Monday, December 22, 2008

Reclassifying from Available-For-Sale to Hold-To-Maturity

Back in September Asset-Backed Alert put out an article describing how various banks (Zions Bancorp, National Penn and others) have rearranged their CDO holdings, reclassifying certain CDOs, previously held as available-for-sale (AFS), into hold-to-maturity (HTM) accounts.

Some background musings relating to yesterday's Financial Times article about IASB, and possibly FASB's adoption of dual AFS and HTM measurements:

This reclassification allows banks to avoid FASB 157-esqe "fair value" accounting, and employ an "amortized cost" (think, "intrinsic") analysis rather than marking to (a rather volatile) market.

The International Accounting Standards Board (IASB) and FASB have been in heavy communication about fair value accounting for a while now, with the hope of maintaining cross-Atlantic consistency. Thus far, FASB has been the stronger proponent of fair value measurement, with IASB allowing for greater leniency and maneuverability.

Some more recent examples:
- Citigroup plans to reclassify approximately $80bn of assets (likely to dampen the effect of further writedowns at year-end)
- IAS 39 reclassifications: see Deutsche Bank's and Unicredit's Q3 2008 earnings conference calls of Oct. 30 and Nov. 11, respectively

These principles present various challenges, including the ability to recognize and appreciate the likelihood of an asset's impairment, and whether it's other-than-temporarily-impaired (OTTI) as a result of market conditions.

But let's consider the crucial item here: irrespective of whether they're impaired assets, why not take the writedown today, even if its not a fundamental, permanent writedown? The sooner the banking system licks its wounds and returns to profitability, the better, and from a macro-perspective the sooner we can shrug the burden of losses the sooner we can return to a functioning, profitable financial market.

TARP has provided the banks with the liquidity to stomach the loss now, but it looks like CEOs (and perhaps FASB and IASB) are allowing the short-sightedness to continue and, with it, prolonging the pain.

Wednesday, December 10, 2008

Opal CDO/Structured Products Summit

We came down to sunny southern California for the Opal Financial Group Summit which ended yesterday and thought we'd relay some of what was spoken about.

To be fair, despite the lush greens of the Dana Point resort town, the attendees were rather bleak about what the future holds, in terms of the resurrection of the structured finance market in general, the calling of the "bottom," expected future recovery rates, and the foreseeable issuance (or lack thereof) of new issues to the market in general and particularly relating to residential and bank loans.

Across the board, panelists expressed their views that 2009 would be a very tough year. Wide-spread pessimism as to the leveraged loan recovery rate future relative to other historically difficult times, with Four Corners' Michael McAdams being the notable exception, expecting 1st lien recoveries above the 50s to low 60s region, particularly for good managers who are able to hold on to the loan for a while post default.

On the economic side of things, from the panels and from discussions we had with market participants, almost nobody was confident in the government's effectuation of the Troubled Assets Relief Program (TARP) and almost everyone was opposed to the automakers' bailout. There was less talk about the covered bond market alternative to securitization than we would have expected ... perhaps alternative lending forms and mechanisms are in developmental stages behind the scenes to repaint the unfairly blemished face of the securitization industry. We'll share our views on the covered bond market shortly.

To end on a positive note, traders were seeing increasing trading levels over the last month, and expect this to continue through year-end at last, as (often newly-funded) opportunistic and distressed funds have begun to put their capital to work.

Is this a (permanent or temporary/false) bottoming with technicals matching fundamentals, or simply an end-of-year rebalancing and maneuvering of balance sheet assets and liabilities for fiscal year-end accounting and audit purposes?

Monday, December 1, 2008

Deleveraging by Leveraged Funds-of-funds

The calling of Allianz’s EUR300 million Phenix CFO -- purportedly the first to be liquidated -- augurs poorly for the hedge fund industry, adding a further redemption burden to their tally of existing difficulties: staving off general investor fear and redemption requests; reserving against price markdowns and margin/haircut postings; deleveraging in a difficult market; establishing new and maintaining current sources of funding; combating higher funding costs; complying with increased accounting and regulatory demands; mitigating against rating agency downgrades; ...

And now a new source of redemption requests - by CFOs

CFOs -- collateralized fund obligations -- are essentially leveraged bets against the performance of a (oftentimes managed) portfolio of hedge funds. As is the case with CDOs, investors in CFOs go "long" the performance of a set of receivables (usually from debt). For CBOs, these receivables are the coupons of bonds (hence the "B" in CBO). For CLOs, loans. For ABS CDOs, the underlying are ABS (really, RMBS) tranches. For CFOs, the return of the funds, with the underlying typically comprising direct purchases in hedge funds or referenced exposures via total return swaps.

CFOs differ from typical CDOs in a few ways (e.g., similar to market-value CDOs, overcollateralization tests measure market value coverage - as opposed to par/principal coverage; there's no real notion of interest coverage ratios; existence of minimum net worth tests with various curing and/or liquidation procedures, such as the issuance of additional preference shares).

