Unrelated to total return swaps (mentioned as being discussed with potential counterparties in my note referenced below), which are a true risk transfer when done without floors, the WSJ had to retract information from a different source related to claims of a puttable-ABCP transaction. In addition, WSJ omitted the portion in my note that the risk reduction would only occur if Merrill found counterparties [for the transactions under discussion]. My accounting point was how one would calculate the net reduction in exposure if there is significant residual credit risk. Accounting does not provide the necessary transparency. Merrill did not take issue with the information on total return swaps saying it had properly accounted for all of its transactions with hedge funds.

Merrill has not explained exactly how it achieved its reported total reduction in exposure, however. Subsequent to the WSJ's November 2 article referenced below, Merrill announced its total exposure to CDOs and subprime mortgages is around $27.2 billion (including exposures in the bank and thrift entities) of $6.3 billion more than it disclosed in late October in its third quarter release..

Deals with Hedge Funds May be Helping Merrill Delay Mortgage Losses ($)

THE WALL STREET JOURNAL - PAGE ONE November 2, 2007
By Susan Pulliam

EXCERPT

"Merrill has been making the rounds asking hedge funds to engage in one-year off-balance-sheet credit facilities," Janet Tavakoli, who consults for investors about derivatives, told clients in a recent note. "One fund claimed that Merrill was offering a floor return (set buy-back price)," she said in the note, "so this risk would return to Merrill." Ms. Tavakoli said such transactions would explain how Merrill's mortgage-related exposure dropped in the third quarter.

END OF EXCERPT

Note: In the article, my comments with respect to trades with hedge funds concern the potential counterparty credit risks posed by hedge funds, assuming Merrill was even able to find counterpaties for the proposed transactions. These transactions may be completely appropriate provided there is a true transfer of risk and reward, and provided that associated options, if any, are correctly priced and potential exposure is properly recorded.

Merrill, however, did not provide sufficient transparency to draw any conclusions when asked about its hedges and how it accomplished its reduction in ABS CDO exposure


Article is available via the above link to subscribers of The Wall Street Journal.


Clients of Tavakoli Structured Finance also have access to proprietary TSF research, which is not published in any other paid or public forum.

Please click here for other articles.