Will Citi (C) and Merrill (MER) Book $20 Billion ARS At Face Value? Or Take More Losses?

Now that firms like Merrill (MER) and Citi (C) are dealing with the auction-rate securities scandal by buying back tens of billions of dollars of ARS from clients, an important question remains: Will the firms put the ARS on their books at par value…or will they take an immediate writedown? If the latter, the ARS moves could, yet again, create the need for more capital.

Different classes of ARS are worth different amounts, but the lack of a market for them means that almost all are worth less than 100 cents on the dollar. Merrill and Citi will buy the ARS back at full value. The question is whether they’ll carry them on their books at $1 or take a chargeoff. The latter seems more fair.

Citi is buying $7 billion or ARS. If we assume modest impairment of, say, 10%, that would lead to another $700 million writeoff. Merrill’s $10 billion, meanwhile, would lead to another $1 billion writeoff. These losses would be modest by recent standards, but would be material, and with some flavours of ARS, they would be a lot worse. The firms also might not want to carry the ARS on their books, in which case they would likely have to sell them at a steep discount, the way Merrill did with its CDOs.

Bottom line, the resolution of the ARS scandal could create the need for yet more capital.

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