In the case of Phenix CFO, according to Bloomberg, more than 75 of the 80 hedge funds invested in by the structure have either liquidated or limited (or completely suspended) client withdrawals from their funds. With this in mind, Phenix's bondholders voted to liquidate the deal.

This notification, which came out on Friday, ends a tough month for hedge funds and banks in general, as can be seen from the graph below (click on it to enlarge).

UPDATE - February 2, 2009: Fitch Ratings Announcement

To address short-term volatility in CFO performance as well as reporting delays from underlying hedge fund investments, Fitch's [newly updated] analysis applies a 10% haircut upfront to the most recent reported portfolio NAV. The 10% haircut was derived using the worst monthly return decline reported by Fitch-rated CFOs.


Hedge fund returns, as represented by several multi-strategy indices, declined approximately 20 to 25% in 2H 2008. As well, Fitch has observed reductions to hedge fund CFO liquidity (including gating, restructuring, side pockets) in a range of approximately 5% to 40% of net asset value(NAV) in fourth-quarter 2008.

Interestingly, this final paragraph bring us back to our October '08 piece (Jack of All Trades?), highlighting the underperformance of multi-strategy hedge funds.

UPDATE - March 26, 2009: Moody's downgrades all tranches issued by SVG Diamond Private Equity II. SVG is a CDO somewhat similar to CFOs, but is backed by returns to shares of (principally) private equity (PE) funds, as opposed to a diversified pool of hedge funds.

Thursday, November 20, 2008

Unequal Hedge Fund Disclosure - How "Fair Value" May Become Unfair

The Problem

All hedge fund disclosures are equal, but some investors apparently have more equal transparency than others.

Perhaps, for a tough sale, a hedge fund manager may be inclined to show certain procedural documents to a certain investor, while the less inquisitive investor may not be privy to the same information. That's just a guess, but whatever the case may be, let's call this situation "Preferential Treatment."

For example, fund-of-funds ABC knows that hedge fund HF would exit strategy STR if situation XYZ occurs. Suppose fund-of-funds DEF doesn't isn't privy to this exit strategy.

An Accident Waiting to Happen

From a fair value perspective, should ABC's investment in HF be accounted for equally with DEF's investment?

I would argue they're not equal, even though the HF's NAV is obviously the same for both funds-of-funds. ABC clearly has optionality that DEF lacks. Knowledge of HF's procedures gives ABC the option to either invest more or redeem, as it may see fit, whereas DEF is unaware of any changes. For the financial engineers out there, you all know that options cost money. ABC is long an additional option in this example, and so ABC's investment in HF should be greater than or equal to that of DEF.

Similarly, as an investor, knowing about your hedge fund's side pockets or ability to ring-fence part of its portfolio is crucial knowledge, as it affects your "redeemability."

Whereas the imposition of gates is highly publicized, the usage of side pockets is not well publicized: GLG Partners, and to an extent JB Global Rates Hedge Fund, being notable exceptions (see, for example Side Pockets - Keeping Hedge Fund Capital in Their Pockets).

A Litigation Disaster

Here's how this all went wrong for some firms (including Bear Stearns), according to certain excerpts from the SEC's: "Lessons Learned from Significant Examination Findings and Recent Enforcement Actions."


November 13, 2008


DELMAGE: ... we've seen situations where firms have failed to consistently apply these redemption policies.

Again, this is primarily in private funds. As everyone's well aware, firms have opposed gates. They've curtailed other abilities for people to extract liquidity from their underlying investments.

And again it comes out to disclosure. The [SEC] staff is gonna be looking at what's in the private offering documents, what's in the marketing materials, what's been in the ADV regarding the process for handling redemptions.

Timing, you know -- when certain times, certain dates, how much notice people need to give before they want their -- get their redemption proceeds -- and I guess, as part of that, one thing we will be looking at is to make sure there is no preferential treatment. Obviously, one of our concerns is, you know, maybe in days leading up to the announcement of the gate being imposed -- certainly the insiders of the investment advisor or maybe larger investors who have
a sizable stake in -- in the underlying funds -- are allowed to get their money out on different terms than other investors before the gates have been imposed.

And we've actually been seeing that in a number of examinations where, in this situation, the firm didn't impose the gate but they created a side pocket for a pretty sizable portion of the portfolio and had informed investors, and I believe they actually had sent out notice and people agreed to it, that they would be able only to redeem from the liquid portion of their investments up to a certain percentage.

And what we actually had seen -- looking at journals, e-mails again -- we had seen, you know, certain investors being able to redeem 100 percent of their investment. We had seen -- or saw situations where redemption requires had been backdated to certain investors.

