When Merrill Lynch (MER) sold $30.6 billion of CDOs to Lone Star for a $4.4 billion loss last month, bulls billed the move as the “kitchen sink” event that would finally mark the bottom for the battered stock. Citigroup’s Prashant Bhatia, doesn’t go so far as to call a bottom, but he certainly echoes their positive sentiment.
analysing Merrill’s remaining exposure to CDOs, Bhatia argues that MER’s net long exposure has been drastically reduced. MER’s gross long exposure to CDOs before the sale was roughly $58 billion. The $30.6 billion sale brought that figure down to $27 billion and, according to Bhatia, net exposure is down even more:
Post the recent sale of $30.6b of notional CDOs to Lone Star (2006-2007 high-grade), we estimate that Merrill has roughly $27b of remaining gross notional long exposure (Figure 2), with a carrying value of $8.8b (marked at an aggregate low/mid 30¢ on the dollar). To put this into perspective, Merrill Lynch has essentially reduced its original gross long exposure by 85% (from $58b to $8.8b) through a combination of sales and writedowns.
Bhatia estimates that Merrill’s net exposure on the $8.8 billion carrying value is about $1.6 billion after hedges. What’s more, the counterparties that are insuring Merrill’s position are more reliable than the ones that recently blew up, argues Bhatia, making MER’s overall position less tenuous:
Previously, based on the hedges breaking down, the net exposure was not reflective of the actual risk. However, with the sale of a material part of the portfolio that had ineffective hedges, cancellation of certain hedges and the reserves around remaining hedges, net exposure is much more representative of the risk…
Merrill’s $8.8b of gross long exposure is hedged with $6b of contracts with AIG and other highly-rated, non-monoline insurers & broker-dealers, and another $1.1b of contracts with MBIA. So while Merrill still has loss potential from CDO positions, the exposure has been reduced and the loss content is limited, given our analysis.
To arrive at the $8.8 billion carrying value for Merrill’s remaining $27 billion in gross CDO exposure, Bhatia gives Merrill’s remaining CDO vintages an average value of approximately 35 cents on the dollar. Keep in mind that Merrill sold its other $30 billion for 22 cents on the dollar. Is there really enough visibility on the quality of these earlier vintages to justify marking them up 60% over the market price for Merrill’s other CDOs? And what’s to say that they won’t depreciate further? The secondary mortgage market, the housing market, and the credit environmentlall continue to deteriorate, which can’t auger well for the value of these assets.
All things being equal, however, Merrill has taken strong steps to clean up its balance sheet. As Bhatia points out, Merrill’s aggregate exposure to all kinds of mortgage assets (not just CDOs) has shrunk by 40% since Q307.
MER still does have considerable exposure to commercial real estate and Non-U.S. residential loans. If conditions in these markets deteriorate as many predict they will, the writedown cycle could begin again.
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