Oct. 25 (Bloomberg) -- The collapse of confidence in Merrill Lynch & Co. after the world's biggest brokerage lost six times more than it forecast earlier this month helps explain why Treasury Secretary Henry Paulson's attempt to rescue SIVs is troubled.

Merrill Chief Executive Officer Stan O'Neal told shareholders yesterday that the New York-based firm had a loss of $2.24 billion, the biggest in its 93-year history, after reducing the value of mortgages and asset-backed bonds. Those are the same hard-to-trade securities owned by structured investment vehicles, or SIVs, that Paulson is attempting to keep afloat with a new $80 billion fund.

Paulson's plan, announced last week, may do little to address the lack of transparency that has roiled global fixed- income markets since July 31, when two hedge funds managed by Bear Stearns Cos. went bankrupt following losses on securities tied to subprime mortgages. Investors aren't willing to rely on estimates by Wall Street traders to value these bonds and there's no central trading system or exchange. Fitch Ratings says the value of SIVs, which own more than $320 billion of bonds, fell to 73 percent as of Sept. 28 from 100 percent in July.

``Continuing to mask transparency by means of rearranging risk without actually offloading or recognizing the true value of that risk is not going to help anyone,'' said Joseph Mason, an associate professor of business at Drexel University in Philadelphia and a former financial economist at the Office of the Comptroller of the Currency.

`Additional Analysis'

That's what Merrill found out. O'Neal said Oct. 5 that the company wrote down the value of mortgages, asset-backed securities and loans for leveraged buyouts by $5 billion after defaults on subprime mortgages to people with poor or risky credit histories reached a five-year high and contaminated securities backed by home loans and other types of debt.

Yesterday, after ``additional analysis,'' O'Neal said the charge was really $8.4 billion, the biggest reported by a Wall Street brokerage.

Investors concluded Merrill wasn't managing its holdings and drove the shares down 5.8 percent yesterday, the biggest decline in five years. The stock fell 3.7 percent further today, dropping $2.32 to $60.90 in New York Stock Exchange Composite trading, after CIBC World Markets said the firm may need to write down another $4 billion of assets in the fourth quarter. Merrill is a passive minority investor in Bloomberg LP, the parent of Bloomberg News.

Standard & Poor's, calling the loss ``startling,'' cut its rating on Merrill's senior unsecured debt to A+ from AA-. Fitch and Moody's Investors Service also lowered their ratings on the company.

Buyers Absent

The cost to protect against a default in Merrill's bonds doubled the past two weeks. Credit-default swaps used to speculate on the company's creditworthiness or hedge against losses, have climbed 44 basis points since Oct. 10 to 86 basis points, according to CMA Datavision in London. A basis point is 0.01 percentage point.

Paulson's attempt to stem further declines in credit markets was announced Oct. 15 when New York-based Citigroup Inc., and JPMorgan Chase & Co., and Charlotte, North Carolina-based Bank of America Corp. said they will set up the fund to buy securities from SIVs, which sell short-term debt to buy mortgage securities and finance company bonds, profiting on the spread between the two. Wachovia Corp., also based in Charlotte, has said it also will back the fund, known as the master liquidity enhancement conduit, or M-LEC. The plan doesn't include government money.

Cheyne Capital

Many of the 30 SIVs worldwide can't find buyers for their commercial paper -- debt that comes due in 270 days or less. The concern is that without the funding, the SIVs would have to sell their investments and might have to accept fire-sale prices. That would force owners of similar securities to assign new, lower values to their holdings, causing losses to spiral.

As an alternative, banks could take over the assets, though that would tie up capital and restrict lending, putting a drag on the economy.

Citigroup, Bank of America and JPMorgan, the three biggest U.S. banks, didn't disclose the size of the fund or say what assets would be purchased, except that they would be ``highly rated.'' The fund plans to finance assets by selling medium-term notes and commercial paper to investors, the companies said last week. The banks would provide credit lines to the entity, backing that SIVs don't have.

SIVs are starting to go under because they can't obtain funding once short-term loans come due.

Commercial Paper

London-based Cheyne Capital Management Ltd. and IKB Deutsche Industriebank AG's Dublin-based Rhinebridge Plc, a fund set up in June, defaulted on a combined $7 billion of debt after failing to obtain back-up financing.

Even after the Federal Reserve reduced its target interest rate for overnight loans between banks by 50 basis points to 4.75 percent on Sept. 18, investors are skittish about providing loans to borrowers pledging hard-to-value assets as security.

Asset-backed commercial paper maturing in less than 30 days yields 20 basis points more than the Fed's target rate for overnight loans between banks, up from 5 basis points three months ago. The amount outstanding fell in each of the past 11 weeks, tumbling 25 percent to a seasonally adjusted $883.7 billion.

On average, about 44 percent of SIV holdings are in mortgage-backed securities, 2 percent of which is in subprime mortgage bonds, and 11 percent is collateralized debt obligations, which package pools of debt, according to a report last month by Zurich-based UBS AG, the world's biggest money manager to the wealthy. The rest is finance company bonds and other asset-backed debt.

