I tend to do a lot of videos
with simplified examples and round numbers. But let’s get a little bit of
dose of reality and actually analyze a real transaction
that happened. Just to show to you that some of
these CDOs are selling for well below what the people paid
for them, or what that they were listed as
on the books. And even the price is actually,
probably, even worth less than what the person
actually paid. Let’s just analyze this and then
I’ll let you make your own conclusions. So this was a press release. This is part of the press
release that Merrill Lynch sent out on July 28. And just remember, they had
just finished reporting earnings, right? As of June 30. That’s when they do a snapshot
of their books. So keep that in the
back of your mind. Right? It says on July 28, Merrill
Lynch agreed to sell $30.6 billion gross notional amount of
U.S. super senior ABS CDOs to an affiliate of
Lone Star Funds. So this is important. So the $30.6 billion,
what is that? That’s the number that either
Merrill Lynch originally paid for it, or the amount
that they originally valued those CDOs are. So $30.6 billion gross
notional– notional, I have a notion it’s worth this–
notional amount of U.S. super senior. That sounds safe. Super senior, ABS– that’s
short for asset back security– CDOs– we know
a lot about CDOs now, collateralized and obligations–
to an affiliate of Lone Star Funds. So this is a Texas private
equity firm. I’ll underlined them in green,
because I think they know what they’re doing. For purchase price
of $6.7 billion. So just off that first line,
just very superficial, before we do any other real analysis,
notice that, at one time, there was an asset that someone
had a notion was worth $30.6 billion. And now they sell to
this private equity firm for $6.7 billion. So what’s the recovery
on that asset? Just superficially? And we’re going to dig in a
little bit and realize that recovery is even worse
than that. They’re able to sell for $6.7
something that they originally thought was worth $30.6. So that’s $0.22 on the dollar. So this, at least what that
first sentence implies, it is $0.22 on the dollar. At least relative to the
original amount that the those assets were booked at. At the end of the second
quarter of 2008. Notice, the end of the second
quarter of 2008 was four weeks ago relative to this
press release. That’s June 30, four
weeks ago. Not like can happen
in four weeks. At the end of the second quarter
of 2008, these CDOs were carried at $11.1 billion. So this is interesting. So Merrill Lynch, at one point,
probably last year, had these assets on their balance
sheets for $30.6 billion. They, too, realized that they
were stinky assets. And they said, well, we have
to, just to be somewhat genuine, we have to write down
these assets a little bit. And notice, they don’t want to
write them down too much, because if they write them down
too much no one else is going to want to invest
in Merill Lynch. Or maybe they’ll say Merrill
Lynch might not even have anything left. But at some point, they said,
you know what, we will be pseudo honest with the market. And these things that were worth
$30.6 billion, we’re going to write them down
to a $11.1 billion. So they must have taken– if
they did that in one period, I don’t know how many periods it
took them to realize that this $30.6 billion asset was really
worth $11.1– but in those periods, they would have had
to take a– what is that? A $29.5 billion write down. Right? And they did that to look pseudo
honest that the asset it is worth $11 billion. But they valued it
at $11 billion. And then four weeks later, they
sell it for $6.7 billion. So whatever was on their books
on– as far as this asset is concerned– whatever was on
their books on July 1, or on June 30, what are they getting
recovery relative to that? They’re getting $6.7 billion for
something that just four weeks ago, not a lot can
happen in four weeks. Woops. $11.1 and then I can
delete that. So they got $0.60 on the dollar
relative to what was on their books as of June 30. Right? So It’s a $0.60 recovery
relative to what they thought it was worth only
four weeks ago. And then they say, in connection
with this sale, Merrill Lynch will record
a write-down. Essentially, now we
sold this thing. So now we have to essentially
come to terms with reality. And so they recorded
a write-down of $4.4 billion pretax. And what’s $4.4? That’s the difference between
what they thought it was worth, between the $11.1 billion
and what it ended up being worth, or $6.7 billion. What’s interesting here
is that’s not the end of the bad news. You might think that’s
bad enough. They were only able to get
$0.22 on the dollar for something that they originally
valued at $30.6, or what four weeks ago they valued at
$11.1 billion, right? And I don’t think they got
