A Market Price for Subprime CDOs

Back in July, Merrill Lynch took the bold step of admitting that a significant portion of its holdings were worth a lot less than it had previously acknowledged.

It sold roughly $31 billion worth of mortgage-linked CDOs to investment management firm Lone Star at $0.22 on the dollar for a total of $6.7 billion. This deal has popped up in recent coverage of the events of last week in both the WSJ and NYT as Merrill was forced to sell itself to Bank of America.

The proposed bill by the Treasury Department says that the initial $700 billion in bailout funds would be used to buy "mortgage-related assets." It's hard to say how much of what Wall St. firms want to get off their books is in CDO form, but you'd have to bet that a significant portion of it is just that.

Hopefully, the political jockeying over the bailout will lead to a much more transparent asset-purchasing process than the proposed bill calls for, and this market value set by Merrill Lynch -- in the likely event that the company wasn't holding a particularly bad batch of subprime mortgages -- should act as a guideline for those negotiations.

One of the worries over the bailout is that it's very difficult to value sour assets since no two are the same. But this is a nice advantage of using the Merrill-Lone Star deal as a yardstick since, presumably, the CDOs Merrill sold were also like snowflakes. It would depend on the composition of the Merrill assets, but if they are relatively representative of the mortgage-backed CDO universe, then that would add to the argument for using 22-cents-on-the-dollar as a measuring stick.

This isn't to say that the government can buy the CDOs at that price because if more firms were willing to accept
$0.22, there'd be less mystery and fear surrounding bank balance sheets. But it's hard to see the case for the government paying much more.

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