Piercing the Securitization

Wells Fargo is cursing the day it agreed to act as trustee on the Tropic and the Soloso TruPS CDO series...

For those not following, TPG found a loophole in the deal docs which allows it to cherry pick assets directly out of the CDO's portfolio, at ridiculously discounted prices, if 66.66+% of the CDO’s equity agrees to it.

TPG aims to secure the equity’s vote by paying them a consent fee* – obviously, this is bad for all the rated notes (who were hoping for par or at the very least a real market price).

* bribe

Read more here.

Tropic IV CDO Ltd.'s equity has voted. No surprise there, the equity went with yes.

Whether or not to execute, on the equity’s yes, is now Wells Fargo’s call - this leaves them in a bit of an awkward position: (1) accept and get sued by the rated notes, (2) reject and get sued by the equity.

This past Monday, Wells Fargo turned to a higher power, the United States District Court Southern District of New York, to protect itself against/resolve the Tropic IV CDO Ltd. dispute and all related future disputes.

Only have a hard copy the Wells Fargo's interpleader complaint. Will update with a link soon.

The complaint discloses some of the participants involved in the Tropic IV CDO Ltd. dispute – see below.

The Imperfect Hedge

The outlook continues to be bleak for trust preferred securities CDOs (TruPS CDOs).

Not only does the FDIC continue to seize bank after bank, but the rate of bank failure continues to increase. By our calculations, using FDIC data, we moved from an annualized FDIC-insured institution default rate of 1.1% as of mid-year 2009 to 1.53% as of quarter-end September 31.

These default rates appear to be relatively mild versus say corporate bond default rates (which are well north of 10%); but we must remember that TruPS CDOs were structured based on the implied and historically-observed lower default rates of banks, due to their operating in a more heavily regulated environment. Thus, TruPS CDOs were able to be arranged with comparatively low levels of subordination, despite the low recovery rate on TruPS CDOs' deeply subordinated underlying asset class: trust preferred securities. In other words, built to protect against annualized default rates around 0.35%, TruPS CDOs find themselves ill-positioned to stomach the exponentially higher default rates.

Nor does it help that the FDIC might be incentivized to close all banks -- that is, including the well-capitalized banks -- if they operate under the same bank holding company umbrella. With the FDIC's deposit insurance fund running low, the FDIC's ability to exercise their cross-guarantee authority results in this unfortunate consequence for the better performing banks, as was the case with Citizens National Bank (Teague, TX) and Park National Bank (Chicago, IL) who were brought down along with FBOP. Both Citizens and Park National are considered "Average" performing banks by PF2's internal analysis, based on 6/30 call report data.

With bank default and deferral rates moving up, resulting in deal-wide decreases in "excess spread" levels, many TruPS CDOs have become increasingly sensitive to their interest rate hedges.

In our July 22 report we noted that:

"With TruPS CDOs already being pressured by the lack of interest generation by the defaulted and deferring securities they’re holding, the additional burden caused by the deals’ interest rate hedges is becoming increasingly torturous. TruPS CDOs usually have asset‐level swaps (although sometimes the swap has been implemented on the deal level) that exchange a pre‐negotiated fixed rate for LIBOR. With LIBOR being low, the cost of the swaps to the deal becomes tangible, on average accounting for 1.23% of the total deal portfolio size on an annual basis, or 1.45% of the performing deal size. (The median cost is 1.31% of total or 1.58% of the performing
balance.)"

These detrimental interest rate hedges -- almost always at the top of the waterfall BEFORE any payments are made even to the most senior rated notes -- are now coming under scrutiny by the rating agencies. For the first time (as far as we're aware)Moody's explained in a press release on Friday that the interest rate swap in Soloso2007-1 may negatively affect the performance of the original senior Aaa tranche, Class A-1L, prompting its downgrade to sub-investment grade (Ba1 rating). Emphasis added by us.

"Furthermore, due to the significant increase in the actual defaulted amount (an additional $17mm occurred this past month), the transaction is now negatively impacted by an unbalanced pay-fixed, receive-floating interest rate swap that results in payments to the hedge counterparty that absorb a large portion of the excess spreads in the deal. Today's actions therefore reflect that the burden of making hedge payment over the remaining life of this transaction will significantly reduce the amount of cash available to pay Class A-1L Notes and put interest payments of Class A-1L at significant risk."

Moral of the blog: beware of the hedge.