`Lack of Transparency'

The lack of trading in mortgage securities has made it almost impossible to reach a consensus on the value of much of the SIV's holdings. More than 80 percent of fund managers surveyed last month by Greenwich Associates, a Greenwich, Connecticut-based consultant, said they ``experienced difficulty'' in getting a price quote from dealers for asset- backed securities and CDOs.

``There's still a very serious problem of lack of transparency in those markets, lack of trust on the part of market participants in the value of securities and the lack of trust in their counterparties,'' Martin Feldstein, an economist at Harvard University in Cambridge, Massachusetts, and chairman of the National Bureau of Economic Research, said in an Oct. 4 interview.

Falling Value

Under Paulson's plan, securities owned by SIVs that can't refinance their debt will be transferred to the bank fund. The banks didn't say how they will determine a value for the assets. That may play into the hands of banks and investors who want to avoid marking down their holdings, potentially extending the slump in credit markets, said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York.

``The real issue is this might prolong the inevitable, which is financial entities eventually having to mark-to-market their assets,'' Crescenzi said.

The average net asset value of SIVs rated by Fitch fell to 73 on Sept. 28 from more than 100 in July. A 0.5 percent drop in value of assets is equivalent to a 7 percent decline in the so- called NAV, Fitch said.

Citigroup, the biggest U.S. bank, is the largest owner of SIVs, with seven pools that have a combined $80 billion in securities, according to spokesman Jon Diat.

Gordian Knot

The company said on Sept. 6 that its $22.4 billion Beta Finance SIV had a net asset value of 85.3 at the end of August. That fell to a range of 75 to 80 by Oct. 8, according to Fitch. Citigroup's $15.1 billion Sedna Finance SIV ended August with a value of 81 and declined to as low as 70 in mid-September before recovering this month to between 75 and 80. The bank's $13.4 billion Five Finance had a value of 81 in August, before dropping as low as 70 by Oct. 8.

The largest SIV, the $52 billion Sigma Finance Corp., declined to let Fitch disclose its value. Sigma is run by Gordian Knot Ltd., a London-based asset manager led by Stephen Partridge- Hicks and Nicholas Sossidis, who created the first SIV in 1988 when they worked at Citigroup before leaving in 1993 to form their own company.

``This is the dullest business on the planet,'' said Partridge-Hicks. ``What we do is old-fashioned spread banking.''

Rhinebridge's value dropped to 65 to 70 as of Sept. 20, according to Fitch. Since then, the value fell far enough to force the SIV to stop debt payments. All Rhinebridge's holdings are in structured finance securities, about 35 percent of which are CDOs, according to S&P.

Buffett Weighs In

MBIA Inc., the world's biggest bond insurer, today said its Hudson-Thames Capital Ltd. SIV is seeking alternative financing after having difficulty funding itself. MBIA said it has invested $15.8 million in the SIV's capital notes though has no obligation to help support it.

S&P reports show the value of pieces of top-rated CDOs owned by Rhinebridge slumped 15 percent or more in three days last week. Once an SIV's net asset value falls below 50, a clause is typically triggered requiring the fund to liquidate.

``One of the lessons that investors seem to have to learn over and over again, and they'll have to learn it over again in the future, is that not only can you not turn a toad into a prince by kissing it, but you also cannot turn a toad into a prince by repackaging it,'' billionaire Warren Buffett said today to reporters in Daegu, South Korea, where he's visiting cutting- tools maker TaeguTec Ltd., a subsidiary of Berkshire Hathaway Inc.

Buffett, called ``the world's greatest investor'' by biographer Robert Hagstrom, has described derivatives as ``financial weapons of mass destruction.''

Greenspan Critique

Former Fed Chairman Alan Greenspan said last week that investors may see Paulson's plan as little more than a shuffling of assets, further undermining confidence.

The accord could be ``somewhat adverse'' for the market ``because if you believe some form of artificial non-market force is propping up the market you don't believe that the market price has exhausted itself,'' Greenspan said, according to Emerging Markets, a newspaper published for last week's meeting of the International Monetary Fund.

Paulson, a 61-year-old former CEO of New York-based Goldman Sachs Group Inc., the most profitable firm in Wall Street history, said the deal will ultimately reassure financial markets and should be operating soon.

``It will take a while, but it should be done by the end of the year,'' Paulson told reporters on Oct. 19 after a meeting of finance ministers and central bankers from the Group of Seven industrialized nations.

Paulson's proposal may at least help boost trading in some securities, said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington and a former economist at the New York Fed. The central bank, now run by Ben S. Bernanke, indicated it supports the plan. A Fed official who declined to be identified said this week the plan is well-enough designed that it may help credit markets.

``It's definitely positive, the only question is how big a positive,'' Posen said. ``I give Paulson a lot of credit for coming up with something that looks private sector that he can take credit for.''

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Neil Unmack in London at nunmack@bloomberg.net

Last Updated: October 25, 2007 16:47 EDT