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.”