Again, in certain situations, certain funds, depending on their asset class, have suffered some liquidity problems. There were other funds that didn't have that same problem and it appeared that the more liquid fund was funding the illiquid fund's redemption request; again, not disclosed to investors, nowhere in the offering documents.

... I think the lesson to be learned is, obviously, when the [SEC] staff sees a fund -- has imposed gates or somehow curtailed liquidity -- we are going to be looking at the disclosure documents. We're gonna be looking at how redemption requests have been handled, especially the period leading up to the announcement of that event.

... obviously, you have a fiduciary duty -- giving people preferential treatment, you know -- engaging in practices, you know -- backdating and other things, obviously, does not meet that test.

CHRETIEN-DAR: Just to emphasize Bill's point about preferential redemption not only is that a problem, in terms of your fiduciary obligation to your clients, but your insider [trading] procedures probably should be affected by this type of activity. There were -- in private litigation -- we saw that there were shareholders in the reserve fund made claims of inside information, in that some investors got out before the money markets fund broke the buck.

So there were a lot of private claims about insider training. The commission brought an action against the two portfolio managers of the Bear Stern hedge funds that invested in subprime-related securities.

And redemptions were also a big issue in that case, not only in terms of the commission's allegations regarding the representations on the status of redemptions, which was important to investors to know about, but on the criminal side there were allegations that the portfolio manager pulled out of the fund as he was reassuring investors about the fund.

So not only is it, you know, what you tell your investors, in terms of the status of redemptions, but also what you were doing with your own stake in those funds. Bear, apparently, had a policy at the time that portfolio managers in the funds that they mentioned should have a personal stake.

Thursday, November 13, 2008

1 in 5 Americans 60+ Days Delinquent

J.P.Morgan came out with their September 2008 Home Price Update. The report shows the national average 60+ delinquency rate at a whopping 17.24%. Florida leads the numbers with 28.76% of borrowers 60+ delinquent (Michigan is next in line with 24.55%).

We graphed the state-by-state distribution of these delinquencies:

(Click on the graph to enlarge)

Wednesday, November 12, 2008

An Investor's Guide to Hedge Fund Leverage (Part 1)

Leverage (more specifically deleveraging) difficulties have caused more than their fair share of pain of late in the hedge fund world.

We're going to explore the concept of leverage by way of an example for now; let's suppose:
  1. we're in a simple world (let's call it Wonderland) in which the price of a bond or a loan remains constant at $100 per $100 of par;
  2. managers can only buy (go long) assets, and no naked shorting is allowed;
  3. AA bonds carry coupons of LIBOR + 90 basis points (i.e., L + 0.9%); and
  4. A bonds carry coupons of LIBOR + 125 bps (i.e., L + 1.25%).
Imagine these bonds are fairly illiquid and so the manager's strategy is to buy them and hold them to maturity. Assuming zero defaults, the manager who buys AA bonds will earn L + 90 bps on his/her investment, while the manager who took on more risk with single A bonds will earn L + 125bps.

Let's put aside our feelings about whether LIBOR + 1% or so is a "good" return. One thing we know for certain: unless LIBOR goes crazy and hits the 29% mark, your hedge fund is never going to earn 30% annually by simply buying and holding bonds, even if there are never any defaults. We're not going to invest in a hedge fund that targets L + 1%; to compensate for the limited upside potential of bonds/loans, relative to equity, fixed-income hedge fund managers need a little more zip. To "hit" the big numbers (assuming no shorting for now), they need leverage.

Leverage can be "achieved" in various forms, such as total return swaps and repurchase agreements ("repos"); for now let's examine the essence of the mechanism.

Suppose hedge fund HARRY has $10mm of capital and wishes to buy a $10mm position in that AA bond paying L + 90 bps. HARRY could buy it, after which HARRY is fully invested and yielding L+ 0.90%.

HARRY enters an agreement with bank that wants to sell HARRY the bond. The agreement says that bank will LEND HARRY $10mm to buy the bond, subject to the following conditions:
  1. HARRY must post the purchased bond to the bank as collateral for the loan;
  2. HARRY must pay bank LIBOR + 10 bps on the loan, as long as it's outstanding; and
  3. HARRY must post 5% haircut against the AA-rated collateral (to mitigate the bank's risk that the collateral defaults or depreciates in value).
Summary: HARRY's collects L+90 on this bond, pays L+10 to the bank, and has to put down $500K capital (5%) as haircut. Thus, he captures L+ 90- (L+10) = 80 bps on this transaction (of size $10mm). Since he's posting 5% haircut, he can logistically (we're still in Wonderland) perform this operation 20 times (20 x $500K = $10mm = HARRY's total capital). In so doing, he's making:

20 x 80bps x $10mm = a handy 16% return p.a. on capital

Some market terminology for you:
  • HARRY is 20 times levered;
  • HARRY manages $10mm capital, but has $ 200mm of assets under management (AUM);
  • The bank's lending rate to the hedge fund is often termed the "Pricing Rate"; and
  • The "haircut" described may also be referred to as initial margin, but bear with me here - we haven't yet breached the topic of "variation margin."
The better the collateral quality, the lower the haircut. Using a 1% haircut in the above example, would allow HARRY to lever up 100 times in Wonderland. Municipal bonds -- historically typically AAA rated and often insured -- are an example of collateral that could be highly leveraged on the back of this strong credit quality.