UPDATE November 3, 2009: We have received a press release from Moody's stating that a supermajority of equity noteholders in at least one TruPS CDO, Tropic CDO IV, have voted to allow the execution of a certain problematic loophole. You can read more about the loophole here, but here's a summary: the loophole allows a third party, subject to obtaining supermajority equity vote, to purchase assets directly out of the CDO's pool at the proposed and voted-upon price. The caveat is that the equity holders are pretty much out of the money at this point in TruPS CDO world, and so for a reasonable consent fee may reasonably be induced to vote in the affirmative, having (as far as we're aware) no fiduciary responsibility to protect noteholders senior to themselves. In the case of Tropic IV, the bidder was Trust Preferred Solutions LLC, which we understand to be a Minnesota vehicle of private equity firm Texas Pacific Group (TPG). Their bid was 5 cents on the dollar for what we believe were among the better preference shares in the portfolio.

Here follows an excerpt from Moody's press release that speaks to this situation:

"In a notice dated October 30, 2009, Wells Fargo Bank, N.A., trustee for Tropic CDO IV, stated that the holders in excess of 66 2/3% of the Preferred Shares directed the trustee to accept an offer to sell certain [securities] to a third party. This offer to purchase part of the transaction collateral at a substantial discount, if executed, will have a negative impact on the rated notes. The trustee has also stated that it intends to file an interpleader action requesting a judicial determination regarding how to proceed in respect of the offer. Today's rating action reflects the uncertainty surrounding the outcome of this proceeding and the potential negative impact from the Offer. Moody's is following the development of this situation closely."

"and yes I said yes I will Yes."

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”

OUR OPINION

Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.

Liquidity

Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.


Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Anatomy of a Recovery

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.

Rating Agency Legal Liability Standards

Here follows PF2 Director Mark Froeba's written response to one of Senator Bennett's follow-up questions from the August 5th hearing on "Examining Proposals to Enhance the Regulation of Credit Rating Agencies."

SENATOR BENNETT: As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive "strike" suits by trial lawyers. These suits benefitted no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995.

Is there any justification for now altering this standard just for credit rating agencies?


MARK FROEBA: Yes, there is ample justification for altering the pleading and liability standards just for the credit rating agencies. Here are three arguments in support of changing these standards.

First, the major rating agencies have enjoyed the privilege of a government-sponsored monopoly for many years. In order to reduce the negative consequences of this monopoly, the government also encouraged competition among the agencies. There is overwhelming circumstantial evidence that the agencies responded by competing with each other not on price or efficiency or productivity or quality but, instead, on rating standards, revising rating methodologies and standards whenever necessary to build or maintain market share and revenue. Changing pleading and liability standards for the agencies would provide a key restraint should rating standards ever again end up in competitive free fall. Fear of liability will curb the appetite for market share, dampen the negative effects of competition, improve rating quality and, thereby, ultimately make lawsuits less necessary. The rating agencies, in exchange for continuing to enjoy the privilege of a government-sponsored monopoly, should be subjected to easier pleading and liability standards at least where litigants claim that bad ratings have injured them.

Second, when the rating agencies generate bad credit opinions, they have nothing at risk except their reputations. Other market participants involved in the transactions that failed in the subprime crisis, eg, investment banks, investors and collateral managers, all had some financial stake in these transactions. When these participants got it wrong, they were punished by financial losses, in some cases even to the point of bankruptcy. Having a significant financial risk is enough to warrant separate pleading and liability standards for these market participants. If reputation risk alone once provided the rating agencies with the same kind of incentives as financial risk, Enron taught them a new lesson. The bankruptcy of Enron within only days of losing its investment-grade ratings did severe damage to the reputation of the agencies but did little to hurt their business. In the aftermath of Enron, the rating agencies enjoyed some of their most profitable years ever. Thus, fear of reputation damage after Enron did nothing to check the ratings that caused the subprime crisis. It would be very difficult now to overstate the damage that the subprime crisis has done to the reputation of the rating agencies. If they all survive the current crisis unscathed – as seems almost certain -- they will be taught a lesson very dangerous to the world financial system: no matter how bad their ratings, no matter how damaged their reputations, they will not fail and the rating business will not go away because there is nowhere else for it to go. Without incentives that are far more potent than reputation risk, we cannot expect the rating agencies to reform themselves and impose greater quality and accuracy on their ratings.

Third, the rating agencies have long enjoyed near complete immunity from liability for bad ratings. This immunity is based upon an old line of cases that found the rating business -- assigning and reporting ratings – to be a form of journalism subject to free speech protections. More than forty years ago, this finding had some merit. The rating agencies assigned ratings to bonds and then reported all of their ratings in periodicals sold to subscriber/investors. Bond issuers paid the rating agencies nothing. However, the rating agencies largely abandoned this model forty years ago. The new model shifts the cost of the rating from subscriber/investors (eager for the most accurate rating) to bond issuers (eager for the highest rating). It is easy to see how the new model changed the rating agencies’ incentives. It is also difficult to imagine how real journalism could make a similar business-model switch. (It would be as if each newspaper story were commissioned by the subject of the story, based solely upon facts submitted by the subject, and published only upon the subject’s approval of the story and payment of a fee for its writing and publication.) Eventually, the courts will discover that the credit rating business is no longer anything like a form of journalism and should not be entitled to free speech protections. This will not happen overnight and may be a long and expensive process. In the meantime, the financial markets need help restoring their confidence in the quality and integrity of credit ratings assigned today. Changing the pleading and liability standards just for the agencies is an important first step in this process.

