Regulatory Capital Arbitrage

Yesterday's repackaging of G Square Finance 2007-1 Ltd.'s A1 tranche is interesting for a handful of reasons.

The process itself is indicative of the market's thought process in general, and the origin of securitization in the first place: to take something lowly-rated and, via the application of leverage (or subordination), to create something with a higher rating.

In this instance, out of a CDO tranche rated in the CCC region by Moody's and S&P, they've created some portion of investment grade debt, as per the rating methodology of Dominion Bond Rating Services (DBRS).

What Happened? - Why Interesting?

Essentially we have what looks to be a vanilla new-issue CDO-squared (CDO^2). Based purely on the future proceeds of the existing A1 tranche, two new tranches were issued: one being the subordinated piece, comprising 77% of the new capital, and the other 23% being rated BBB(low) by DBRS.

DBRS has never really been a player in the CDO market: investors in CDOs would typically demand at least one of the "Big Two" (Moody's, S&P) or two of the "Big Three" (Big Two plus Fitch) before purchasing a tranche.

This tells us one of two things is happening: either (1) the market no longer needs a rating from either Moody's or S&P, or (2) there is no intention or need to sell the tranche.

More likely (2) than (1), but a mixture is probably most likely.

Firstly, given the tarnished reputations of the Big Three, one can legitimately excuse using an alternative rating agency.

Secondly, the holder may not want or need to sell the tranche, but may simply seek regulatory capital relief: once the item is rated in the CCC region, you're essentially having to cover it one-to-one from a regulatory capital perspective. If able to re-invent this same tranche in such a way as to have any of it (in this case 23%) rated higher, that portion will achieve certain capital requirement relief. Thus, instead of having 100% requiring one-to-one reg. capital, you now have 77% requiring heavy capital reservation, with the other 23% requiring less - possibly significantly less.

Thirdly, it is possible that the holder's reg. capital requirements do not require the rating be from one of the Big Two or Big Three, but any nationally recognized statistical rating organization (NRSRO). In that case, the holder could essentially pick (or "shop" for) whichever of the ten NRSROs appeals most to him or her, in terms of (a) cost of using such NRSRO and/or (b) amount of leverage such NRSRO will allow at the rating level(s) he or she wishes to achieve. In summary, the lower the fees, and the lesser the required level of subordination, the more appealing the NRSRO.

Hello competition. (Not that we approve of it, but simply comment on its existence.)

(As an aside, according to Asset-Backed Alert data, Moody's was asked to rate only 39.8% of MBS deals issued in 2008, down from 74.2% in 2007. Keep in mind that often more than one rating agency will rate the same deal. DBRS was on 17.6% of 2008 deals, versus 2.9% in 2007.)