Bailout 12: Lone Star Transaction A real life example of a transaction involving CDOs.
Bailout 12: Lone Star Transaction
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- 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.
- 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.
- 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.
- $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.
- 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.
- 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?
- 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.
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