The Spread Between "Schrodinger's Goose" - Merrill, And Bank Of America Soars To 2009 Highs
Following the recent surge in blue light special asset dispositions courtesy of Bank of America's precarious liquidity conditions, many have speculated that the bank will be forced to sell none other than Schrodinger's Goose: Merrill Lynch, which is at the same time both dead (pre bailout) and golden (due to some legacy reputation it has as a fabled Wall Street firm, now mostly based on intangible value). Nowhere else is this more evident than in the CDS spread between the two entities. After trading at close to convergence for about a year, the CDS levels between the two entities have seen a dramatic dispersion in recent days, soaring to over 50 bps (BAC CDS at 340, ML at 394). This is the widest the spread has been since early 2009 when the world was ending and everyone was buying whatever CDS they could get their hands on. The only comparable widening was in May 2010 when Europe blew up for the first time. So what should one do here? A divergence trade would mean that BAC is going to deteriorate so much it will have no choice but to dump Merrill, an outcome which will likely see both spreads blow out to 2008 wides, only to be followed by the need to nationalize CFC which will likely mean a collapse in Countrywide Home Loans spread (as we hypothesized two weeks ago). As if that was not confusing enough, the likely future of standalone BAC CDS post this event will likely be a tightening as the bank spins off its most toxic division, but then widens as the realization that America's biggest depository is no longer TBTF and spin offs are imminent. That... or the divergence collapses as the BAC blow out continues while investors speculate that upon its sale Merrill will have less risk than its old parent. In either case, keep an eye on this spread as it could be the canary in the coalmine for what BAC management plans to do w/r/t the Schrodinger Goose, CFC, and overall future business as a going concern expectations.
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