Good article from the WSJ (subscription) on how some CDO’s went bad along with why risk became concentrated. Includes a nice graphic that explains how CDOs work. From the article:
the system works only if the securities in the CDO are uncorrelated — that is, if they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation because the companies that issue them operate in different industries, which typically don’t get into trouble simultaneously.
Mortgage securities, by contrast, have turned out to be very similar to one another. They’re all linked to thousands of loans across the U.S. Anything big enough to trigger defaults on a large portion of those loans — like falling home prices across the country — is likely to affect the bonds in a CDO as well. That’s particularly true for the kinds of securities on which mezzanine CDOs made their bets. Triple-B-rated bonds would typically stand to suffer if losses to defaults on the underlying pools of loans reached about 10%.
The WSJ has issued a retraction on their story around the supposed deal by Merrill to move risky assets off balance sheet to hedge funds while guaranteeing a return.
In its correction on Monday, The Journal said that the deal didn’t go through. “Merrill didn’t complete the deal after the firm’s finance department determined it didn’t meet proper accounting criteria,” the paper said in its correction. “In addition, Merrill says it has accounted properly for all its transactions with hedge funds.”
Note the phrasing “didn’t meet proper accounting criteria.” Translate, someone on the trading side thought it was a good enough idea to get the accountants to look at it.
The situation is looking even more grave for Merrill Lynch. The WSJ (subscription) is reporting:
Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.
The transactions are among the issues likely to be examined by the Securities and Exchange Commission. The SEC is looking into how the Wall Street firm has been valuing, or “marking,” its mortgage securities and how it has disclosed its positions to investors, a person familiar with the probe said. Regulators are scrutinizing whether Merrill knew its mortgage-related problem was bigger than what it indicated to investors throughout the summer.
In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.
What makes this all the more amazing is that Merrill Lynch appears to have participated in a similar scheme (in reverse) with Enron where Enron sold barges in Nigeria to Merrill Lynch and agreed to repurchase those barges at a later date for a fixed price that guaranteed a return. Merrill paid substantial fines in connection with the barge transaction. In that case Enron was trying to inflate earnings. In this case, if the article is accurate, Merrill was trying to hide losses. Several Merrill bankers were convicted over the barge deal though those convictions are under appeal.
For an excellent article on the problem of marking-to-market complex (and not so complex) securities in the current market see this WSJ article (subscription) from October 12. It provides some great insight into the massive change in write downs at Merrill Lynch, which I discussed in this post.
The article also reveals that
Some financial firms have sought in recent weeks to avoid write-downs by selling mortgage positions to hedge funds, with an agreement that allows the hedge fund to sell them back after a set period. A hedge-fund trader says his firm recently bought $1 billion of risky subprime mortgage loans from Bear Stearns with a one-year pact, known as a “mandatory auction call,” under which Bear agrees to participate in an auction for the loans that will provide the hedge fund with a minimum rate of return, according to a person familiar with the situation. “They didn’t want the mortgages on their books,” the hedge-fund manager says.
Such financial arrangements typically are considered proper if there’s an economic purpose to the trade and if risk is taken on by both parties. Legal problems could arise if such trades are part of an attempt to conceal a company’s financial picture, regulators say.
After the off-balance sheet scandals of recent years, it’s hard to believe that this type of trade has returned so soon.
Published October 26, 2007
Tags: Merrill Lynch, Wachovia
The news that Merrill Lynch’s CEO E. Stanley O’Neal had recently reached out to Wachovia to explore a potential merger hit the tape this morning. Peter Cohan on Blogging Stocks puts it well:
As Citigroup’s (NYSE: C) Chuck Prince illustrates, the key to keeping the CEO job is not generating consistently superior corporate performance, it’s maintaining good relationships with your board of directors. Without the board’s support, Prince’s string of disappointing quarters would have cost him his job long ago. Lesson: if you let the board know you’re failing then you keep your job — but if you surprise the board, you’re out.
That’s why corporate loner Stanley O’Neal, Merrill Lynch (NYSE: MER)’s CEO, is likely to get the boot. Because not only did he oversee a 58% increase in writing off bad investments two weeks before Merrill’s latest earnings announcement, he committed the unpardonable sin — if you want to keep the CEO title — of initiating merger discussions with Wachovia (NYSE: WB) without board approval.