Now let's have a look at some actual (slightly historical) numbers, while remaining for a while in Wonderland...

(Click on the table to enlarge it)

This concludes Part 1. Part 2 will follow shortly, and will discuss, among other things:

  • deleveraging, and its effects
  • variation margin - and what happens with 2008 numbers
  • leverage facilities: diversification, termination
  • and possibly, the cases of Bear Stearns Asset Management (and Merrill Lynch), and the municipal arbitrage deleveraging nightmare

Monday, November 10, 2008

The Bankruptcy Burden

We're not economists, and certainly not of the Chris Flanagan/Mark Zandi ilk, but thought we'd give it a bash for a change and share with you all some of our thoughts on the October bankruptcy filings, which were up a troubling 13% from September for the US as a whole.

(Click on the graph to enlarge)

While an increase is understandable -- if not expected -- the rate of increase (i.e., the convexity) is disturbing.

As is typical, the lion's share (+- 95%) of these are non-commercial and heavily concentrated (99%) among chapters 7 and 13 of the bankruptcy code, although the distribution differs vastly from state to state (see table below).

We know October was a tough month for fixed-income, and by extension for banks and hedge funds, but the pain here remains non-commercial (think residential homeowners with little equity in their houses, in areas exhibiting strong home price depreciation).

(Click on the table to enlarge it)

We found this to be largely consistent with's Dismal Scientist's analysis of recessionary vs. at risk states from last month (the top 5 are all in red, and the bottom 5 -- aside from Mississippi -- are all in orange, for now.)

We'll keep you posted on changes as the commercial real estate difficulties start to take their toll on corporate sustainability.

Thursday, November 6, 2008

Back to the (Hedge Fund) Future

So the hedge funds are struggling.

Name the fund, pick the strategy; it's struggling. It doesn't matter if you're an academic playing the curve (Myron Scholes' Platinum Grove) or a contrarian macro-fund manager (Peter Thiel's Clarium).

Don't get me wrong here - I'm not suggesting all hedge funds are equal. Indeed some are more equal than others. The access to funding and execution resources may be material differences (although these funds often tend to be more highly leveraged on the back of their support system, and in this deleveraging nightmare are subsequently underperforming their peers despite the availability of this backing - see for example Highbridge Capital, Goldman's Global Alpha, UBS's Dillon Read, and various Citigroup hedge funds).

And despite all the blah blah about 2 & 20 fees being problematic, let's face it - it's not the fees causing 20%, 50% or 80% losses. And it's not regulation either: almost by definition, hedge funds are not having to mark-to-market (MtM) their illiquid/hard-to-value securities. (I'm not strictly correct here, particularly for Och-Ziff, Blackstone and Fortress, which are publicly traded.)

So what is it?

If you're a hedge fund, you're net long; if you're trading OTC securities, you're subjected to comparatively massive bid-offer spreads; and if you're levered, you're dependant on the banks for financing.

What does this all mean?

As a hedge fund you've got capital and you're being paid to put that capital to work. Even if you're long/short equity, you're typically net long at least the same amount as your capital, unless you're holding substantial portions in cash. As an investor in a hedge fund, you don't want your manager charging you hedge fund fees to invest in cash. You can do that yourself. For free.

In a down-cycle, the equity hedge fund manager would have to be a pretty impressive stock picker and seller just to cut even. It's tough to be consistently correct, especially in a fear-driven, volatile market.

But it's the fixed-income hedge funds that have to deal with large bid-offer spreads on OTC-traded securities to cover the market's illiquidity premium/discount and the intermediary's (bank's/broker's) risk that it can't off-load the security and may become subjected to downside MtM pricing risk. You have to be pretty good just to come out even.

And then there's that little issue of leverage. With hedge funds going under all over the place, the banks are understandably being ultra careful about who they lend to (not to mention spending extraordinary amounts of time reverse-engineering the value of their clients' portfolios, to get a better idea of any pending client defaults). If you're looking like defaulting, your haircuts are going to go out of the roof and/or they may draw their line completely. So your hedge fund's default probability -- or more accurately your leverage providers' perceptions of your default probability -- adds an additional burden to the deleveraging nightmare (see our piece Illiquidity: Self-perpetuating Phenomenon). But a blog on this will have to wait for another day...

Where to from here?

