Merrill Sells Portion of $850 Million Bear Funds (Update1)

Date: Thursday, June 21, 2007
Author: Jody Shenn

June 21 (Bloomberg) -- Merrill Lynch & Co. backed away from a threat to dump about $850 million of securities it seized from Bear Stearns Cos. hedge funds, according to a person with knowledge of the firm's plans.

Merrill sold a small portion of the collateralized debt obligations through an auction, said the person, who declined to be identified because the decision hasn't been announced. The firm plans to hold onto the remaining securities for now, the person said, without being more specific.

The decision removes the risk that a large amount of securities would be liquidated immediately. Merrill set the sale in motion to reclaim its loans to the two hedge funds, which had posted losses of as much as 20 percent by betting on CDOs. The plan may have confirmed that other funds were overvaluing their holdings of similar securities, potentially causing a chain reaction of writedowns causing billions in losses.

``It's an industry issue,'' said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. ``How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?''

Merrill Lynch spokeswoman Jessica Oppenheim declined to comment.

Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds. Spokesman Russell Sherman declined to comment.

Shares Rebound

Investors from hedge funds to pension funds and foreign banks have snapped up CDOs, securities backed by pools of assets, as a new way to invest in debt, making it the fastest growing market and pushing the amount outstanding to more than $1 trillion.

Shares of Bear Stearns, the fifth-biggest U.S. securities firm by market value, rebounded after three days of declines. Merrill, the third-largest, continued its decline. Both companies are based in New York.

The perceived risk of owning corporate bonds jumped to the highest in nine months before paring the rise. Contracts based on $10 million of debt in the CDX North America Crossover Index rose as much as $10,000 in early trading today to $179,000, according to Deutsche Bank AG. They retraced to $170,000 at 12:14 p.m. in New York.

`Systemic Fallout'?

U.S. Securities and Exchange Commission Chairman Christopher Cox said yesterday that the agency's division of market regulation is tracking the turmoil at the Bear Stearns fund.

``Our concerns are with any potential systemic fallout,'' Cox said in an interview.

Bankers and money managers bundle securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating because they are first in line for any losses. Investors in this so-called equity portion expect to generate returns of more than 10 percent.

CDOs were created in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk-bond king Michael Milken. Sales reached $503 billion in 2006, a fivefold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody's Investors Service.

New York-based Cohen & Co. was the biggest issuer of CDOs last year. It has formed 36 CDOs since 2001, including 15 worth a total of $14 billion in 2006, according to newsletter Asset- Backed Alert.

Biggest Names

Not since 1994 have mortgages at banks with past due payments been so high, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at 8,650 U.S. banks. Lehman analysts estimated in April that the collateral backing CDOs had fallen by $25 billion.

The Bear Stearns funds are run by senior managing director Ralph Cioffi, 51. One of the funds, the 10-month old High-Grade Structured Credit Strategies Enhanced Leverage Fund, lost 20 percent this year. Officials at Bear Stearns declined to disclose the losses.

The funds had borrowed $9 billion from the biggest names on Wall Street. Aside from Merrill, other creditors included Goldman Sachs Group Inc., Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. All of the firms are based in New York, except Bank of America, which is based in Charlotte, North Carolina.

As the funds faltered, Merrill sought to protect itself by seizing the assets that were used as collateral for its loans. JPMorgan planned to sell assets linked to its credit lines before reaching an agreement with Bear Stearns to unwind the loan, people with knowledge of the negotiations said yesterday.

`Pretty Ugly'

Merrill's decision yesterday to accept bids on $800 million of bonds it took as collateral for its loans further stifled trading in CDO securities, said David Castillo, who trades asset- backed, commercial-mortgage and CDO bonds in San Francisco at Further Lane Securities.

``Nobody wants to look at the truth right now because the truth is pretty ugly,'' Castillo said. ``Where people are willing to bid and where people have them marked are two different places.''

Some CDOs are so rarely traded that their owners can't tell whether they are worth 50 cents or 90 cents on the dollar, said Scott Simon, who owns CDOs among his $200 billion of mortgage- and asset-backed bond investments at Newport Beach, California- based Pacific Investment Management Co.

``The problem with these bonds is that there's no market,'' said Simon. Investors also don't know how many of the CDOs are held by buyers who paid cash or whether ``it's going to be a series of Bear Stearnses'' because the hedge funds borrowed money to make the purchase.

Risk Rises

The perceived risk of holding Bear Stearns bonds jumped to a three-month high, according to traders betting on the creditworthiness of companies in the credit-default swaps market.

Contracts based on $10 million of its bonds rose $4,000 to $49,000, according to composite prices from London-based CMA Datavision. An increase in the five-year contracts suggests deterioration in the perception of credit quality.

Shares of Bear Stearns rose after three days of declines, gaining $1.06 to $144.26 in New York Stock Exchange composite trading. The stock was down 12 percent this year before today, compared with the 0.4 percent advance of the Standard & Poor's 500 Financials Index. Merrill dropped $1.25 to $86.43 and Citigroup fell 26 cents to $53.18.

Long-Term Capital

The reaction to the Bear Stearns situation is reminiscent of Long-Term Capital Management LP, which lost $4.6 billion in 1998.

Lenders including Merrill and Bear Stearns met and agreed to take a stake in the Greenwich, Connecticut-based fund and slowly sold the assets to limit the impact of its collapse.

``We're not surprised to find the principal circle of players is pretty interconnected,'' said Roy Smith, professor of finance at New York University Stern School of Business and former head of Goldman's London office. ``What we're looking for is whether the interconnection creates a negative domino effect: Whether Hedge Fund A creates a problem for other hedge funds, which in turn creates a problem for the prime brokers that are lending to them.''