As described in a Khan Academy video, Merrill Lynch offloaded some CDOs to an entity called Lone Star Funds in the following way: (1) the purchase price was marked as \$6.7B; (2) Lone Star provided \$1.7B in cash; (3) Merrill Lynch provided a \$5B loan for the rest of the purchase; (4) if Lone Star defaults on the loan, their only exposure is the CDOs themselves.

This creates an interesting arrangement where \$6.7B is kind of like a strike price on an option. If the CDOs are worth less, then Lone Star loses all of the \$1.7B and Merrill takes a haircut proportional to how much less. If they are worth more than \$6.7B, Merrill caps out at \$6.7B and Lone Star receives the profit.

Is this kind of arrangement common (I am completely new to finance)? Does it have a name? At first, it seemed like a way of cooking the books (marking the sale price of the CDOs higher than it was) but when I thought about it, it seemed more like a speculative arrangement on its price.


That's not quite right. Lone star essentially pays 1.7bn for a call option on the CDO, struck at 5bn. If the cdos are worth less than 5bn, lone star defaults and Merrill collects the cdos.

This arrangement is called a purchase of cdos using a non recourse loan. Meaning , Merrill has no recourse to any assets of lone star other than the cdos.

A buyer would do this because it's a way to buy cdos using leverage with limited downside. A bank would do this if they desire to get the CDo position off their books ( however , there may be some debate on the accounting treatment , since the bank will own the CDo again if it falls below 5bn).

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