We can't pretend to have all the answers; let's call these guesses for now:

Similar to the increased regulatory demands Goldman and Morgan now face as bank holding companies (subject to the Fed), hedge funds are suffering from increased scrutiny and, with it, criticism of their investments and operations - not to mention decreasing investor confidence and redemptions skittishness.

(Even New York City Mayor Michael Bloomberg endorsed the U.S. Treasury's recent recommendation of a new "market stability regulator," that would be able to step in when markets got out of control, having oversight over firms that generally escape regulation, like hedge funds and private equity firms.)

In the absence of "free reign" we envision the natural progression (particularly among the larger hedge funds) towards advisory or asset-management-esqe businesses (think PIMCO, Blackrock): the move away from bank dependency to the unleveraged world of asset management seems an appealing option; alternatively, the move into the advisory space is quite cheap and relatively swift a process, especially as they already have the expertise in-house.

Monday, November 3, 2008

Illiquidity: Self-perpetuating Phenomenon

This relates to our earlier piece Jack of All Trades which talks about why multi-strategy hedge funds are amongst the worst performing hedge funds, in this down-cycle. With the help of some UBS research we read a while ago, we've put together a chart describing the downward spirals we're seeing at high-yield companies and -- more particularly -- hedge funds.

It is downward spirals such as these that bring down leveraged hedge funds like LTCM, and highly-levered companies like Lehman and Bear Stearns, and which keep the SEC and insurance Superintendent Eric Dinallo busy chasing down any market participants who spread false rumors that may initiate or perpetuate such a cycle.

(Click on it to enlarge the graph)

On the corporate side, the difficult market conditions manifest themselves in a re-pricing of credit risk across the board. Corporate debt and equity suffer with the onset of illiquidity. (The more illiquid the asset, the higher its illiquidity "premium" to the discount margin, the lower its price.) The general widening of credit spreads translate into a higher cost of funding for the company, which, coupled with the limited access to funding (debt/equity), may encourage rating-agency downgrades, as the corporation's default probability is increased. Downgrades, then, further decrease the value of the company's debt/equity, increase the cost of funding, and so the vicious cycle perpetually fulfills itself.

For leveraged funds, the self-perpetuating tendencies are more acute; with price deterioration, leveraged funds are typically forced to post additional variation margin (often one-for-one, as the collateral backing their funding is worth less). Obtaining additional cash to post as margin may require the highly levered fund to sell assets ("forced sale").

(As an aside, when forced-sales are occuring en masse in the market, they cause the value of these assets to decrease, as investors can wait for opportune moments to buy assets, at a discount, from forced sellers.)

Once you're a forced seller, you become an increasingly likely default possibility, and so your lender will likely raise haircuts, which causes further forced selling (deleveraging), price deterioration, margin calls, &c.

Friday, October 31, 2008

Systemic Risk in the Sovereign Air

Larger-than-life market-perceptions of systemic risk have blown sovereign debt wider and their credit default swap (CDS) levels to epic proportions.

With the US Treasury's 10-year CDS as wide as 40 bps (i.e., 0.4%) -- a 40-fold since early 2007 -- we're being forced to re-evaluate just what is meant by the "risk-free" rate of return (which is traditionally the UST, in fixed-income world).

According to the following chart (click on it to enlarge), perhaps 27 bps should be the minimum credit-related risk-adjustment used in conjunction with discounting by by the "new" risk free rate...
(1 basis point (bp) = 0.01%. In other words, the seller of protection earns a 0.4% annual premium on US debt, versus a 39.5% annual premium on Argentina; but beware that shorting the CDS will require you to post wicked amounts of margin given the volatility.)

Remember: A country's default probability is a measure of both its ability and its willingness to pay its debt.

Wednesday, October 29, 2008

Jack of All Trades?

We are brought up with the mantra that, while substantially limiting the upside, diversification saves us on the downside. Being by nature (partly subconsciously) risk-averse we tend to diversify endlessly, protecting against losing our dinner, even if it means a lesser chance of a royal dinner with the Queen.

Possibly true for the individual - not necessarily for the managed funds. Let's dig deeper...

Our investigations into recent hedge fund performance bring us back to our deliberations on whether diversification really is always such a good thing. (Remember, the monolines, in an attempt to diversify their portfolios, moved away from being purely muni-bond insurers, and were stung by their participation in the structured finance market. See Muni Bond Insurance (for the short term) for more on this.)

This chart (click on it to enlarge) shows us that multi-strategy hedge funds are among the worst performing in the down cycle.

Some thoughts and possible explanations/justifications:
(1) Multi-strategy funds tend to be more highly leveraged on the back of this diversification (just like certain ABS, CDOs)
(2) As you have more strategies under management, you may tend to lose asset-specific expertise
(3) Perhaps better managers like to keep it clean and simple...

Summary opinion: perhaps diversification is truly a good thing if it's not mis-used or mis-applied. If the diversified fund or portfolio is able to be more aggressively managed purely due to the benefits of diversification, the plain vanilla option, often cheaper, may just become more enticing.

