Tuesday, July 29, 2008

No Thain, No Gain

What timing. I was just sitting on my couch last night wondering what I'd do if I had a spare $1.68 billion. Then I woke up this morning to find that Merrill Lynch CEO John Thain had issued a press release detailing the company's latest balance sheet developments. I'd like to focus on just one of the announcements -- Merrill's sale of $30.6 billion of collateralized debt obligations (CDOs) .

The sale of this $30.6 billion basket of CDOs is being made to private equity firm Lone Star Funds for $6.7 billion, or a mere $0.22 on the dollar. Better still, Merrill is loaning Lone Star 75% of the funds for the purchase. Furthermore, this loan is backed only by the securities that Lone Star is buying. So, Lone Star is ultimately risking only $1.675 billion of its own capital to purchase $30.6 billion of CDOs. A mere 5.5% of the face value of the securities is at risk for Lone Star! That's like buying a house with only 5% down! How can you lose?! Ok, bad example.

Granted, a good portion of these CDOs are likely to be worthless, but it's hard to imagine a loss in excess of 94.5% if held to maturity. I'm not exactly a fan of CDOs, but I like those odds. I used to want to own a casino, but now I want to buy securitized debt for 5.5 cents on the dollar. If only I had that spare $1.68 billion.

This is clearly a sign of how desperate Merrill is to clean up its balance sheet. It also demonstrates the power of liquidity in a panicky market. It's a buyer's market out there and cash is king. Merrill needed to sell much more than Lone Star needed to buy, and with a limited number of willing buyers available, Lone Star was clearly in the driver's seat.

It's also worth noting that this isn't exactly an arms-length agreement since Merrill is loaning 75% of the purchase price. This means that the actual price of these CDOs would likely have been even lower in a true sale. Still, other financials are carrying similar CDOs at well over 22 cents on the dollar, and this transaction is going to force them to yet again write these securities down.

Disclosure: The Rubbernecker is long distressed debt buying and short about $1.68 billion dollars (rounded).