A View Into Merrill Lynch's CDO Risk Mitigation Via the Bond Insurers

Anyone following the bond insuers, or having the misfortune of being a shareholder of one of them, is probably aware that XL Capital is trying to cancel its insurance contract with Merrill Lynch. Thanks to Naked Capitalism for a post about a Merrill Lynch story from the Wall Street Journal shedding some light on why XL feels it was screwed.

I don't know what the fair use limit on quoting news stories is but I'm going to quote the whole section dealing with the bond insurers.

(source: Merrill Upped Ante as Boom In Mortgage Bonds Fizzled, By SUSAN PULLIAM, SERENA NG and RANDALL SMITH, April 16, 2008; Page A1. The Wall Street Journal)

As the CDO business slid, Merrill's top managers embarked on a new plan, referred to as the "mitigation strategy." The aim was to find ways to hedge exposure through deals with bond insurers. This would reduce the size of write-downs Merrill would otherwise have to take.

Through August, Merrill insured $3.1 billion of CDOs against losses in a series of transactions with bond insurer XL Capital Assurance Inc.

In August, Merrill proposed that XL insure about $20 billion more of its CDO exposure, according to papers XL filed in court after their relationship deteriorated. "Pick your size. It's a very nice deal for XL and a big help for ML," a Merrill salesman told an XL employee, according to the papers XL filed in federal court in New York. XL declined the additional business.

Merrill turned to another bond insurer, MBIA Inc. MBIA agreed to insure around $5 billion of the securities. But it wouldn't cover interest payments; it would only cover principal payments when they come due in more than 40 years.

Continuing to scramble, Merrill got a tiny insurer called ACA Financial Guaranty Corp. to insure about $6.7 billion of its CDOs. The problem was that ACA was poorly capitalized. It was insuring more than $60 billion of debt securities -- a third of which were mortgage-related -- yet had only about $400 million of capital and few other resources to cover claims.

Some other firms, including Lehman Brothers Holdings Inc., had already set aside reserves against their hedges with ACA, concerned that ACA would be unable to cover losses on the bonds it insured. Lehman wrote down its exposure to ACA during the first half of 2007.


Merrill's deals with the insurers helped it to show a reduction of about $11 billion in its CDO exposure in last year's third quarter. Coupled with CDO-related write-downs of $6.9 billion in the quarter, this brought Merrill's CDO exposure down to $15.8 billion, from $33.9 billion in June. The bond-insurer deals thus helped reduce Merrill's third-quarter net loss, although it was a still-hefty $2.3 billion...

In December, Standard & Poor's cut its financial-strength rating of ACA to junk level. That forced Merrill to write down its CDO hedge with ACA by $1.9 billion in the fourth quarter, leaving questions about why it had turned to such a thinly capitalized partner.

XL Capital's agreement to insure Merrill CDOs is embroiled in litigation. XL sought to walk away from the deal, contending Merrill had violated the terms. Merrill sued last month to force XL to honor the agreement.

In a countersuit, XL said the purpose of the bond-insurance deal was simply to enable Merrill to report that its CDO exposure was lower. "Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions," the suit said. A spokesman for Merrill says XL "makes assumptions that are, very simply, wrong."

The article illustrates how Merrill Lynch was really desperate and trying to unload all the super-risky CDOs onto the monolines. Some smart thinking at MBIA seems to have limited the damage in this instance (MBIA has enough dumb mistakes with their HELOCs and CESes though), but XL Capital and ACA fell victim to these risky CDOs.

Any bond insurer with exposure to 2007 vintage CDOs, especially the last half of the year is going to take massive losses. As of December 31, 2007, Ambac has 2.3% of its total exposure in 2007 vintage (closing date). This represents about $6.5 billion of CDOs and around $2.4 billion of CDO-squareds. Thd CDO-squareds--all of them CDOs of mezzanine CDOs--may end up being total losses. The real question is regarding their CDO performance. But a lot of it will come down to the legal structure and the quality of underlying asset. As the story points out, MBIA was willing to insure principal and not interest payments, where the payment for principal could be as long as 40 years away from now. If the tainted monolines have to make distant payments like that, the situation won't be as bad it seems. No one really knows the details of the contracts and I suspect the companies themselves don't know. As I pointed out in a prior post, Warren Buffett says you may need to read 750,000 pages of documents to understand one CDO-squared. I am not sure how many people (including the experts at the monolines) have gone through the documents and really know the legal framework. This whole thing is a mess and I don't even know why I got myself involved in the thick of things. It would have been much easier to go and invest in Citigroup :)



I don't really know how easily John Thain will repair Merrill Lynch's balance sheet and its reputation. This whole mess leads to me believe even more strongly that management is less important than it seems. Warren Buffett always pays close attention to management but even he is going to be utterly wrong on many things when all is said and done.

For instance, I'm sure Buffett likes the management of Moody's since he is their largest shareholder. Buffett wouldn't have invested so much in Moody's otherwise. Although Moody's stock price decline may not show it, they have done arguably more damage than almost any other company (except someone like Bear Stearns--collapse of Bear would have been a disaster).

Buffett has also praised Jeffrey Immelt, the CEO of G.E., and said he is one of the top executives in the world. I don't follow G.E. but if their financial division is actually what created the profit growth at G.E. in the last decade, and if the financial division is as risky as some rumours state, then G.E. is going to have a rough time in the future. Jeffrey Immelt, who many would have said is one of the best CEOs, is going to turn out to be no different than many others. If a big portion of G.E. actually turns out to be a toxic financial division, Jack Welch is also going to be tarnished. (For what it's worth, I don't have a strong opinion of G.E. Also note that G.E. is more diversified and larger, so it isn't going to collapse or anything.)