Friday, October 24, 2008

Overnight Madness

Aside from the well-publicized widening and volatility in both the issuer-based and asset-backed commercial paper markets -- which until recently moved in tandem with the Fed Funds rate -- we're noticing an increased market interest in the short-term rating of the issuance. And this "tiering" is not limited to term-funding, but has infiltrated the overnight lending market. As always, a picture says a thousand words:

(Click on the graph to enlarge)

Volvo's Slowing Demand

From Bloomberg News: Volvo Cuts Truck Market Outlook After Demand Slumps

Kind of a random post for this blog but these numbers are just insane...
The Gothenburg, Sweden-based company won just 115 European orders in the third quarter, down from 41,970 a year earlier
Volvo has cut production at two European factories and is eliminating 1,400 jobs at its truck division in response to slowing demand.

That's a 99.73% drop folks (and this number is likely to go up as cancellations line up) - Not sure I would refer to this as "slowing demand" at this point...

Thursday, October 23, 2008

The Luxuries of a Covenant Light Lifestyle

Blackstone president and COO Tony James wrote a piece for the Financial Times this morning touting covenant light loans as a "positive development," allowing companies "the flexibility to work through their problems and, thus, help maximise total enterprise value."

When a business hits a downturn, because of either poor management or external forces, you want the business to continue. An ongoing business has a far greater total enterprise value than one liquidating. Loans with strict covenants can destabilise an otherwise healthy company, when even a short recession over a few quarters might trigger defaults. The holders of the senior debt take action; cash flow stops to the junior debt, suppliers stop shipping, customers flee and employees lose jobs. The equity holders with little or no remaining stake in the business not only find it difficult to restore health to the business, but they have no economic incentive to do so.

Equally important is the value destruction that ensues when a company defaults. Creditors squabble and courts hold interminable hearings. In the meantime, the company drifts. The very worst time for a boat to lose its pilot is during a storm. But this is exactly what results from the traditional hair-trigger covenants that many see as the healthy formulation of leveraged capital structures.

All valid points, perhaps. But let's dig a little deeper...

Typically, the two pertinent loan covenants are incurrence and maintenance covenants. Incurrence covenants restrict the company's ability to issue debt (typically, senior to this loan - which makes sense, especially if you're the lender and wish to retain your level of seniority). Maintenance covenants describe (minimum) collateralization levels (think coverage ratios) that must be maintained to avoid the loan from being in default. When you speak of covenant light loans, you're primarily talking about loans who lack the maintenance covenant(s). The fewer the covenants, the lower the likelihood of default, and hence Mr. James' rosy article.

Now let's consider covenant light loans as a microcosm for today's environment. Everybody's long regulation. Regulation is king. The market has seen what happens without it, and decided that it prefers regulation. Let's examine the lack of restriction (as a metaphor for regulation) on covenant light loans. The covenants act as a means for the lender to involve itself (think govern or regulate) in the performance of the company if/when it fails to comply with its covenants. Among other things, the lender can extract additional spread from the failing company (as an alternative to enforcing default) or, upon default, the lender at least has a strong position at the negotiation table, as a senior secured lender, and since the only-recently-failing maintenance coverage ratio describes the company's ability to "cover" the loan, the lender often walks away whole, or at least close to whole.

In the absence of such a covenant, the lender has limited recourse until default. Granted that defaults are less likely, but once they occur, who is to say what the recovery rate may be?

In summary, if I'm borrowing, I'm long the additional flexibility (unless it costs much more); but as a lender, one has to expect that the severity of any defaults will be sharply higher than those having quality/coverage controls in place. This is the real downside that should be guarded against: lenders with large exposure to low-recourse, low-recovery loans which are or may defer interest or "pay-in-kind."

Wednesday, October 22, 2008

Pension Paradise

Here's a story from Professional Pensions we thought we'd relay without commenting on. We'll leave any judgments up to our readers (who may or may not be happy holders of pensions).

USS plans five-fold increase in alternative investments
Mark Selby

THE Universities Superannuation Scheme is set to increase its allocation to alternative investments.

The £29bn fund’s annual report revealed it is in the process of increasing its alternatives portfolio from 4% to 20% – investing in a mix of private equity, hedge funds and commodities.

USS saw its funding levels drop to 77% in March after rising to 98% in June 2007 using a gilts valuation measure.

USS head of alternatives Mike Powell said the aim of the alternatives portfolio was to deliver equity type returns but with lower risk.

He said: "In our view the recent turbulence in the hedge fund industry has provided USS with a great opportunity as a new entrant and will make USS a very attractive partner for hedge funds given our long term investment horizon.

"The fallout in the industry will also prove to be a great arbitrator of quality and skill amongst the huge number of hedge funds. The size of the allocation is not fixed and we allocate capital to where we see the best risk adjusted opportunities."

