Is Merrill’s CDO Transaction With Lone Star Consistent With Markit ABX Pricing?

According to Merrill’s press release:

“CDO Sale: On July 28, 2008, Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pretax in the third quarter of 2008.

Merrill Lynch will provide financing to the purchaser for approximately 75 percent 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.”

All said and done, in this transaction Merrill sells credit exposure to $30.6 billion super senior ABS CDO in return for $1.68bn in cash from Lone Star (= 5.4 cents on the dollar.) Merrill also retains any losses above the $1.68bn secured by the assets Lone Star holds from this transaction.

Seen in this light, this transaction is itself constructed like a CDO where Lone Star buys the first-loss equity tranche with a face value of $1.68bn. In this particular case, the attachment point of this equity tranche is $1.68bn/30.6bn = 5.4%. Said differently: Lone Star carries the first loss over 0-5% of gross notional amount of $30.6bn

What is the current price of an equity tranche? The current Markit ABX.HE Indices show that the lowest rated ABX.HE.BBB- tranche comprising the BBB- segments of 20 subprime deals closed in H1 2007 (i.e. the ABX.HE.BBB- 07-02 Index) trades at 5.56 cents on the dollar. Similarly, the BBB- 07-01 vintage currently trades at 4.89 cents on the dollar (ABX.HE equity tranche prices are not available because not rated). The price of 5.4 cents on the dollar paid by Lone Star is actually quite in line with the ABX derivatives prices for low rated subprime tranches!

Arguably, since Merrill in this transaction repackages and sells on the credit risk of already repackaged CDOs and not of simple RMBS, the proper derivative index to look up is the TABX that tracks CDO^2 (see here for a concise glossary of the structured finance alphabet soup)

Due to an exponentially worse TABX performance compared to equally rated ABX derivatives indices, Markit was unable to generate new pricing for TABX tranches since March. The latest available price for the TABX-HE 07-2 07-1 BBB 0-3 equity tranche is 5.25 cents on the dollar. Again, derivatives prices seem to give a pretty accurate picture of the underlying market values. Auditors take note.

Seen in this light, the purchase by Lone Star seems less of a bargain. As the TABX performance is literally off-the-charts in a negative sense, the proper question to ask is if Lone Star actually overpaid for what it got?

0 Responses to "Is Merrill’s CDO Transaction With Lone Star Consistent With Markit ABX Pricing?"

  1. Kinabalu   July 29, 2008 at 7:46 pm

    I like the way you broke this transaction down. It seems to me that the question you pose is appropriate: "the proper question to ask is if Lone Star actually overpaid for what it got?". However isn’t the next question even more appropriate: Why is Merrill claiming a 11.1 billion reduction? Sounds like the actual reduction is only $6.1 million ($4.4 million writeoff plus $1.68 million cash received.)

  2. Free Tibet   July 30, 2008 at 6:24 am

    No. I don’t get it. It would seem to me that Merrill sold super senior at what you call equity prices. Or, depending on the value of the note they accept on a vehicle with no other assets, much less than that. I can imagine equity prices going to those levels, or even to 0. And quickly. That’s where the volatility was expected to be. The part I don’t get is how there could be no cash flow on what we would expect to be AAA tranches.And if the market were simply illiquid, could they not park that on level 3 until the cash flow proved the worth? To me it points to Merrill needing 1.68b so badly that they would do anything. But then what is even more perplexing is that NAB has done similarly.

  3. eparisi   July 31, 2008 at 5:14 pm

    Merrill is not selling the entire portfolio for 5 cents on the dollar – in fact, it is retaining all the risk above $1.7bn. But the riskiest first-loss exposure of the portfolio was sold to Lone Star and not at a firesale price but at a price consistent with the Markit ABX. In my view, that’s a smart move, especially as Moody’s is announcing further CDO downgrades…

  4. PhilT   August 4, 2008 at 3:23 pm

    Does this mean that the $29 billion that the FED has taken onto its balance sheet from Bear Stearns is now only worth 5.4 cents on the dollar? (Am I being too simplistic?)Best …

  5. eparisi   August 4, 2008 at 4:58 pm

    The way I would look at it is that by mid-March the available equity tranche price index was at 10, now it is at 5. As we know, the Fed is not required to mark-to-market; taxpayers are only hurt if the losses materialize.

  6. PhilT   August 8, 2008 at 5:53 pm

    Thanks for your reply EParisi! Is it then fair to conclude that the face value of the toxic assets that the FED took onto its balance sheet from Bear Stearns was actually above $400 Billion?If so, is it known or able to be derived – what percentage of the $400-Billion was JP Morgan the counter-party?Best wishes for a good weekend …