According to Merrill’s press release:
“CDO Sale: On July 28, 2008, 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 for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pretax in the third quarter of 2008.
… 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. The transaction is expected to close within 60 days.”
All said and done, in this transaction Merrill sells credit exposure to $30.6 billion super senior ABS CDO in return for $1.68bn in cash from Lone Star (= 5.4 cents on the dollar.) Merrill also retains any losses above the $1.68bn secured by the assets Lone Star holds from this transaction.
Seen in this light, this transaction is itself constructed like a CDO where Lone Star buys the first-loss equity tranche with a face value of $1.68bn. In this particular case, the attachment point of this equity tranche is $1.68bn/30.6bn = 5.4%. Said differently: Lone Star carries the first loss over 0-5% of gross notional amount of $30.6bn
What is the current price of an equity tranche? The current Markit ABX.HE Indices show that the lowest rated ABX.HE.BBB- tranche comprising the BBB- segments of 20 subprime deals closed in H1 2007 (i.e. the ABX.HE.BBB- 07-02 Index) trades at 5.56 cents on the dollar. Similarly, the BBB- 07-01 vintage currently trades at 4.89 cents on the dollar (ABX.HE equity tranche prices are not available because not rated). The price of 5.4 cents on the dollar paid by Lone Star is actually quite in line with the ABX derivatives prices for low rated subprime tranches!
Arguably, since Merrill in this transaction repackages and sells on the credit risk of already repackaged CDOs and not of simple RMBS, the proper derivative index to look up is the TABX that tracks CDO^2 (see here for a concise glossary of the structured finance alphabet soup)
Due to an exponentially worse TABX performance compared to equally rated ABX derivatives indices, Markit was unable to generate new pricing for TABX tranches since March. The latest available price for the TABX-HE 07-2 07-1 BBB 0-3 equity tranche is 5.25 cents on the dollar. Again, derivatives prices seem to give a pretty accurate picture of the underlying market values. Auditors take note.
Seen in this light, the purchase by Lone Star seems less of a bargain. As the TABX performance is literally off-the-charts in a negative sense, the proper question to ask is if Lone Star actually overpaid for what it got?