clearing by yearend some credit-default swap trades through a central counterparty that could absorb the failure of a market-maker.


Anyone got that? "Errors" in a hundreds of trillions market?

you ain't seen nothin yet ....

Posted by: b | Jul 31 2008 19:32 utc | 4

Errors - that's what the lawyers get paid to find when they call your bosses' bosses' bosses' bosses in. Remember when netting & closeout was supposed to resolve all that minutia? Good times...

Posted by: ...---... | Jul 31 2008 20:04 utc | 5

A line from your post b. "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 question asked at the time was, So what is the Fed gonna do with the junk paper? And the answer was, We the peeps gonna eat it at a bailout breakfast.

Plus, we all knew this was just one taste of *socializing debt, privatizing profit*, the new favored approach to damage control which can last for a limited time until the taxpayers catch on, I mean begin to feel hungry and cold.

Sorry to beat a dead horse here, but can anyone tell me how govt and bankers plan to make nice with 22 cents or 10 cents on the dollar? In other words, why would I hire Bear Stearns, Merrill Lynch, my local banker or broker, or any of the rest of em to manage my money for me?

Posted by: rapt | Jul 31 2008 21:33 utc | 6

Why do you think they're clamping down on UBS & LGT? To choke off mass recourse to capital flight. Otherwise you can't debase the currency, they

Posted by: ...---... | Aug 1 2008 2:04 utc | 7

'll jus bolt

Posted by: ...--- | Aug 1 2008 2:05 utc | 8

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