Collateral Reserves: What Is Behind Record Low And Negative Yields

It was truly startling when it was announced. The second and more dangerous phase of the Global Financial Crisis had begun on July 15, 2008. Within two weeks, Merrill Lynch had etched its name on the growing list of “troubled” institutions.

On July 28, 2008, 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 for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

There are all sorts of misconceptions about the sale, some that have continued to this day (for the few who notice these kinds of things). What immediate jumped out was the $6.7 billion purchase price for what seemed to have been almost $31 billion in assets. Indeed, the vast majority of the news stories (many of which have disappeared over the years) written at the time described Lone Star Funds’ incredible deal of 22 cents on the dollar.

Everyone knew it was “toxic waste” and damn if Merrill wasn’t loaded up on it. How much is everyone else really exposed?

All the press release said was “$30.6 billion gross notional” not par value nor book value. We don’t know, and none of Merrill’s previous filings had ever specified, what the market value of these assets had been at inception. “We don’t know” is how a lot of these things worked.

This highly uncertain nature raises some very good questions along the lines of monetary mechanics. Shadow money. The kinds of lessons that stick with you long after the affair has been put to rest in the history books.

Merrill’s CDO sale in some ways reinforced the example of Bear Stearns – and not just because a lot of Bear Stearns’ troubles were related to its own holdings of ABS CDOs.

(Click on image to enlarge)

We can spend an awful lot of time diagramming and detailing these instruments and those like them, what they were used for and why banks seemed so enamored with the type. In fact, I’ve already done so elsewhere (Eurodollar University). ABS CDO’s can be of a couple of different kinds but what they all have in common is that they make what is erstwhile illiquid assets into a liquid security.

What’s so important about that? In a word: repo.

You can’t show up at JP Morgan’s repo desk with a lot of papers holding title to thousands of mortgages and expect to fund them on the basis of those individual loans. That doesn’t work. For one, the cash owner, the interbank repo lender, wants collateral that is highly liquid because that way the cash owner knows the collateral being received isn’t going to move much while in his possession.

If you default by refusing to return his cash and he’s stuck with all those individual mortgages, what good are they for his purposes? He can’t liquidate them tomorrow and get his money back.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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Moon Kil Woong 4 weeks ago Contributor's comment

Good and interesting argument again. I think the low yields on short term treasuries are also caused by central banks around the world scooping them up as fast as they can as other poorly managed companies bonds look increasingly junk like.

Simone Radcliffe 3 weeks ago Member's comment

You are getting warm Jeffrey, but it is not quite the reason for what is taking place, still i enjoyed the article.

Harry Sinclair 1 week ago Member's comment

And what do you think that reason is Simone?