Tuesday, July 29, 2008

Merrill's failure in hedging CDO

Merrill dumped 30 bil face value of CDO for just 22 cents per dollar. At some degree, it reflected company's failure to hedge CDO exposure. At the end of Q2 08, the company has net exposure just 4.5 bil, gross exposure 19.9 bil. Well hedged CDO should be independen of market condition. Hence, Merrill only needs to get rid of 4.5 bil book value of unhedged CDO. Merrill sold 11.1 bil book value (30 bil face value) of CDO for approximately 6 bil. It leads me to believe that at least 6.6 bil of CDO failed to be hedged well, highly probably due to the poor quality of counterparty. Don't forget, Merrill had taken a loss of $4 bil in Q2 concerning credit revaluation due to the downgrades of CDS insurers. The following excerpt from WSJ further reinforces my thoughts ... Merrill also didn't let on that it had struck a deal in principle around early July with bond insurer Security Capital Assurance Ltd. to tear up derivative contracts tied to $3.74 billion in CDOs. That agreement, which hadn't been finalized, resulted in a $500 million payment to Merrill, also announced Monday ... Why would Merr did it now when the market condition still out of woods and it had raised some capital? There are multiple explanations: To precaution against capital inadequecy; Pessimistic view of the prolonged outlook of market downturn. Above these, I would say that Mer sees the failure of hedging and no liquidity of CDO and want to put CDO mess behind forever.

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