Media reports say that big global banks like Citigroup and UBS will be under renewed pressure to write down or sell billions of dollars in so-called toxic assets.
This the result of Merrill Lynch's decision recently to dump $30 billion in mortgage-related securities at a huge discount.
Merrill is getting rid of collateralized debt obligations (known as CDOs) for $6.7 billion, roughly 22 cents on the dollar. The buyer is Lone Star Funds.
We all know that today the secondary market for CDOs is extremely illiquid. Investors need to keep in mind that Merrill will provide financing for 75 percent of the heavily discounted (78 percent off) purchase price. But does even that discount wash? Not really.
The financing will amount to $5 billion. This implies that these CDOs are worth much less than 22 cents on the dollar.
It's nothing new. These kind of "sales" transactions, that is, broker-dealers "selling," is a way of liquidating toxic waste at a discount while providing hedge funds and private equity funds heavily subsidized financing for it.
So, investors should understand that the "real" discount value is frequently (these days, anyway) much higher than the announced discount.
As a result, the writedown of these assets is seriously misleading to the common investor.
Here's a breakdown: The writedown is smaller than it really should be because Merrill is providing most of the financing for the transaction. This market is totally illiquid and literally nobody could sell $11.1 billion worth of these toxic CDOs.
Remember, the interest rate at which the financing occurs is often significantly lower than the appropriate, risk-defined rate at which this risk financing will occur. As Merrill has not announced the terms of its financing, there should be serious suspicion of heavily subsidized financing terms.
The collateral for this again-risky financing is the same toxic waste that was sold to Merrill. Take into account that if this Merrill transaction with a nominal market value of $11.1 billion tranche (now priced at $6.7 billion) falls another 25 percent, the collateral for the 75 percent financing (which is non-recourse, since it is secured only by the collateral) will be worth less than the underlying assets, and thus additional losses will be incurred by Merrill.
In other terms, as pointed out by Bloomberg News, "the financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion."
In understandable English this means that, in a extreme scenario in which the CDOs actually end up being worth zero, Merrill will end up having sold them to Lone Star for 5.5 cents on the dollar rather than 22 cents.
The investor should ask himself, Is this toxic junk even worth 22 cents on the dollar? In reality (and that's what all investors are asking for!), the true market value of this garbage is closer to zero than to 22 cents.
So don't get fooled when Wall Street is now shouting that 22 cents on the dollar sets a market benchmark for writing down these kind of CDOs. (And don't forget the good old Citi is still carrying CDOs on their books at a value of 53 cents.)
Many other firms will now have to use this benchmark. So, the ongoing farce of pretending to "mark down to market" the value of this junk will continue for a few quarters with continued bleeding of earnings.
It would be more honest for the financial firms to write down to zero the value of these assets and leave open a possible positive revaluation if they turn out being worth more than zero. They should also keep them on the balance sheet rather than pretending to "sell" them via greater debt, which only massively adds to the credit risk that these firms are taking at the time when they should be de-leveraging rather than re-leveraging further.
The investor should really put into question if this is sound financial balance sheet restructuring or another Ponzi scheme of a house of debt-upon-debt cards.
To me, when you sell your worthless junk and provide financing for it, this cannot be considered a "sale" but rather another accounting scam whose purpose is hiding the full extent of the losses.
If this is the way to run finances today, then it is no wonder that the system is totally broken.
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