On July 28, Merrill Lynch released a press release where it describes a sale of “$30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion.” These CDOs had already been marked down to $11.1 bn, resulting in a further loss of $4.4 bn.
Additionally, “Merrill Lynch will provide financing to the purchaser for approximately 75 percent of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction.” Because the loan is backed only by the CDOs, as is lucidly visualized in this diagram, the effective equity Merrill Lynch received was $1.7 bn, or 5.5c on the dollar, for its CDOs.
Of all the attention thrown on Merrill Lynch on this sale, relatively little has been given to Lone Star’s spectacular deal. Though no details are available, the attachment point on super senior deals tends to be 30% or higher and goes all the way to the bottom of the portfolio. Lone Star has effectively purchased an option on the CDOs with a 5.5c premium for an upside of about 72.5c.It may be anyone’s guess what the losses on the portfolios actually are, but Lone Star’s tranches have not been hit.
Lone Star’s Carry
Super senior tranches orginiated at the height of cheap credit usually paid not much more than 10 bps over Libor. For this analysis, I have conservatively assumed the CDOs pay a spread of zero. Though details have not been released on the cost of Merrill Lynch’s funding, it could come in at the same spread as the CDOs are paying out. If this is the case, the deal enables Lone Star to significantly leverage its carry on its equity investment. Per $1 notional, expenditure on ML’s funding for 16c offsets with another 16c of carry Lone Star would receive, leaving about 67c of carry of which Lone Star is only investing 5.5c. Effectively, Lone Star is able to leverage the carry on its investment at 12x (67c / 5.5c)!
If 3m USD Libor is currently 2.80%, then Lone Star is earning an annual return of 33.92%, without factoring the upside on the principal.
The big assumption here is that Merrill is funding at Libor flat (or the spread the CDOs pay). Even if this is not the case, Merrill would need to charge a spread of a whopping 1000 basis points over Libor for Lone Star to receive no excess carry!
All in all, this looks like an absolutely fantastic deal for Lone Star with enormous upside and little downside. I wonder if they could put my $1000 to work …
Further Reading
- Merrill Lynch – Merrill Lynch Announces Substantial Sale of U.S. ABS CDOs, Exposure Reduction of $11.1 Billion. Jul 28, 2008.
- Alea – Merrill Number Crunching – Ultra Short Edition. Jul 30, 2008
- Seeking Alpha – Merrill Lynch: Unafraid of Contradictions by Graham Summers. Aug 5, 2008.
- Bloomberg – Merrill Gives Up Gains, Is ‘On Hook’ for CDO Losses by John Glover. Jul 30, 2008.
- Seeking Alpha – Why Merrill’s CDO Sale Doesn’t Mean Big Writeoffs Elsewhere by Tom Brown. Jul 31, 2008.
- The Economist – Thain takes the pain. Jul 31, 2008.
- Seeking Alpha – Merrill CDO deal: How can they book it a sale? by Whitney Tilson. Jul 29, 2008.
- Seeking Alpha – Merrill Cleanses Itself – We Think by Dear John Thain. Jul 29, 2008.