Why the CDO Market Is Doomed

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What a bizarre state of affairs financial companies are in.

Many investors cheered Merrill Lynch's (NYSE: MER) all-out fire sale of $30 billion worth of collateralized debt obligations, or CDOs, that it dumped for $0.22 on the dollar last week. Finally, investors can breathe a sigh of relief knowing that at least a chunk of the real-estate-backed assets that were pushing Merrill down the commode is a thing of the past, even if the company has to book a huge loss as a result. As painful as it is, at least shareholders can put a nail in the CDO coffin that's been plaguing them for so long.

Right?

Maybe, maybe not
Digging a little deeper, you'll see Merrill didn't really sell the assets for $0.22 on the dollar -- that's just how much the securities were priced at. There's a big difference between the two. As Merrill's press release puts it:

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. 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.

Translation: Merrill lent the buyer, Lone Star Funds, around $5 billion to buy $6.7 billion of CDOs. If those CDOs go belly-up, Merrill can't go knocking on Lone Star's door to get the money back. In theory, Merrill can still lose as much as $5 billion on the deal. All it essentially did was transfer the upside to Lone Star while keeping most of the downside on its own books. Doesn't seem like a very good deal, does it? Investors (including me) who thought the CDOs were actually "sold" seemed to miss that part. Lesson learned ... it helps to read the fine print.

Here's why that's especially bad
The sale price of the CDOs -- $0.22 on the dollar -- was the headline, because many people assumed that would become the benchmark that other companies, such as Citigroup (NYSE: C), Lehman Brothers (NYSE: LEH), Morgan Stanley (NYSE: MS), and Bank of America (NYSE: BAC), would use to unload their stockpile of mortgage-backed assets.

As bad as it sounds, $0.22 on the dollar might end up being out of reach for companies that want to get rid of these assets for good.

Since the 75% loan doesn't have effect on any of Lone Star's other assets, the most it can lose on the transaction is around $1.7 billion, or about $0.06 on the dollar of the $30 billion in assets it bought. To put it another way, if there wasn't a "we've-got-your-back" loan attached to the sale, it's almost certain that Lone Star would have only agreed to purchase the assets for much, much less than $0.22 on the dollar.

That doesn't sound fun
Now the severity of the situation becomes a little clearer -- $0.22 on the dollar scared the life out of investors who don't want to fathom the consequences of unloading assets at such ghastly levels. Trouble is, if banks and other holders of mortgage-backed securities actually want to sell these assets in bulk (as in sell for good, without non-recourse financing), there's a chance that pennies on the dollar will become the norm. For an industry desperately wanting to scream "uncle," that points to more writedown bonanzas ahead. Good grief.

Of course, it's entirely possible that the true value of these securities is more than pennies on the dollar. Just as optimism pushed real-estate assets to preposterously high levels, pessimism can bring them down to similarly nutty values. Goldman Sachs (NYSE: GS) and JPMorgan Chase (NYSE: JPM) have both capitalized on assets that were wildly mispriced in the past year.

Will mortgage-backed CDOs become the next vulture-swarmed market? Maybe someday. Until then, the saga continues.

For related Foolishness:

• Mother Merrill Blows Her Top
• Psst. Buddy. Wanna Buy a Bond?
• Time to Pull the Trigger?