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.