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Bailout 12: Lone Star transaction

A real life example of a transaction involving CDOs. Created by Sal Khan.

Video transcript

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. Right? 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. Right? 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. Woops. $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. Right? 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. Right? 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? Right? 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.