Merrill relief another illusion in hall of mirrors ?

By Pedro Nicolaci da Costa - Analysis

NEW YORK (Reuters) - U.S. bank stocks may be staging another suckers' rally.

The launchpad for this week's recovery in financial sector shares was another huge $5.7 billion writedown from Merrill Lynch MER.N, which was swiftly followed by what is fast becoming Wall Street's motto in the year-long credit crisis: the worst is over.

Not so fast, say skeptics, who argue that Merrill's announcement actually contains the seeds of another downturn in the credit markets.

Nouriel Roubini, whose long-time view that the U.S. economy was headed for trouble has been vindicated by slumping house prices and rising defaults on mortgages, says the devil is in the collateralized debt obligations which are often backed by mortgage debt.

In particular, he argues that the fact that Merrill was forced to finance three quarters of the sale of $30.6 billion of its collateralized debt obligations, or CDOs, means that the securities are worth even less than the depressed value they garnered in the transaction.

"That implies that these CDOs are worth much less than 22 cents of the dollar," said Roubini. "The true market value of this garbage is closer to zero."

In the latest twist in financial engineering, Merrill actually used the toxic securities it had been unable to offload as collateral in the transaction with distressed debt investor Lone Star, so the bank is still on the hook for possible losses, analysts said.

In addition, Merrill's attempt to raise capital via a $900 million stock sale to Singaporean sovereign wealth fund Temasek, also came with a caveat of its own: the investment bank will give the Temasek a rebate of $2.5 billion on an earlier $4.4 billion share purchase.