Wednesday, October 15, 2008

JPMorgan vs. Morgan Stanley

As an update to yesterday's piece, just to be fair to all parties involved, JPMorgan today stated they're newly bearish on AAA CLOs. Morgan Stanley yesterday described their bullish stance, saying that AAA CLOs could survive 10% CADR at 50% recovery rates. JPMorgan contend that widening is likely given the deep repressionary risk which will take its toll.

We'll keep you posted, but just a note that from an analytical perspective, unless (and this is a key "unless") the AAA tranches attaches (i.e., suffers any principal writedown), the value of the tranche will likely be higher for more severe default rate environments, as O/C trips will speed up payments to the AAAs. The shortened duration, then, improves the value when discount rates (DMs) -- as they are -- are higher than the promised coupon/spread on the tranche.

Tuesday, October 14, 2008

Are AAA CLOs "Safe?"

There's been a fair bit of structured finance research this month discussing, and mostly touting, the merits of investing in AAA CLO paper, which has been caught up in the generally widening market trend (currently trading around LIBOR + 475 bps).

For the most part, we expect the better cash CLO AAAs to avoid principal writedowns; generally, the underwriting standards for CLOs have improved over time, unlike their ABS CDO counterparts. Of course, the synthetic (LCDS) CDOs backed by senior secured loans (note: reference obligation is borrowed money) were not as fortunate. Many of these deals entered into an Event of Default upon Lehman's bankruptcy filing. See our prior pieces on Investigating the GIC and Eligible Investments for more on this.

For the leveraged/mark-to-market investor, we show a graph of the DM movement over the last 10 weeks -- based on just over 300 bid, offer and transactional data points since 07/31/08 -- and let you decide for yourself whether we're at the bottom:

(Click on it to enlarge the picture)

Tuesday, October 7, 2008

IOSCO's Call for Comments

The International Organization of Securities Commissions (IOSCO) put out this Consultation Report this morning -- with a request for comments -- on Best Practices for Funds of Hedge Funds. The comment period ends January 5, 2009.

This report develops their prior piece with respect to guidelines relating to (a) a fund of hedge funds' management of liquidity risk, and (b) their due diligence processes performed before and during the investment.

Thursday, October 2, 2008

A Parachute from the Past

With the troubled assets relief program (TARP) being omnipresent in the news these days, we thought we'd take you back to 1996 (based on CCA of 1990) Press Release.


PR-8-96 (2-6-96)

The FDIC Board of Directors today issued a final rule that, with certain exceptions, prohibits troubled holding companies, banks and thrifts from making "golden parachute" payments. These are typically large cash payments to executives who resign just before an institution is closed or sold. The regulation was issued under authority granted by the Crime Control Act of 1990.

The new rule also limits the ability of any holding company or FDIC-insured institution to pay the liabilities or legal expenses of an employee or director who is subject to an enforcement proceeding.

The statute permits the FDIC to prohibit or limit golden parachute and indemnification payments, but provides several exceptions, such as for qualified pension and retirement plans. Other exceptions have been added by the FDIC with the recognition that such payments have reasonable business purposes. The rule provides guidance to the industry on which payments are considered legitimate and which are considered abusive or improper.

The agency first proposed rules in this area in 1990, and then issued a second proposal for additional comment in March of last year. The final rule, which is similar to the 1995 proposal, becomes effective on April 1, 1996.

# # #

Congress created the Federal Deposit Insurance Corporation in 1933 to maintain public confidence in the nation's banking system. The FDIC insures deposits at the nation's 12,000 banks and savings associations and it promotes the safety and soundness of these institutions by identifying, monitoring and addressing risks to which they are exposed.

Monday, September 22, 2008

Investigating the Eligible Investments

In many ways connected to our earlier piece on "Investigating the GIC," Moody's downgraded various LCDO tranches underwritten by Lehman Brothers. As their name suggests, these CDOs are backed by loan credit default swaps (LCDS). With the underlying being by nature synthetic, funded issuance can be invested in "Eligible Investments," such as a GIC.

For these deals, proceeds of funded issuance was invested (either substantially or completely) in the Lehman Brothers ABS Enhanced LIBOR Fund, which according to Moody's, consists of -- or invested in -- a portfolio of highly-rated asset-backed securities. Moody's remarks confirm the suspicions we describe in our earlier piece on GICs: that the proceeds of liquidation may not be sufficient to repay in full the principal amount of the funded note tranches.

Those notes were downgraded by 3 to 6 rating subcategories across the board. We're admittedly surprised by the mildness of these downgrades, but they remain on watch for further downgrade, so stay tuned.

Wednesday, September 10, 2008

Structured Research Ratings

Institutional Investor published its survey results for top structured securities research firms of 2008,
with JPMorgan again taking the cake. Lehman Brothers and UBS follow closely in 2nd and 3rd respectively, with Citi a distant fourth. Credit Suisse and Merrill tied for fifth.

