Merrill Sells Mortgage CDOs for 22 Cents-on-the-Dollar

The International Monetary Fund (IMF) estimates that over $1 trillion in mortgage assets will be written off, and Merrill Lynch's CDO sale to Lone Star Funds for 22 cents-on-the-dollar underscores the state of the mortgage markets and the plight of Fannie Mae and Freddie Mac.  This article by ING highlights the mortgage market's woes.

How Much is that CDO in the Window?
by Craig Allen, Senior Communications Writer

Merrill CDO Sale Highlights Current Financial Sector Woes

The Merrill Lynch’s fire sale of $30.6 billion in collateralized debt obligation (CDO) securities, backed up by mortgages, to private equity firm Lone Star Funds, highlighted a low point in the continuing credit crisis, and underscores the current plight afflicting financial services companies even as many work valiantly to shore up their blighted balance sheets. Losses in this area have amounted to $400 billion since this credit crisis began. Given this dour picture, more importantly, some are also wondering whether this sale marks a tipping point where other banks and institutions may feel they have reached bottom in terms of what the market will bear as a price for these assets.

Moreover, write-downs of tainted subprime and Alt “A” mortgages in the form of CDOs have continued unabated. Recently released housing data has also served to compound these valuation issues. The S&P/Case-Shiller Composite Home Price Index reported last week that single family home prices fell to a record low for this cycle, perpetuating a continuing trend (see Chart 1).

House Price Downtrend Remains in Place

The government-inspired bailout of Fannie Mae and Freddie Mac, passed by Congress last week, also provides prima facie evidence of the state of the mortgage market and valuations, and underscores what can happen when a government-sponsored entity does the Administration’s bidding. Fannie Mae and Freddie Mac played the role of shortstop by stabilizing a wobbling economy and mortgage market by buying up mortgages that promoted less-than-stellar lending practices.

As a result, between them Fannie Mae and Freddie Mac hold or insure over $550 billion of Alt “A” mortgages and over $200 billion of subprime mortgages. The continued viability of Fannie Mae and Freddie Mac is critical to the stability of prices in this area. 

After almost a year of the current crisis, the question of the day is: What to do with these assets? This is especially pertinent given Merrill Lynch’s move to take its lumps and accept 22 cents on the dollar as the going rate for its securities. Some firms may continue to hold assets based on the belief that prices will come back. However, with the International Monetary Fund (IMF) anticipating in a recently released report that $1 trillion in assets will be written off when this is all said and done, this judgment provides sobering insight into certain public claims from Wall Street firms that the impairment of these assets is temporary. Bank stocks, and financial stocks in general, have been taking a beating in recent months because of this uncertainty over the value of assets on bank balance sheets. However, a recent spike may provide some temporary hope (See Chart 2)

Finally, A Break in the Beatings for Bank Stocks?

The IMF’s report also notes that while banks have succeeded in raising new capital, their balance sheets are coming under renewed stress, particularly in relation to what future losses they will incur. "Spreads on financial institution debt continue to widen, reflecting uncertainty over the extent of future credit write-offs, the absorption of off-balance sheet entities and future earnings capacity," the IMF said in its Global Financial Stability Report.

Treasury Secretary Henry Paulson’s plan to backstop Fannie Mae and Freddie Mac may provide some solace to the industry and may support market prices, given the significant role these two companies play in the $5.5 trillion U.S. mortgage market. But it remains murky as to whether the big banks feel, internally and privately, an unease similar to that expressed by the IMF about just how temporary the impairment of these assets on their books will prove to be. Given that interbank lending rates are still elevated, and long-term funding rates have risen – despite central banks around the world offering emergency liquidity facilities – it seems many banks harbor concerns that current financial service woes are anything but temporary.