After Merrill's Sale of Bad Debt, Few Have Followed
Despite Interest in Unloading Subprime Assets, Firms Are Reluctant to Take Large Losses, Analysts Say

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.

The securities Merrill sold to Lone Star for $6.7 billion had been valued a month earlier on Merrill's balance sheet at $11.1 billion, a figure that already reflected big write-downs. In conjunction with the sale, Merrill also announced a separate set of write-downs and said it would sell $8.5 billion of stock to pad its balance sheet.

By holding on to their CDOs, other firms might be able to avoid booking such sharp losses -- and raising fresh capital needed to offset them. The companies also could continue to bank the cash flows generated by the CDOs, similar to collecting interest on a loan, until the securities mature and roll off the balance sheet.

But in the meantime, the firms are risking that the housing market will continue to deteriorate. This could bump up the default rates on the CDOs and require additional write-downs on the assets. The troubled securities would also continue to taint the balance sheets of Wall Street firms, contributing to a psychological overhang among investors that could postpone any market recovery.

Analysts said that Merrill chief executive John Thain, hired in December, was in a unique position to dump the CDOs in essentially a fire sale. Bad bets on the securities were made on the watch of his predecessor, Stan O'Neal, allowing Thain to skirt the blame for the loss. And Merrill's balance sheet was strong enough to absorb the impact of the sale.

The assets Merrill sold to Lone Star were called "super senior," meaning they were supposed to be the safest type of CDOs. But Merrill's risk calculations for these securities had proved to be way off.

Merrill still has about $8.8 billion of exposure to these super-senior CDOs. The company says most of this is tied to mortgages from 2005 and earlier and thus even safer because, analysts say, mortgage-lending standards were tighter back then.

Other firms were burned by CDOs, including J.P. Morgan Chase, Bank of America and Morgan Stanley. The latter had ironically bought the securities to hedge a correct bet that the subprime market would weaken. The ill-fated hedge accounted for the bulk of the $7.8 billion write-down that Morgan Stanley took in last year's fourth quarter for its subprime trading division.

Citigroup is the most exposed to super-senior CDOs, according to Jeff Arricale, manager of the T. Rowe Price Financial Services Fund in Baltimore. The bank had an exposure of $18.1 billion as of June 30 after accounting for hedges.

A Citigroup spokesman said the bank is still on track to shed $400 billion of assets over the next three years, as chief executive Vikram Pandit promised investors in May. Some of the reduction is expected to come from asset sales, and some from the assets themselves reaching their maturity date and rolling off the balance sheet.

"I suspect there would be a little bit of a sigh of relief in the market" if Citigroup unloaded its super-senior CDO assets, said Arricale. "But I don't think they have to do something that would require them to raise capital right away like Merrill Lynch had to do. They have the flexibility to hold on or find a buyer at a more appropriate price."

But for now, the only relevant price is the one that buyers are willing to pay.

In keeping with the famously tight-lipped style of hedge funds and private-equity firms, none of the potential buyers identified by analysts -- including Fortress Investment Group, BlackRock, Blackstone Group and KKR -- would comment on their strategies for approaching the CDO market.

But a source with knowledge of Lone Star's plans said managers of the Dallas-based firm "have an appetite for more" acquisitions. And analysts say that other big investment groups have been lining up funds to make opportunistic purchases.

"There's no shortage of distressed investors who would love to scoop these things up on the cheap, and if those buyers are willing to come up a little bit on price, maybe we'll see some transactions," said Bill Fitzpatrick, an analyst at Optique Capital Management in Milwaukee. "But this market is all about the decline in housing prices. If that continues to accelerate, these things will be worth less and less."

Lone Star mitigated much of that risk in its deal with Merrill by getting the firm to finance 75 percent of the deal. The collateral for the loan was the CDO portfolio itself, so if the securities turn out to be worthless, Merrill will bear most of the loss.

Even if terms from other sellers are less generous, private-equity groups and hedge funds still may be willing to take a chance on CDOs. Their clients often are locked into their investments for a number of years, which tends to make them less sensitive to quarterly fluctuations in asset values.

"The thing you would have to worry about if they had to mark them down significantly is what that would mean for future opportunistic capital raises," said analyst Roger Smith, who follows money managers and investment firms for Fox-Pitt Kelton in New York. "But in five years, I wouldn't be surprised if we looked back and a lot of people said, 'Oh my god, look how much money we made. And look how obvious it was.' "

But they'd have to find a seller first.

Staff writer David Cho in Washington contributed to this report.

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