Merrill's fire sale puts spotlight on other banks

July 31, 2008
Merrill's fire sale puts spotlight on other banks
They may have to lower their CDO valuations, take on additional
charges

(NEW YORK) Somehow, US$4.4 billion just evaporated at Merrill Lynch.
Less than two weeks ago, Merrill Lynch valued the toxic mortgage
investments on its books at US$11.1 billion. Now, it is selling those
investments for US$6.7 billion - and financing most of the purchase
to boot.

The fire sale raises a troubling question for the nation's battered
financial industry: Have other banks with similar investments
overestimated their values? That question reverberated across Wall
Street on Tuesday as analysts began assessing the implications of
Merrill's move to cleanse its tainted balance sheet.

Executives at Citigroup, JPMorgan Chase and Bank of America began
reviewing the bundles of mortgages, known as collateralised debt
obligations, or CDOs, that their companies hold on their books. Those
companies may have to lower their valuations, and take additional
charges, if their assets are similar to those sold by Merrill.

Still, financial stocks rallied on Tuesday, as investors hoped the
deal at Merrill signalled that the troubles plaguing banks' balance
sheets might be coming to an end.

'This is setting some sort of precedent for these prices,' said
Stuart Plesser, an analyst with Standard & Poor's Equity Research.

Merrill's deal also shone a light on the desperate measures banks are
taking to clean up their balance sheets. As Wall Street firms
negotiate deals to sell troubled assets to private equity funds and
hedge funds, they are offering generous loans to potential buyers.

For Merrill, this meant lending US$5 billion to Lone Star Funds
toward the US$6.7 billion purchase price. If the assets deteriorate
below their current marks, Lone Star loses the first US$1.7 billion,
then the losses move to Merrill. Merrill could lose up to US$5
billion, though the bank may have protections on the deal that it has
yet to disclose.

Analysts were sceptical. 'It's not truly unloading the risk,' said
David Trone, an analyst with Fox-Pitt Kelton. 'I mean, from an
accounting standpoint, it's gone, but from a real risk standpoint,
it's still there.' Merrill is not the only company that has made
loans to seal a deal.

Citigroup and Deutsche Bank made similar loans in the spring when
they sold billions of dollars in loans used to finance corporate
buyouts.

And, in May, when UBS sold mortgage bonds to a BlackRock investment
fund, the Swiss bank lent US$11.25 billion of the US$15 billion
purchase price. That deal left UBS on the hook for any losses more
than US$3.75 billion.

'Essentially, what you've done is you've taken a writedown, and
you've put it back on your balance sheet as a loan,' said Brad Hintz,
an analyst with Sanford C Bernstein. 'What they're trying to do is to
clear the balance sheet.'

The round-about pattern of these sales raises more confusion over the
actual value of mortgage assets. In Merrill's case, the CDOs were
originally valued at US$30.6 billion before the credit crisis. By the
end of the second-quarter, Merrill had written them down to US$11.1
billion. And then, it sold them for US$6.7 billion, sugar-coated with
a loan package.

Still, Merrill's price of 22 cents on the dollar was held up as the
new measuring stick on Tuesday, as analysts whipped out predictions
for Merrill's peers. Several focused on Citigroup, a bank with large
exposure to CDOs.

An analyst from Deutsche Bank said that the new marks might cost
Citigroup up to US$8 billion. An analyst from Merrill said that the
writedown at Citigroup would probably be closer to US$6 billion. And
at Ladenburg Thalmann, an analyst said that the marks would be much
smaller. Citigroup declined to comment.

Citigroup chief financial officer Gary Crittenden said on the
company's Q2 earnings call that many of the bank's CDOs were created
before 2006. Those assets are valued at 61 cents on the dollar, for
now.