Morgan Stanley’s recent repackaging of a downgraded Aaa CDO tranche into a new Aaa and a subordinated Baa2 tranche caused quite a stir and what we feel is perhaps an unwarranted outrage. See for example Morgan Stanley, Goldman Sachs Plan To Rebrand Failure As Success and Turning Junk Into Treasure.
Rather, we would argue, the form of these restructured credit ratings -- the very essense of structured finance itself -- if performed correctly will share the common success of Viola’s makeover in Shakespeare's Twelfth Night: each transformation, despite causing initial confusion, will ultimately benefit all parties involved and hurt none, even if at first they may not appear to have done so. (One could argue that poor Malvolio was "most notoriously abused" but, well, it was a comedy after all.)
When the rules of the game change, one must adapt to them. Nobody was injured by the repackaging. No damage was one. And, thankfully, de minimis non curat lex.
It remains a bane of our economy (and a systemic risk) that credit ratings are so deeply intertwined throughout its workings. Thus, there are many reasons, aside from pure regulatory capital arbitrage designs, that may drive an investor to restructure her downgraded tranche. For example:
Fund-level Minimum Rating Criterion
Funds or companies (e.g., mutual funds, insurance companies) may not – according to their investment criteria -- be allowed to hold the tranche at the downgraded rating.
Fund-level Minimum Average Rating Criterion
Funds or companies (e.g., certain fixed income funds, hedge funds) may have mandated weighted average rating thresholds for the entire fund or for certain sections of the fund which may be compromised if they maintain the downgraded security.
Absent the ability to restructure, either of these two criteria alone might encourage or even force the holder to sell her security - and in this illiquid environment, being a forced seller typically translates into suffering a substantial loss on selling. Thus, the ability to repackage potentially stops the investor having to realize a larger-than-necessary loss.
We believe we’re seeing a mixture of the above in the repackaging of the G Square Finance 2007-1 Ltd.’s A-1 tranche.
Back in March, we wrote about how this original Aaa tranche was repackaged into an investment grade tranche (23%) – rated BBB(low) by DBRS -- and a subordinated note (77%). See Regulatory Capital Arbitrage.
As G Square Finance 2007-1 Ltd. continued to suffer credit deterioration in its underlying portfolio, we fear the holder of the note realized that her newly-structured investment-grade tranche, too, may be downgraded to sub investment-grade status.
We suspect that the tranche holder’s fund documents entice her to maintain as much of her portfolio in investment-grade securities (for criteria limitations or regulatory capital purposes, or otherwise), encouraging her to return to DBRS to re-repackage her original A-1 tranche, again trying to achieve as much investment grade as possible out of this declining security. The new breakdown is investment grade tranche (14.89%) – rated BBB(low) by DBRS -- and the remainder is essentially a subordinated note (85.11%).
(While the original A1 tranche was rated by Moody’s and S&P, the repackaged tranche can be rated by whichever rating agency the investor chooses. In this case, the rating agencies are in the ignonomous position of having to compete, among others, on (1) fees charged, (2) quality of service provided, and (3) amount of subordination they require to achieve the investment-grade rating desired – the less subordination the better for the investor.)
In sum, neither Morgan Stanley's nor Viola's approach was exactly what we would call transparent (shout out for the PR department), for which both parties temporarily suffered, and though these repackagings don't immediately create a new source of supply they keep the markets alive and the holders breathing. CDOs are intended as and designed to be long-term par-value products after all, and so almost any institution or implementation that increases the owner's ability to hold them through the illiquid times, and hurts no other party, ought to be met with open arms.
Postscript: Incidentally, G Square Finance 2006-1 Ltd.’s Class A-1 Notes have also been restructured, synthetically, to allow the senior note (38%) to retain an investment-grade rating -- again, BBB(low) by DBRS.