How did Merrill miss a $5.7B hole?

By Bill Fleckenstein

When the stock bubble was under way and, even more importantly, when the real-estate bubble was under way, I continually made the point that bubbles should be avoided, using Japan as an example of what happens in their aftermath.

Folks were often quick to respond: Yeah, but that's Japan. We do things differently here.

It's true, we do do things differently here. But what we do differently is we don't save money, as the Japanese do, and we don't run a trade surplus, as they also do. Other than that, it's pretty much the same here as it was there in the 1980s, as far as a preference for obfuscation versus transparency.

The Securities and Exchange Commission has made a big fuss about changing the rules for shorting stocks, but that's like shooting the messenger. The commission ought to spend its time making sure companies tell the real story and file financial forms that are accurate.

Eminently deserving of the SEC's focus, for example, is the flurry of headlines surrounding Merrill Lynch (MER, news, msgs). Last week, just two weeks after reporting earnings, the company said it would take a $5.7 billion write-off in the third quarter.

Yet in a conference call at the time of the earnings report, when CEO John Thain was pressed about why Merrill wouldn't liquidate assets in need of liquidation, he assured folks that it wasn't something the company needed to do. He also repeated a familiar refrain: that Merrill didn't need any new capital to support its business. "Right now we believe that we are in a very comfortable spot in terms of our capital," he said.

What did Merrill miss?

So the question is: What changed in the past couple of weeks to cause a CDO -- a package of loans known as a collateralized debt obligation -- valued at 36 cents on the dollar to be "sold" last week at 22 cents? What did Thain know about this at the last conference call, and why was it not made clear to folks? (For more on the sale, click here.)

Of course, this is more a consignment sale than a true sale. Merrill is providing 75% financing on a nonrecourse basis. That means it's really receiving about 5 cents on the dollar. It may get the other 17 cents later, or it may get the securities back. In essence, Merrill wrote a put option "down 5 cents on the dollar" and gets a call option to get the other 17 cents.

And the big news is that this was for supersenior tranches, or slices, of these CDOs, the highest-rated and presumably safest debts of all. That, in all likelihood, makes a mockery of the value of hundreds of billions' worth of other CDOs and tranches.

I know that markets change rapidly, but it's hard for me to believe that the value of this security could drop so fast in just two weeks. This is the sort of thing the SEC should be investigating.

On a related topic, the SEC has also announced an investigation into negative rumors that "hit" Lehman Bros. (LEH, news, msgs). Funny, I don't remember the SEC ever investigating buyout rumors surrounding Lehman or Bear Stearns. Nor do I recall the SEC looking into erroneous bullish pronouncements from many entities that touched off this mortgage crisis in one way or another -- i.e., IndyMac Bancorp (IDMC, news, msgs), Washington Mutual (WM, news, msgs), New Century Financial (NEWOQ, news, msgs), Toll Bros. (TOL, news, msgs), etc.

Certainly, the SEC has long turned a blind eye to bullishly oriented market pranks such as quarter-end markups.

Why not rent?

As for the potential of the Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) "bailout" bill to actually solve our housing problem, I thought I'd pass along a few nuggets from Joel Locker of FBN Securities: Even though folks are focused on foreclosure rates, rental vacancies are just as material. As of the end of the second quarter, vacant rental units stood at 10% (about 3.94 million units), up from the 43-year average of 7.16%.

That 2.84-percentage-point difference equates to about 1.12 million excess rental units above the historic mean, which prompts Locker to ask: "Why keep people in houses they can barely afford without government (taxpayer) assistance when rental units desperately need occupancy?"

He also points out that the overall housing vacancy rate climbed to 14.36% against a 43-year average high of 10.75%. (There are roughly 130 million total units, with 18.6 million vacant.) In order to get back to the 10.75% mean, the U.S. would have to create about 4.7 million households. To achieve equilibrium, we would need to create about 6.6 million jobs (assuming 1.4 jobs as creating a household) and not build one additional housing unit.

Those are a few macro numbers to chew on every time some uninformed source declares today to be the end of our troubles. When we finally get to the end of the troubles, many of these big numbers will have been worked through, and the psychology will be much different than it is today. I'm not saying that I'll know when that is exactly, but I'm very confident in saying we're nowhere close yet.

At the time of publication, Bill Fleckenstein did not own or control shares of any company mentioned in this column.