Thursday, July 31, 2008

Merrill Lynch: We can pay you 2,000 now...

Merrill Lynch's surprise announcement on Monday that they were selling $31 billion (par) of ABS CDOs and raising $8.5 billion in common equity has financial CDS moving tighter. Credit default swaps (CDS) on Merrill are 80bps tighter since the news (from 350 to 270). Lehman Brothers is 50 bps tighter and Morgan Stanley is 30bps tighter. Merrill's cash bonds now about 35bps tighter over the last two days, with other broker bonds 2-10 tighter. The pattern of CDS being much more volatile than cash bonds has been common during the last year, as CDS tend to be the favored vehicle of fast money.
To understand why ABS CDOs which were originally super-senior could possibly be worth 22 cents on the dollar, read this post about the danger of "structure squared."

Monoline insurers are seeing an even bigger reaction. Along with the Merrill news, Security Capital (SCA) and erstwhile parent XL Capital agreed to further cut ties between the two companies. XL had previously agreed to reinsure and/or cover certain losses incurred by SCA. The two companies agreed to extinguish those agreements in exchange for $1.8 billion in cash transferred from XL to SCA. This effectively rescues SCA from likely insolvency. Separately, SCA and Merrill agreed to terminate $3.7 billion notional of CDS in exchange for $500 million in cash.

The CDS on insurance subsidiaries of all the monoline insurers are performing very well on this news. SCA CDS has fallen 10 points (equivalent to a 10% gain vs. par on a cash bond) from 33 points to 23 points. FGIC fell 6 points (to 43), MBIA fell 7.5 points (to 25), and Ambac fell 6 points (to 17).

Merrill Lynch will be providing 75% non-recourse funding to Lone Star (the buyer of the ABS CDOs). I think the correct way to interpret this is that Merrill has not shed itself of ultimate default risk. They have, however, shed themselves of mark-to-market risk. Further, some are saying that the financing indicates that the securities sold are really worth 5.5/cents vs. par (25% times the stated sale price of $22). I don't think that's the correct interpretation. The financing indicates retention of risk, not the ultimate trading value of the securities. Its common for dealers to fund client investments, and I don't think that should have a bearing on the valuation of the securities.

So what's the trade? Merrill had by far the largest exposure to ABS CDOs as well as monolines among big dealers. Citigroup was the other. Lehman, Morgan Stanley and Goldman Sachs have little to none. So the fact that Merrill Lynch has set a market for their ABS CDOs at 22 cents on the dollar matters more for Citigroup than any other big bank. ABS CDOs were also very popular among European banks.

In addition, CDS trading has been extremely volatile in recent months. Should this capital raise by Merrill touch off a short-covering rally in CDS, expect the rally in CDS to far outstrip any rally in cash bonds. Eventually cash bonds will be dragged along, as cheaper CDS protection eventually creates an arbitrage in cash bonds. Long-term buyers should watch the CDS market before putting money into cash bonds.

Finally the deal between SCA and Merrill Lynch may create a template for the workout of other CDS contracts on structured finance products. That may indeed be the glimmer of hope that some of the downgraded monolines have been looking for. The most impacted will be MBIA, which was Merrill Lynch's favored insurer. Don't get carried away with optimism here. I'd say that the odds of these companies surviving, as in, making it through run-off, have gone up slightly in the wake of this news. But I wouldn't say the stocks are worth much more.

12 comments:

ccm said...

"Its common for dealers to fund client investments, and I don't think that should have a bearing on the valuation of the securities."

But is it common for dealers to also limit recourse to the specific asset whose purchase was financed?

Accrued Interest said...

No. I'm not saying the financing is meaningless merely that it doesn't suggest the value of all ABS Super Seniors is $5.5. Merrill sold the securities for $22.

Put it another way. If the securities wind up paying out $50 in principal cash flow, Merrill doesn't participate. If it winds up paying out $15 in cash flow, Merrill probably doesn't get hurt. Now if it winds up being worthless in a hurry, MER probably takes 75% of the pain. But that's unlikely. Remember that the super senior is getting every dime of cash flow in the whole structure. So the odds that its worth zero are very low.

Dave M. said...

AI, you were going to do an analysis on FSA's portfolio. What happened? With FSA bonds really tanking lately, it would be timely info. Thanks.

Josh Kalish said...

Sorry if I'm being obtuse, but I just don't get this. Since this is super senior it should have less risk than the entire batch of loan underlying, right? They are first in line to get principal and interest. Just to make it simple, assume there are 2 tranches, 80% super-s and 20% junior. If this would sell @ 100, that can support 20% default, as it is absorbed by the junior. Now if this is selling for 22, then that means they expect something like 15% of the loans to actually pay. That just seems nuts.

Accrued Interest said...

Josh: Here is what you are missing. Say you have a simple home equity securitization. And say that there are three tranches. Senior is 70%, Junior is 20% and Sub is 10%. Senior can take something like 30% losses before it even gets touched. So even in some really bad securitizations, the Senior is going to get most of its principal back.

But what if they did a re-securitization of a whole bunch of Junior tranches? That's what an ABS CDO is. Now say the losses reach an average of 20%, and to make the math simple, let's say that wipes out half of the Junior tranches. Well now our entire ABS CDO portfolio has 50% losses. The Super Senior is going to get hit very hard.

Note that its almost impossible for the Super Senior to be worth zero, since every dime of cash flow goes to the Super Senior. That's why I'm not all that excited about the fact that MER financed their sale to Lone Star.

Accrued Interest said...

On FSA... just got away from me. Sorry. I wish I could just blog for a living, but alas...

Josh Kalish said...

Oh, I see. So super senior is really = the most senior part of the juniors... What was the point of this structure, btw? It would seem to me that you are then two levels away from a lot of risky loans and that it would have to be hard to model what is really underlying your super-senior. Was this originally high-rated?

Accrued Interest said...

Josh: Yes the Super Seniors were originally rated AAA.

Just so that everyone is clear. It was very rare that an ABS CDO would be made up of just RMBS. Usually they threw in other ABS, like auto loans or credit card loans.

They also usually used ABS (originally) rated A and AA mostly as collateral. So given the ratings agency models, the "Super Senior" didn't need a lot of subordination. I saw deals where there was only 10% or so subordination!

Josh Kalish said...

Thx for the explanation.

Do we know how MER came to hold this CDO? Were they in the process of syndicating it? Or did someone actually put it on as part of a trade?

asphaltjesus said...

I have another dumb question, I think I understand the idea that the underlying loan is not getting the haircut.

When I read, "$3.7 billion notional of CDS in exchange for $500 million in cash." I read that some kind of contract that insured $3.7B has been voided (or something like that) for $500M. There appears to be quite the destruction of wealth. How much of the $3.2B loss is marked to market?

Accrued Interest said...

Asphalt:

That's not the right way to think of terminating a CDS.

Actually I'm going to write a whole post on this right now.

Josh:

I think MER held the ABS CDOs as an investment.

Accrued Interest said...

Alright I wrote a nice little post about collapsing CDS, but unfortunately, Google has flagged AI as a "Spam Blog" and I need to wait for them to realize that it isn't before I can post anything. Weird...