And 15 once we reach Alderaan...

Today Ambac is out with news that they too have reached an agreement to terminate a CDS contract with Citigroup. The CDS had $1.4 billion notional and was settled for a payment of $850 million. On Monday, Security Capital reached a similar agreement with Merrill Lynch on 8 CDS, canceling $3.7 billion in CDS for a payment of $500 million.

Remember that a CDS is nothing more than an exchange of risk. One party agrees to pay a periodic fee, while the other party agrees to make up any lost cash flow on a referenced security.
So let's say you enter into a plain vanilla CDS contract referencing Kraft. Let's say its $10 million notional and the deal spread is 76bps (about what Kraft is right now.) Now let's say that the spread on Kraft CDS widens to 100bps. Your contract at 76bps has some positive cash value (about $110,000 on $10 million notional), because of the movement in spreads.

Why? Because you currently own protection on Kraft and only have to pay $19,000/quarter for that protection (76bps * 10 million / 4). Anyone who wants to buy protection now has to pay $25,000/quarter (100bps *10 million /4). Through the magic of Bloomberg, we can calculate what your contract is worth: about $110,000. This means that someone would be willing to pay up front $110,000 to "buy" your lower protection payments.

Now let's say Ambac was the counter-party on your Kraft CDS, and Ambac wants out of the trade. Maybe you are happy to monetize your profits so when they offer you $110,000 you agree.

The media headlines would say that Ambac had exited their $10 million in Kraft risk in exchange for a payment of $110,000.

Now let's look at the deal cut by SCA and Merrill Lynch. Since CDS on the ABS CDOs in question don't trade regularly, we can't tell what the "fair value" actually is. Safe to say that the deal between SCA and Merrill was in part a distressed exchange. If we look at the AAA tranches of the ABX index, the prices range from $88 to $44. It is my contention that ABS CDOs, even if they include large non-RMBS exposure, can't possibly be worth more than the ABX, assuming we're controlling for vintage.

We know that SCA paid Merrill approximately 13.5% of the CDS notional value. That'd imply a dollar price on the CDOs of $86.5. Its not quite that simple, but its close. Anyway, if the price range of the ABX is $88 to $44, the right value of these CDO positions is no better than $60. Probably more like $30. So you'd say that Merrill's acceptance of $500 million is anywhere from 1/3 to 1/5 of what they'd have received from a well capitalized counter-party. Admittedly, I'm completely wagging these numbers, but it's safe to say this was a distressed exchange.

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.

Quick comment on Merrill Lynch's ABS CDO Sales

Here are some quick comments on Merrill Lynch's sale of ABS CDOs.

First, don't confuse ABS CDOs with other types of structured finance, or even other types of mortgage securities. ABS CDOs were truly the most toxic, most dangerous securities ever to carry the AAA rating. This post describes the problem of structure squared best. Its also explained here and here.

Second, I hate the phrase "worst is over." What does that even mean? If you sell a bond for 22% of par, by definition the worst is over. Its already lost 78 points, it can't lose another 78 points! So here we have CNBC claiming that traders are betting the "worst is over." Whatever.

What's really happening is that shorts in stocks and CDS got scared. Look, the odds are high that Merrill Lynch will still be around after this is all over. And we know that Merrill has a profitable brokerage business that is going to be worth a hell of a lot more than $20/share when this is all over. That goes doubly for a less impacted name like Bank of America, and even more so for the whole XLF index. That stuff isn't going to zero. So at some point, if you are short those names, you are going to want out. Given that real money is no where to be found, when the shorts want out, the market is going to move in a big way.

One of these short squeezes is going to mark an actual Bottom (tm). As AI readers know, I hate the sport of Bottom Calling, so I'm staying out of that fray. But a Bottom (tm) is coming someday.