a lot more information. I think they just put that $11.1
billion down on June 30 just because it was probably
a convenient number. Enough of a write-down to make
it look like you’re writing things down. But not so much of
a write-down to scare people too much. But this is the interesting
part. I mean this paragraph talks
little bit about the exposure, and we can get into that. But if I talked about that, I
could talk another 20 minutes. But let’s get to this last
paragraph that was buried in the press release. And this is really the
crux of things. And this, I think, will give you
a clue of the shell games that the financial industry
tries to play on people. Merrill Lynch will provide
financing to the purchaser for approximately 75% of
the purchase price. So Lone Star Funds, they’re
buying it for $6.7 billion, but 75% of that is a loan
from Merrill Lynch. So how much are they lending? 6.7 times 0.75. They’re lending them
roughly $5 billion. Right? So Merrill Lynch is lending $5
billion– I don’t like that color– $5 billion. So Lone Star says these things
are so stinky, we’re only going to pay $6.7 billion
for them. And in fact, they’re even
stinkier than that. In order for me to buy them, I
don’t even want to buy them with my money. You’re going to have to lend
me most of the money to buy that asset. And even this wouldn’t be so
bad if you just lent it generally to Lone Star. And if one day Lone Star, if
these assets were worth nothing, you could still go
after Lone Star’s other assets, right? If you could just go after Lone
Star generally, maybe this loan isn’t such a crazy
thing because maybe Lone Star has a lot of assets. I don’t know. But I suspect that they’re
fairly large private equity firm. This is just insult to
injury right here. You got to give credit to
those Lone Star guys. The recourse on this loan– the
recourse is essentially what you can go after if the
person decides that they don’t feel like paying that loan– 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. So essentially, what Lone Star
did, because Lone Star does own assets other than
essentially this asset that it’s buying right now. I’m guessing it does. That it’s a real private
equity firm. What they probably did is, they
created a corporation that does not own anything
else, right? So that if they default,
nothing’s left. So they created a corporation,
they capitalize that corporation, with whatever,
$1.7 billion. So essentially Lone star puts
$1.7 billion into the Lone Star Funds, or whatever. An affiliate– the affiliate
is probably the corporation that they created. So this affiliate is created
by Lone Star. Lone Star puts in $1.7
billion into it. Merrill Lynch lends this
affiliate $5 billion. And then this affiliate buys,
or Merrill Lynch is able to off load this $6.7 billion
on to that affiliate. And this is a special purpose
entity if I’ve ever heard of one. Because it’s purpose is very
special– essentially for Merrill Lynch to take something
off of it’s books, and not have to write
it down all the way. Think about what happens. Let’s say that these
assets are worth 0. Let’s just say that they’re
completely worthless. In the previous video I
showed you why that could be the case. What’s the loss to Lone Star? Well Lone Star, they
don’t have to pay the 5 billion back. We just said the purchaser will
not own any assets other than those sold pursuant
to this transaction. And that the recourse is only
those assets, right? So if they don’t pay that loan
back, Merrill Lynch, all they can do is take back those
worthless assets. And then what’s going
to happen? Well then Lone Star is just
going to lose $1.7 billion. Or even better, what
if those assets are only worth $1.7 billion? Right? Let’s think about
that example. Let’s say those assets are
worth $1.7 billion. And Lone Star says, you know we
don’t feel like paying back this $5 billion loan. What’s going to happen? Merrill Lynch is going to
just take back those $1.7 billion of assets. So what’s Lone Star’s downside?
$1.7 billion. So essentially, what are
they paying for it? They’re essentially paying $1.7
billion, and they’re kind of sharing the upside in
between $1.7 and $5. So really, if you think that
they’re paying $1.7 or even a little bit more, what is Lone
Star putting at risk? $1.7. So $1.7 billion divided by–
what was the original notional value of this asset?– So
they’re paying $0.06 on the original notional value. And what are they paying
relative to what Merrill Lynch told its shareholders this asset
was worth four weeks before this press release? They’re paying $0.15 on the
dollar relative to that. Well anyway, this is a
real world example. This was not made up by me, and
frankly I don’t think I could have made up something
this outlandish. But it hopefully gives you an
idea of what is actually going on in the real world.