CT Blue

Merrill Lynch just dumped some of its more toxic assets for what looks like a purchase price of 6.7 billion, already a steep discount from their nominal value:

Merrill sold the investments at a steep loss. The United States super senior asset backed-security C.D.O.’s that Merrill sold were once valued at $30.6 billion. As of the end of second-quarter, Merrill valued them at $11.1 billion — or 36 cents on the dollar. And Merrill sold them for $6.7 billion to an affiliate of Lone Star Funds, the Dallas private equity firm.

Merrill provided 75 percent financing to Lone Star Funds, which means Merrill lent the private equity fund about $5 billion to complete the sale.

I hadn’t noticed the part about Merrill loaning the money when I read the article this morning, most likely because it’s toward the end of the article, and I thought I’d already gotten the gist. It was brought to my attention in a post at Firedoglake, whose helpful link I followed to Merrill’s official disclosure about the transaction:

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.

I only took one economics course in college, and I concur that it is indeed the dismal science, but I think I understand the above, and there’s something here the Times didn’t notice, or didn’t remark on.

The linked article makes it clear that the sale will not be to Lone Star Funds, but to an affiliate formed just for the purpose of this transaction. The above quoted language basically means that the extent of Lone Star’s risk is the 25% down payment. Merrill has gotten these assets off its books for $6.7 billion it can post to its bottom line, but it has only shifted the risk of further loss to the extent of that 25% up-front payment. The “recourse” language means that, should this specially created entity default on the loan, Merrill can sue it for the unpaid balance of the loans, but it is restricted to recovering the assets it sold to Lone Star in the first place. Basically that means that Lone Star can walk away from these assets, should they decrease in value, without any further loss, and the only recourse for Merrill is to take them back. It seems a bit reminiscent of the Enron scams of a few years ago. Merrill is claiming that it has gotten out from under these “assets”, but in fact it hasn’t. It’s comparable to a car dealer selling SUVs with the understanding that should the buyer default, the only thing the dealer can do is take back the car. The buyer will keep the car only as long as it suits his purpose, and then dump it back on the dealer, who is stuck with an asset worth far less than the outstanding amount of the loan.

So unless I’m missing something, 75% of this deal is just yet another bookkeeping trick of the sort that got us into this mess in the first place. For Lone Star it’s practically a win-win situation. If the assets appreciate in value, it makes money. If they tank, Lone Star walks away from the deal without further loss.

Presumably, these assets are generating some return. I would be interested to know whether those returns count as an “asset” subject to recovery by Merrill. In other words, if Lone Star were to pull $500 million out of these instruments before dumping them back on Merrill, would that $500 million be recoverable by Merrill? Would it be considered part of the asset, or more in the nature of a dividend, which could be transferred to the pocket’s of Lone Star’s executives? At that point, those earnings would no longer be an asset of the “purchaser”, they would be assets of the executives.

in any event, while Merrill is indeed realizing some benefit as a result of this sale, it is not really transferring much of the risk of loss to Lone Star’s new affiliate. The risk remains with Merrill, so it is a bit misleading for Merrill’s chief executive to say that the sale was “a significant milestone in [Merrill's] risk reduction efforts.”

UPDATE: Hey, it looks like I got it right:

Merrill Lynch’s agreement to sell $30.6 billion of toxic securities gives away the bank’s potential profits on the securities and leaves it on the hook for most of the risk, strategists at Bank of America wrote on Wednesday.

Merrill Lynch & Co Inc has financed 75 percent of the sale of the securities, meaning it is on the hook if the assets decline by more than 5 cents on the dollar, Bank of America strategist Jeffrey Rosenberg wrote.

…

Analysts, including Rosenberg, initially reacted positively to the deal, and Merrill’s shares rose nearly 8 percent on Tuesday, even though the investment bank sold $8.55 billion of new shares to raise capital after selling the assets at a loss.

…

In a report entitled “On Second Thought … ” Rosenberg wrote, “Merrill now finds itself effectively in the position of having sold off its upside but retaining its downside.”

I must admit that Ben Stein is one of those Republicans who really gets under my skin. Perhaps it’s because he’s put himself forward as a poylmath, and operates on an idiot level on so many fronts. He writes on economics for the New York Times, though his credentials for doing so are something of a mystery. In his spare time, he unsuccessfully debunks evolution and blames Darwin for the holocaust.

Last year, as the mortgage crisis started to gather steam, he sought to calm all us Nervous Nellies by telling us:

If I were the editor of the business section for just one day, I would run one immense headline: “Everything Is Going to Be Fine. Go Back to Work.”

Being incapable of evolving, he is back again today telling us that he was right back then, and that a few bank failures, along with the collapse of Bear Stearns, along with the de facto bankruptcy of Fannie Mae and Freddie Mac along with the advent of a probable recession along with a decline in employment are no big deal and everything is still fine.

Like Stein, I’m no economist (unlike Stein, I don’t claim to be), so I’ll leave the details to Dean Baker (who is an economist) at his invaluable blog, Beat the Press:

[Stein's column] includes a number of wondrous “no big deal” comments. For example, the Fed had to step in and rescue Fannie and Freddie from bankruptcy — no big deal. We’ve had only one major bank (IndyMac) fail — no big deal. One of the major investment banks, Bear Stearns, collapsed — no big deal. Of course those minimizing the economy’s problems last summer expected such commonplace events.

We also have the great line “employment in June was considerably less than 1 percent below its all-time peak in November 2007.” You’ve got to really really love that one. Does Stein not know that economies add jobs through time. In other words, we generally expect that in any given month we have more jobs that we ever did before. To be 1 percent below our all-time peak, 7 months after that peak is really quite bad.

In addition, Stein misrepresents the meaning of the employment data. Contrary to what he claims, the numbers do not show “that 94.5 percent of the people who wished to be employed and were capable of work were employed.”

The employment rate (EPOP), the percentage of the non-institutional population that is actually employed, is more than 2 full percentage points below its peak in 2000. This corresponds to more than 5 million fewer people employed compared with a situation in which the EPOP had stayed the same. We can either believe that these people just developed a distaste for working in the last eight years, or alternatively that they are not working because the labor market does not present as many good job opportunities today as it did in 2000. The latter seems more plausible to me, but readers can make up their own minds.

In singing the praises of the economy, Stein also neglects to mention the loss of $5 trillion in real housing wealth over the last two years (almost $70,000 per homeowner), but that’s probably a small point.

Okay, I admit it. I’m jealous of Stein. Here I am laboring away in anonymity and Stein gets to write for the New York Times. I’m at least as unqualified as he to write a column on economics. Of course, I’m also just as unqualified as David Brooks to be a social critic. I didn’t know that Applebee’s doesn’t have a salad bar either. My point is that given the proper motivation I could be just as wrong as Stein, indeed just as wrong as Brooks (I’m overlooking Maureen Dowd here. Since she never says anything, technically, she’s never wrong), just as often as either of them, if only the Times would give me a chance.