Merrill's fire sale sparks fears of more write-downs by the banks

Merrill Lynch's decision to sell mortgage derivatives with a face value of $30bn for less than $7bn has raised fears of more write-downs to come across the troubled banking sector.

And as investors debated whether the fire sale marks the bottom of the credit crisis, there was evidence yesterday that US house prices are continuing to fall, further reducing the value of the collateral that underlies hundreds of billions of dollars of these derivatives.

Wall Street has so far lost more than $400bn on investments in so-called collateralised debt obligations (CDOs) and the final tally will not become clear until the housing market stabilises. However, Merrill's sale does put a current market price on securities that have not been changing hands since the credit crisis began.

At 22 cents on the dollar, that is a lower price even than many had feared. Sceptics also pointed out that Merrill had lent the buyer, the private equity firm Lone Star, 75 per cent of the money to do the deal.

Meredith Whitney, the bearish banking analyst at Oppenheimer & Co, called Merrill's sale a "capitulation", while Prashant Bhatia, analyst at Citi, said it would have consequences across the sector. "This is a watershed transaction that provides price transparency. This is the first large-scale CDO transaction that is not a distressed sale."

Analysts said Citigroup, the US banking conglomerate, would now be forced to recalculate the value of its remaining holdings in mortgage derivatives known as collateralised debt obligations, which were valued at its last results at $22.5bn. Deutsche Bank estimated that this could lead to a write-down of another $7bn.

After Citigroup, UBS has the next largest exposure to CDOs, most recently valued at $15.6bn.

In the UK, shares of Barclays and Royal Bank of Scotland were hit, since both have significant holdings of CDOs. Barclays shares fell as much as 9.5 per cent but closed down 4.1 per cent, while RBS stock closed down 2.7 per cent after dropping more than 7 per cent earlier. Barclays has taken smaller write-downs than most other banks, insisting that its assets are of higher quality than those held by rivals. It wrote down £1.7bn on credit holdings in the first quarter and didn't take further significant charges in the second quarter. RBS has already flagged £5.9bn of write-downs on sub-prime related assets and leveraged loans this year.

Whether Wall Street has written down the value of CDOs by enough, or perhaps even by too much, will depend on the numbers of US homeowners who default on mortgages and the price fetched for repossessed homes.

The Case-Shiller index of house prices in the country's 20 biggest metropolitan areas, released yesterday, showed prices sharply down on a year ago, although the pace of decline has slowed in most areas. The year-on-year declines are still across the "sunbelt" – from Miami, Florida, to Los Angeles in California – which had been the hottest markets during the boom.

The average US home, according to Case-Shiller, is down 15.8 per cent in value on a year ago.

By cutting his losses rather than waiting to see if mortgage derivatives increase in value, CEO John Thain hopes to put Merrill Lynch on a more secure financial footing, ending months of rumours about its capital position which had buffeted the stock. The financial restructuring also included an $8.5bn share issue, which was a significant U-turn for Mr Thain, who had previously said the company had enough cash.

John Thain changes tack

"We're very confident that we have the capital base that we need to go forward in 2008." 18 January (New York Times)

"We will not need additional funds. These problems are behind us. We will not return to the market." 8 March (Le Figaro)

"We deliberately raised more capital than we lost last year. We believe that will allow us to not have to go back to the equity market in the foreseeable future." 8 April (to reporters in Tokyo)

"Right now we believe that we are in a very comfortable spot in terms of our capital." 17 July (investor conference call)

"We have decided to further enhance our capital position by issuing common stock." 28 July (company press release)