Wednesday, October 24, 2007

The socialist take on Merrill's writedown

I don't have much to add regarding Merrill Lynch's 8.4 billion bloodbath. But the good folks over at the World Socialist Web Site have been reading the Asset-Backed Alert Newsletter (I kid you not) and pass along a very relevant nugget of information:

While according to ABAlert, what Merrill did with investments in the subprime market estimated at $15 billion is not yet known. “One often-cited theory is that the bank transferred the banged-up investments from an available for sale account within its brokerage unit to a hold to maturity portfolio at affiliate Merrill Lynch Bank in late June.

“Such a move,” the article continues, “would have enabled the company to follow friendlier accounting procedures, since the contents of the for-sale portfolio must be marked to market [assigned a value based on what they would fetch at current market rates] on a routine basis and the values of assets in the hold book don’t have to be updated until they come due or are sold.”

“Thanks to this accounting maneuver, Merrill posted second quarter earnings that were stronger than expected,” according to ABAlert. Moreover, “The institution reported last month that its profits surged by 31%, to $2.1 billion, during the April-June stretch.”

Merrill is the largest underwriter of CDOs, or collateralized debt obligations—securitized debt instruments into which subprime mortgages are bundled together with other asset- and mortgage-backed securities. The global market in CDOs has soared from $160 billion in 2004 to half a trillion in 2006.

Merrill is by no means the only firm resorting to accounting ploys to hide losses. ABAlert reports that “Citigroup has been making moves resembling Merrill’s. The same goes for Lehman Brothers and Morgan Stanley,” who are also hunting “for internal accounting maneuvers that can lessen the impact of the market dislocation.”

The monies correspond to multi-billion dollar mark-to-market accounts opened by the major investment banks in their role as “warehouse lenders for unaffiliated CDO issuers. The plan was for the issuers to utilize the temporary lines of funding to build up inventories of subprime-mortgage securities that could serve as collateral for future CDOs, and then use the proceeds from those offerings to repay the banks. But as the subprime-mortgage business headed south in recent months, so did the issuers’ ability to complete new CDOs,” ABAlert said.

The move raised questions about the legitimacy of Merrill’s accounting procedures and “outsiders have been plumbing into the financial statements of those institutions, among others that somehow managed to avoid reporting losses, for clues about where they’re stashing the assets and what the true effect on their financial health might be.”

Furthermore, the ABAlert report sounds an alarming note regarding the “growing urgency by investment banks... to minimize the impact on their businesses or at least dress up their books.”

I must admit that this analysis explains recent events. Investment banks swept toxic securities under the carpet hoping that the whole subprime thing would blow over quickly. Interestingly, this clearly was an open secret and clearly the market freeze shows that suspicions about where losses lay were not mere paranoia.

Now the question is whether the banks have come clean. Chances are that they have reported a good chunk of their losses, although measurment issues may delay a full reckoning. However, by having held off on reporting losses for so long they may raise the levels of uncertainty and thus make the situation worse (at least compared to a scenario where they would've reported losses gradually as they happened).