In the product-specific rankings, JPM held firm or improved in all of CMBS, CDOs, ARM and prepayment MBS research categories. On the CDO front, UBS's research, led by Doug Lucas, moved up into 2nd place from 3rd in 2007. JPMorgan's Chris Flanagan, Kedran Garrison and team retain top spot. For the rest of the breakdowns, see Institutional Investor.

Wednesday, September 3, 2008

Investigating the GIC

Came across this article on Creditflux this morning. Think you’ll find it (and our comments below) interesting:

Single-name spread widening biggest factor in CSO valuation declines, says Lehman Brothers
News Digest, 3 September 2008

In a recent research report, Dissecting the losses in synthetic CDO investments and their implications for the credit markets, Lehman Brothers researchers point out that marks on corporate synthetic CDOs continue to deteriorate. They say a valuation below 50% of par is quite possible even if the reference credit portfolio is relatively high in quality.
They take the hypothetical example of an August 2006 10-year double A rated CSO issued at par paying 100bp over Libor at issuance and with collateral invested in a monoline GIC. The deal is linked to a 4-5% tranche of a 100-name portfolio with an average rating of strong triple B and an average spread of 42bp.
They estimate the current value of that deal as 42 cents in the dollar. Most of that fall in value comes from the general widening in credit spreads, which are on average 2.5 times wider than they were when the transaction was issued. The researchers calculate that this has contributed a 34% decrease in the value of the deal after taking account of the gain from convexity and moves in correlation. The decline in the value of the cash collateral has added a 20% loss in value with the balance from transaction costs.
The paper concludes that unwinds or restructurings of CSOs have the potential to send spreads wider and curves steeper and to cause credits which are popular in synthetic CDOs to underperform. But Lehman says that significant unwinds are unlikely in the near term unless there are unforeseen accounting or regulatory changes or large-scale changes of rating methodology.

Let’s just agree upfront that we’re not too surprised by these valuation numbers, but we’ll focus on the carefully hidden sentence: The decline in the value of the cash collateral has added a 20% loss in value with the balance from transaction costs.

We’re assuming this “cash collateral” is the GIC. Essentially, the AA tranche they’re describing suffers -- in addition to the pains of this liquidity crisis -- from the depletion of the eligible investments (i.e., the GIC), which has lost 20%. GICs are typically comprised of assets of the highest credit quality, usually with an emphasis on their being short-term assets, typically at least P-1 rated (short-term rating) and/or Aa3-rated or higher (long-term rating).

The GIC’s loss -- especially in a fully-funded transaction -- may itself be enough to wipe out the AA tranche, which detaches at 5%, even if the synthetic portfolio suffers no losses.

Perhaps it’s not too surprising that the AA CDO tranche is down 50 plus percent in mark-to-market losses, given the GIC – the supposedly most reliable portion of its investments is itself down 20%, and the circular relationship entailed. (Let’s only hope this 20% is a recoverable MTM loss, and hasn’t been realized.)

Wednesday, August 27, 2008

Side Pockets - Keeping Hedge Fund Capital in Their Pockets

In the light of increased regulation, we’re seeing a fair share of interest in side pockets. Without further ado, here’s the low-down:

Side pockets are essentially segregated sub-accounts used by some funds (think hedge funds) to allow them flexibilities in dealing with, and accounting for, illiquid and non-marketable instruments (think CDOs), and potentially other assets.

How, Why?
The fund’s offering and organizational documents should disclose pro forma the extent to which it may transfer fund investments to side pockets.

Side pockets provide a structural mechanism for transferring certain (typically illiquid or hard-to-value) investments into a separate class of the fund. The fund investors’ participation interests are separated in tandem with the assets: only those investors having ownership interests at the time the side pocket is created for a specific investment are exposed to the performance of that “side-pocketed” investment.

This accounting arrangement allows the fund to defer valuation of side-pocketed securities until a valuation or liquidation event occurs, such as the disposal of the security, the bankruptcy of the issuer, or the manager’s transfer of the side-pocketed security back into the fund’s main pool of (liquid) securities.


Importantly, an investor’s liquidity is limited while any investment to which she is exposed is side pocketed.
In other words, an investor cannot fully withdraw from the fund until all side-pocketed investments to which she is exposed are removed from the side pockets. She retains her proportionate share in these side-pocketed investments -- even after completely withdrawing from the fund’s primary investment portfolio -- and is subject to an unlimited lock-up period on this portion, during which she will generally not receive any distribution proceeds.

Management Fees, Accounting Repercussions…

Side pocket investments have typically been valued at cost (as opposed to being marked-to-market) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When side-pocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket.

UPDATE - November 7, 2008: Public announcement that GLG Partners ringfenced illiquid investments from its European equities hedge fund