Rating Agencies: The More the Moroser

It turns out I couldn't find a better antonym for "merrier" than "moroser."

But it is a grave and serious (both suggested antonyms) issue we're approaching today: the regulators' and market participants' aim to foster competition in the credit rating agency market. Just yesterday, various market participants and reporters expressed great delight at the NAIC's ruling to allow Realpoint LLC to rate portfolios of commercial mortgage-backed securities. (Separately, the NAIC is purportedly considering the viability of creating their own, not-for-profit rating agency.)

While we don't have anything whatsoever against Realpoint -- and while we certainly support the need for reform -- we would want regulators to tread this path carefully to avoid the creation of too many new credit rating agencies (CRAs or "NRSROs"). Remember, it was ratings competition that encouraged the decline in ratings quality in the first place, as the CRAs competed to win and maintain market share and revenue by altering their ratings standards.

We are not alone in this opinion. A former rating agency managing director submitted the following in prepared testimony to the House Oversight and Government Reform Committee:

“Senior management [at Moody's] still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten policies.” - Eric Kolchinsky

Competition as a concept is not necessarily a bad thing: for one it serves to bring down prices. We are not saying the "Big Three" CRA oligopoly should remain status quo. Nor are we saying that there should be a Big Three nor that it need remain Moody's, S&P and Fitch who comprise the Big Three. But we are saying that CRAs are not like hedge funds. Having three or five or ten accurate CRAs is worth a whole lot more than having 30 CRAs, irrespective of whether those 30 are accurate.

Why?

First, the recent years since Enron's failure have shown that regulating the CRAs is no mean feat. (Indeed the reforms proposed then were ineffective in buffering against this financial crisis.) It's going to be much more difficult to regulate an army of CRAs with different methodologies than to regulate only the currently existing ones. The SEC's website indicates that at least ten CRAs have already been granted NRSRO status.

Second, the creation of additional NRSROs places additional burden on the investor, who now has to familiarize herself with the slew of new methodologies.

Third, the CRAs were never competing on ratings cost anyway - they're competing on ratings standards (and historical performance to a limited degree). In other words, the less conservative approach might achieve a higher rating and win business. Now there will be more approaches to choose from. Thus, the availability of several alternatives only increases the problem of "ratings shopping," as issuers and structurers cast a wider net to achieve their ideal mix of (i) ratings quality/timeliness/service, (ii) ratings cost and (iii) minimal subordination level required to reach their target rating, in the case of structured finance securities. In the worst case scenario, thus, the rating chosen by the issuer, which typically seeks the highest rating, will be the most lenient measure available from the numerous CRAs. But this does nothing for the investor, who is usually best served by the most accurate rating. And the rating agencies are, after all, an investors service.

Fourth, the CRAs better fit the mould of regulator than that of market participant (buyer/seller). This financial crisis has brought upon us the realization that often having too many regulators can cause a problem: in the U.K. there is talk of the absorption of the FSA; in the U.S. the independent functionings of the OCC, OTS, and FDIC has resulted in various discussions -- especially with regional and community banks being able to swiftly switch between regulators -- which may result in one or more of them being folded into the SEC or the Fed, bodies proposing to take on further responsibilities going forward. Perhaps, then, we should be keeping tighter reins on the CRAs too and rather working towards creating fewer, manageable NRSROs with more meaningful responsibilities.

- PF2

Step 1: Rating Agency Reform

Anybody who’s seen the movie Charlie Wilson’s War will appreciate the fact that signs of economic improvement doesn’t mean we can take our foot off the peddle.

The film describes Charlie’s (ultimately successful) efforts in leading Congress to support Operation Cyclone, the largest-ever CIA covert operation, which supplied weapons to the Mujahideen during the Soviet war in Afghanistan. But the movie ends on a somber note, citing the U.S.’s premature exit in the epitaph to the film:

“These things happened. They were glorious and they changed the world ... and then we f----d up the endgame.” – Charlie Wilson

(The result: the Mujahideen eventually flowered into the Taliban and backed Osama bin Laden's war against the U.S.)

Our situation is hopefully not as drastic, but the point remains: even if we feel we have survived the crisis -- and that unemployment and default rates are leveling off -- we still need to implement the necessary reform measures to avoid the creation of a different monster in future.

With this in mind, we’ve put out our first paper on rating agency reform. The piece ends:

“The ultimate objective of this reform is to encourage financial market transparency and responsibility, from which liquidity will inevitably follow.”

Read it; criticize it; share your thoughts.

- PF2