For banks holding CDO debt, things are going to get worse before they improve. And for Merrill Lynch, that could mean another huge writedown in Q4 - up to $7bn.
As reported by the FT on Friday, analysts are still uncomfortable with Merrill’s CDO and subprime assets. Despite having halved its CDO holdings - from $32.1bn at the end of the second quarter, down to $15.2bn currently - and significantly reduced its $8.8bn of Q2 subprime securities to $5.7bn, Merrill still faces big problems.
Firstly, it is likely to have sold it’s most highly rated assets already - meaning what remains will be much harder to shift. Secondly, given the current conditions in the markets, Merrill are going to have big problems finding institutions to hedge their exposures with. And, thirdly, it looks like CDO and subprime assets still have a way to fall.
William Tanona, Goldman Sachs analyst, removed Merrill from his “buy” list and said he expected the bank to take an additional $4.5bn of writedowns in the fourth quarter on its remaining $20.9bn portfolio of CDOs and subprime mortgages.
That analysis is worked out on the back of the performance of CDO and subprime tracker indices.
Goldman use the TABX as a proxy for CDO performance:
And the ABX is widely taken as a proxy for subprime securities. Here’s the performance of AAA rated bonds:
How much further left to fall? Well subprime mortgages aren’t going to enjoy a price renaissance anytime soon - need we dwell on the worsening reset outlook in 2008?
As for CDOs, the consensus is that prices are going to keep on falling. The market has yet to work out a stable price because of the instruments’ huge embedded leverage - both intrinsic and extrinsic. Consider this scenario, as told to the FT’s Gillian Tett:
Imagine a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital - a 2% price decline in the CDO paper wipes out the capital supporting it.
Little wonder then, that CDOs have the market spooked at the moment.
Securities with ratings as high as AAA from at least 45 CDOs were either cut or put on review for a downgrade by Moody’s on Friday.
And while other banks have been clever enough to hold little or hedge - the story for Merrill, as told above, obviously isn’t so great. The most bearish analysis we’ve heard so far, sees Merrill taking a further 50 per cent hit to it’s CDO inventory alone - which would materialise as a loss of $7bn.