Will the recent garage sale at Merrill Lynch trigger a new round of gut clenching writedowns at places like Citigroup and UBS?

That's the talk on Wall Street, as Merrill Lynch (MER) recently unloaded $30.6 bn in collateralized debt obligations once rated Triple-A for just 22 cents on the dollar to Lone Star Capital. On closer look, the private equity fund in Dallas is saying these CDOs are really worth just 6 cents on the dollar, as Merrill loaned Lone Star 75% of the deal to get this Kryptonite off its books, and Merrill only has recourse to these CDO assets if Lone Star welshes on the loan.

Before we get to who's next, it bears repeating that Lone Star got to use as collateral for the loan the very assets Merrill is dumping. So Merrill is now relying on $5 bn in credit exposure from Lone Star, after pocketing $1.7 bn cash (booking that $5 bn as a receivable on its balance sheet in the third quarter, we expect, and $1.7 bn as a gain on sale).

Worse, the way the deal is structured, if the assets fall in price by 25%, Merrill could see some of this toxic waste float back on to its books--remember, these assets already have sunk about 40% in value in the past month or so. 

So in effect Merrill lent $5 bn to Lone Star to buy, gross value, $30 bn in securities, and at the same time it paid Singapore's Temasek $2.5 bn to buy its shares, $2.5 bn arising from earlier anti-dilution measures Temasek wrung out of Merrill in its earlier capital raise.

So the mark is there, the gauntlet thrown down, who will follow Merrill in its footsteps as Wall Street cleans house, any takers? Just as Merrill and Citi's Chuck Prince led the way in their maniacal "dance" in subprime, with Merrill paying $1.3 bn for subprime lender First Franklin in September 2006 right when loans started bellyflopping right and left, will Merrill's move create pressure for other Wall Street shops to follow suit?

Not so fast. Not every CDO will be written down to 22 cents on the dollar, despite what you are hearing from bank analysts on Wall Street, though the potential certainly exists, as I've already warned you about (see blog "Merrill's Latest Misfire").

The reason being, CDOs are not homogenized products, given that CDOs are really just a way to structure a deal, honeypots that have now turned into tarpits on Wall Street. Not every CDO is alike, they carry different debt instruments, with different asset and credit qualities. So the writedowns will of course vary in size and severity.

Of course be mindful here of the wholly unedifying and more than disturbing email exchanges uncovered by our sister publication the Wall Street Journal, where an S&P manager reportedly said ratings agencies were helping to create an "even bigger monster--the CDO (collateralized debt obligation) market. Let's hope we are all wealthy and retired by the time this house of card falters." Nice.

Merrill's $30.6 bn in CDOs was made up of super senior (does Homer Simpson work on Wall Street?) paper backed by subprime mortgages with souring vintages dating to 2006 to 2007, at the height of the housing bubble when lenders had gone completely berserk. Similarly, the recent whopper UBS (UBS) booked came from CDOs backed by 2006 to 2007 loans.

Citigroup is in the crosshairs here, as it has the biggest remaining CDO portfolio on Wall Street, with $22.5 bn on its books at the end of June. UBS comes in second with $15.6 bn (analysts say its holds are valued between 30 cents and 40 cents on the dollar). At Citi (C), some $16.8 bn or so of its CDOs come in the form of asset-backed commercial paper.

Deutsche Bank says a future writedown at Citi could amount to $7 bn or more, stemming from marks taken to its remaining CDO portfolio as well as its monoline exposure. Goldman Sachs says the writedown could be twice as large.

Doubtful, as a $16 bn writedown would be the equivalent of aiming a huge howitzer right at its engine room, something Citi knows its stock can't afford as was trending toward Time Warner (TWX) levels. Watch Citi, as well as other banks and investment houses, take the writedowns piecemeal, given the wiggle room in the accounting rules.

Also, my read of it is that Citi's CDO portfolio may have protections built in that Merrill's portfolio did not have. And about 80% or more of these Citi CDOs date from 2003 to 2005, when lenders hopefully were more circumspect about who walked in the door. Loans from 2005 seem to be closer to the end of defaults than those made in 2007. Default rates on 2007 loans continue to inexorably rise.

Citi chief financial officer Gary Crittenden says the bank is comfortable valuing this portfolio at 62 cents on the dollar.  We shall see.

Check out the news just in that Ambac, the bond insurer, ripped up credit default swaps (CDS) with Citigroup on a $1.4 bn slug of CDOs. Ambac (ABK) is saying it is marking the bonds down to about 29 cents on the dollar, setting aside $1 bn in cookie jar reserves to deal with this markdown. Reports indicate that Citi agreed to slash the price of tearing up the CDS to $850 mn, creating a $150 mn gain for Ambac. One analyst notes that if Citi has the bonds marked lower than $550 mn, or if they sell them for less than $550 mn, they will take a loss on the net position. 

Remember, Merrill Lynch did a similar CDS tear up with bond insurer Security Capital Assurance when it booked its recent massive writedown.  

All of a piece with Wall Street's very expensive freelance experiment helping the government's stated goal of 100% homeownership in this country-expensive being an understatement, as the housing bubble hiked the homeownership rate to, yawn, 69% from 64% at the start of this recent mania. Banks have lost about $480 bn since the start of the crisis last year, having replaced $345 bn of that sum with new capital, says Bianco Research.