After Merrill's Sale of Bad Debt, Few Have Followed

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By Heather Landy
Special to The Washington Post
Tuesday, August 26, 2008

NEW YORK -- Merrill Lynch sent an important message last month to its Wall Street brethren when it sold off a massive portfolio of securities badly damaged by the subprime mortgage meltdown: Someone was still willing to buy them.

Shareholders and regulators who had been urging banks and investment firms to rid themselves of problem assets welcomed the development. But a mass exorcism of the securities -- which remain a burden for Wall Street as it tries to scrape its way out of the credit crisis -- never materialized. That's because by agreeing to sell at 22 cents on the dollar, Merrill sent another powerful message: Purging the mortgage-related securities would require pricing them at a fraction of their face value.

The sale left Merrill's peers wondering whether they should take a similar loss on the securities or hold on to them and risk an even further drop in value. The dilemma is one of several that Wall Street firms face as they try to unfreeze markets and repair balance sheets devastated by the credit crisis.

Treasury Secretary Henry M. Paulson Jr., eager to restore investor confidence in the system, has been urging Wall Street executives to clean up the mess quickly and raise more money. Fresh capital would make it easier for the firms to absorb the losses on assets that have declined in value and calm investors who fear a possible run on the bank, like the one that prompted the collapse of the investment firm Bear Stearns in March.

"Every day I talk with a couple CEOs, just encouraging them to sell assets, recognize losses, raise capital," Paulson, a former chairman and chief executive of Goldman Sachs, said in an interview. "I can't think of a time in history when a CEO of a financial institution has gotten in trouble or lost his job because they had too much capital."

"The good news," he said, "and the testament to our system is, capital is available."

Wall Street firms and U.S. banks have raised more than $175 billion of capital in the past year, according to figures compiled by Bloomberg. Investors have scooped up shares and bonds issued by the companies, demonstrating their continued faith in the industry, while bottom-fishers have been emerging to buy out-of-favor assets at deep discounts, signaling that they predict at least a partial recovery in the assets' value.

Merrill found a distressed-investment specialist to take over its portfolio of beat-up securities known as collateralized debt obligations, or CDOs. Lone Star Funds, a Dallas-based private-equity firm, agreed July 28 to pay Merrill $6.7 billion for CDOs with a combined face value of $30.6 billion. It also got Merrill to finance the bulk of the transaction.

CDOs are repackaged debt securities that are carved into pieces offering a share of the cash flows from the underlying assets. The assets can include mortgages, loans or bond market derivatives known as credit-default swaps.

Some holders of CDOs might fetch more for their securities than did Merrill, depending on the quality and risk profile of the assets. But even those that stand to fare better remain leery of selling at a time when buyers clearly have the upper hand.

"Firms that can weather it may realize that with the distressed sales prices out there today, they probably would be much better off holding the securities," said Peter Kovalski, a bank analyst at Alpine Funds in Purchase, N.Y.

As the subprime market meltdown led to higher default rates on mortgages and mortgage-related CDOs, investors in CDOs were forced to take big write-downs to reflect the steep decline in value.

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© 2008 The Washington Post Company

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