Last days in the Bunker.
Price discovery in structured finance – specifically for collateralised debt obligations – has proved to be a rather painful and winding road. It has taken until now for anyone (LoneStar) to set a price for triple-A CDO tranches (22 cents on the dollar) that seems faintly plausible.
That price discovery has not only hurt the banks. As Friday morning’s FT reports, Merrill’s big CDO writeoff will have a particularly painful effect on the UK taxpayer: deprived of $8bn in tax revenues, with the potential for the bank to avoid corporation tax for the next 60 years.
The reason is that Merrill booked its CDO losses through its London subsidiary, Merrill Lynch International.
Unfair? Perhaps. But then the US taxpayer is picking up the bill (or rather, losing out on it) for UBS’ CDO-palooza. Quid pro CDO.
And anyway, London was the world’s centre of financial innovation, in structured finance terms. Not only were most of the more complex CDO deals structured here, in many cases, their architecture was invented here too. The same goes for the SIV, the SIV-lite and the CPDO. They’re Londoners.
CDO managers are certainly reluctant to cut the prices on their CDOs. Most think 22 cents on the dollar is a very low benchmark. Notes Equity private:
Amusingly, two CDO managers I knew tangentially simply refused to accept reality. Their superior management ability made it impossible for their CDO structures to fail. The (Markowitz) efficient frontier was calculated to blend the tranches to perfect proportions, down to two decimal precision. Superior in every way these structures. Until they weren’t. I can’t help but poke fun.
In defence of CDO managers, though – and perhaps by extension, London – the problem is not necessarily inherent in the deals themselves (afterall, on a fundamental level, many undervalued triple-A tranches are still backed by adequate collataral – at least to a value far higher than …. cents – that, in spite of the worst housing crisis in the US for nearly a century) but rather, the way deals were held or traded by banks.
Presumably, at least, that’s why LoneStar is buying.
The trading of those CDOs, of course – that is, the use of CDS, negative basis trades, LSS conduits and such like to “hedge risk”, warehouse holdings and sell off lots of the other tranches – was a US affair.
Related links
Merrill number crunching I – FT Alphaville
Merrill number crunching II – FT Alphaville
We knew about the Merrill writedown on Friday… didn’t you? – FT Alphaville