Thursday, April 17, 2008 1 comments ++[ CLICK TO COMMENT ]++

Merrill Lynch Write-down Foreshadows Bond Insurer Mark-to-market Losses & Any Fair Value Accounting Fans Still Left?

Merrill Lynch released its first quarter earnings today and the stock is trading up. The news probably wasn't as bad as some were expecting. Merrill Lynch is cutting 10,000 workers so its not good news for workers in the industry but if housing doens't deteriorate much further (I don't think it will) then we are likely past most of the big write-downs. Do note that successful investors have different views on how much worse the situation can get in housing.

The main purpose of this post is to point out the markdowns that Merrill Lynch took due to the monoline insurer hedges:

Merrill's results reflected $1.5 billion in write-downs on CDOs, bringing the total over the past nine months to more than $18 billion on those securities alone. The bank also took a $925 million write-down on leveraged loans and a $3 billion loss on hedges with bond insurers.

Merrill Lynch's $3 billion loss due to the monolines may indicate further deteriorating for the monolines. It gives some idea of what is looming for the monolines' earnings calls over the next few weeks. One thing to note, though, is that Merrill Lynch had high exposure with nearly-bankrupt SCA so we don't know if this loss is due to the SCA's weak insurance underwriting or if it is due to expected losses from credit deterioration of the underlying RMBS.

Merrill still holds some $26 billion of CDOs, offset on its books by $20 billion of short positions. Thain aims to sell off the positions, but indicated Thursday he doesn't yet see buyers bidding at prices at Merrill will accept.

ML will likely have to hold onto those CDOs until the credit crisis is over and I suspect ML investors are pricing that in.

If you want to see another flaw with mark-to-market accounting, here is a bizarre result:

Merrill's loss would have been a lot deeper had it not been for a $2.1 billion gain booked on the declining value of the bank's own debt. The move, while counterintuitive, is a legitimate quirk of mark-to-market accounting. Merrill's Wall Street peers also book such benefits, though Merrill's was unusually large.

I'm not an accountant and I have no idea if it's makes sense in accounting for you to post a profit just because your debt value declines, but this seems quite bizarre. I suspect the mark-to-market accounting fans will dwindle to a fan club consisting solely of accountants pretty. I found an excellent blog dedicated to trashing fair value accounting. There are still some fans of fair value accounting, such as Dave Merkel of Aleph blog, but, boy, if the the subprime losses projected by marks (and hence causing businesses to raise capital at extreme prices) don't turn out to be true, it's going to be one of the biggest disasters caused by the accounting profession in history. What happened with Enron and Worldcom, or tech firms fiddling around with accounting statements, is going to look like a joke compared to the steep price the accounting profession is asking the financial (and other distressed) firms to pay.

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1 Response to Merrill Lynch Write-down Foreshadows Bond Insurer Mark-to-market Losses & Any Fair Value Accounting Fans Still Left?

April 25, 2008 at 9:24 PM

Wait. I'm a fan of Fair Value Accounting? I've said that it is not avoidable, given the complexity of certain derivative instruments that do not trade. For a more complete rendering of my thoughts on the topic, read here:

Especially note the article on March 21st, which starts out: I’m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

I would also encourage you to read the AAO Weblog, and The Accounting Onion weblog -- those guys are pros, while I'm an amateur, though hopefully, an intelligent user of financial statements.

But, thanks for reading my blog.

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