BofA Says Merrill's Huge Hit was in December (Not November)?
The China Syndrome and Dead Man's Curve Suggest November
TSF - January 26, 2009 by Janet Tavakoli

James Mahoney, a Bank of America spokesman said: “Beginning in the second week of December, and progressively over the remainder of the month, market conditions deteriorated substantially relative to market conditions prior to the Dec. 5 shareholder meetings. So Merrill wound up making adjustments for the quarter that were far greater than anticipated at the beginning of the month [December]. These losses were driven by mark-to-market adjustments which were necessitated by changes in the credit markets, and those conditions change on a daily basis.” (“BofA’s Latest Hit” – WSJ January 26, 2009).

Maybe. But BofA and Merrill will have to explain that in some detail, because shareholders will want to know why the November roiling of the markets did not cause huge mark-downs. How about some disclosure to reassure everyone? Especially since at least one investment bank already explained how November was such a horrific month that they had a surprise loss due to the credit markets. Yet, BofA says Merrill’s surprise loss was in December, so let’s recap November.

This did not get enough press, but in early November, Chinese banks (top tier banks like Bank of China and Industrial and Commercial Bank of China) refused to fork over billions in collateral on dollar/yen FX trades which were out of the money after the yen’s October appreciation. The headlines should have read (but didn’t): “Chinese Banks say: STUFF IT.” The Chinese banks won a game of drag race “chicken” with foreign banks. Most credit support annex agreements would say that closing out these trades would be an event of default, and then the cross default on all the trades would kick in with the same counterparty. But the credit of the Chinese banks was better than many of their counterparties, and they renegotiated contracts with the Chinese banks.

What inspired Chinese banks to play and win this game of brinkmanship? The motive may be entirely unrelated to the bath that highly-placed “retail client” Chinese have taken with investments in mini-bombs, er, I mean mini-bonds, sold to them with “AAA” ratings by U.S. investment banks. The latter is just icing on the rice cake.

Hedges on exotic equity trades failed (delta “hedging”) in October when Volkswagen rose, and French banks took losses, and around $50 billion of these trades would roll in December. That was obvious in November. Correlation books took huge hits. Also in November in Asia, I believe, correlation trades blew up and Merrill Asia’s correlation book may have taken huge losses, and it was partly linked to structured (equity) products. “Correlation” trades unwound like crazy and there were large losses. Yet, Merrill says it did not take huge losses in November?

In the last three weeks (primarily last two weeks) of November, corporate leveraged loans, private equity (and related loans) and commercial real estate hit the skids.

Some of November’s events triggered Goldman’s surprise loss of more than $2 billion, most of which (for Goldman) occurred in the last two weeks of November reportedly from corporate leveraged loans, correlation trades, private equity and related loans and commercial real estate. But according to Merrill, its losses were in December, not November. Maybe. But as a U.S. taxpayer, I say: Prove it. I would like to see a detailed explanation of how Merrill’s rubber gripped the road round Dead Man’s Curve during a horrific November (Goldman could take a lesson from Merrill—who knew?), and I’d like to see the breakdown of its surprise losses in December.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008), and
Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (John Wiley & Sons January 2009)

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