Monday, November 30, 2009

Introducing RatingsReform Blog

Expect[ed] Loss Readers,

We'll be moving our future blogs on rating agency reform and regulation to a new site:

Please visit us there to follow our commentary on credit ratings reform and to share your opinions with us. Oh, and don't be shy to sign up!

- ExL

Tuesday, November 10, 2009

Marathon, or Just a Quickie?

Friday’s Asset-Backed Alert describes the (mildly fascinating) behind-the-scenes activities of Marathon CLO I, a 2005-vintage CLO managed by Marathon Asset Management.

According to the article, Marathon itself recently purchased most or all of its deal’s senior-most tranche from Bank of America, at prices purported to be in the 85 cents on the dollar range. To turn a quick profit on their senior note investment, Marathon swiftly sold off roughly two-thirds of the collateral underlying the CDOs, with the proceeds being diverted towards substantially paying down their senior tranche, at par. By our back of the envelope calculations, if Marathon purchased the entire tranche, they would have made a profit on this trade of roughly $26.75mm already, with potentially more to follow.

As far as we’re aware all of the deal’s par coverage tests (“OC tests”) declined between mid-September and mid-October, despite continued improvement in the market for leveraged loans, which support these CLOs.

Why is this Interesting?

(1) While Marathon may have benefited greatly from its extensive trading activity, all other noteholders are, at least in our opinion, worse-positioned for it: in a month in which most CLOs’ OC test ratios improved, all OC ratios of Marathon CLO I suffered, arguably purely as a result of their aggressive trading during this period.

(2) The substantial paydown of the Class A1 notes (CUSIP 565763AA7) might encourage Moody’s to upgrade the tranche from its current rating of A1, with a possible Aaa rating in sight.

(3) Managers are typically disincentivized from any earlier-than-necessary unwinding of their deals: the longer their deals run, the longer they continue to collect management fees for managing the collateral; however, in this situation, the upfront profit of say $26mm would vastly outweigh the potential additional revenue stream of less than $2mm per year that a manager may hope to earn in fee from managing a deal such as this. (Managers earn fees based on the size of the portfolio, so a paydown decreases future fee generation.)

(4) The spirit of the deal is that managers are supposed to manage “across the capital structure.” In other words, though very difficult, they’re supposed to make managerial decisions that are in the best interests of all investors of the deal, certainly not only the senior-most tranche holders. At the same time, the dynamic is that rating agencies are trying to protect their rated noteholders, but not only the senior-most holders. Though it’s an imperfect system, the collateral manager is often required to purchase some of the equity of its own deal, to ensure that it manages across the structure, thereby sending proceeds down the waterfall as far as the equity notes (see here for examples of how this structural nuance can be manipulated).

(5) In this scenario, largely as a result of the early liquidation of assets, most if not all of the other rated noteholders will suffer, which could bring the rating agencies’ ratings on these notes into question, and the equity holders likely lose any potential upside they might otherwise have hoped to gain on their investment.

(6) Aside from allowing “Credit Risk” sales, rating agencies try to protect against aggressive management by limiting the amount of trading activity permissible by a manager (see example language below). With Marathon posturing such a large proportion of these sales as “Credit Risk Sales” it really calls into question the definition of a “Credit Risk Sale” and the question of a manager’s ability to arbitrarily designate a sale as a Credit Risk Sale simply to allow for its effectuation. Given that they were able to sell these assets at, on average, over 90 cents on the dollar, can they really have been Credit Risky? Does Marathon know something about all of these loans that the rest of the market does not? Did they all just suddenly become Credit Risks, encouraging Marathon to liquidate them in the best interests of all holders, or is Marathon acting in its own capitalistic interests?

Example Indenture Language



Section 12.1. Sale of Underlying Assets and Eligible Investments.

(a) Except as otherwise expressly permitted or required by this Indenture, the Issuer shall not sell or otherwise dispose of any Underlying Asset. Subject to satisfaction of all applicable conditions in Section 10.8, and so long as (A) no Event of Default has occurred and is continuing and (B) each of the conditions applicable to such sale set forth in this Article XII has been satisfied, the Asset Manager (acting pursuant to the Asset Management Agreement) may direct the Trustee in writing to sell, and the Trustee shall sell in the manner directed by the Asset Manager (acting as agent on behalf of the Issuer) in writing:

(i) any Defaulted Obligation, Credit Improved Obligation or Credit Risk Obligation at any time; provided that during the Reinvestment Period and, with respect to Defaulted Obligations and Credit Risk Obligations, at any time, the Asset Manager (acting as agent on behalf of the Issuer) shall use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount (A) with respect to Defaulted Obligations and Credit Risk Obligations, at least equal to the Disposition Proceeds received from the sale of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon), and (B) with respect to Credit Improved Obligations, at least equal to the Aggregate Principal Amount of the Underlying Asset that was sold; and provided further, that the Downgrade Condition is satisfied;

(ii) an Equity Security at any time (unless earlier required herein); provided that during the Reinvestment Period, the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets with a purchase price at least equal to the Disposition Proceeds of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon) received from such sale;

(iii) any Underlying Asset which becomes subject to withholding or any other tax at any time; and

(iv) in addition, during the Reinvestment Period, any Underlying Asset not described in clauses (i), (ii) or (iii) above, if (x) no Downgrade Event has occurred and (y) with respect to any sale after the Payment Date occurring in September 2012, the Aggregate Principal Amount of all such sales for any calendar year does not exceed 25% of the Portfolio Investment Amount; provided that the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount at least equal to the Aggregate Principal Amount of the Underlying Asset sold (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon).

UPDATE, November 20, 2009: This morning's Asset-Backed Alert edition suggests, quite disturbingly, that Fortress and TCW may be considering similar moves to that of Marathon, in their Fortress Credit Funding CLO and Pro Rata Funding Ltd. deals, respectively.

Thursday, November 5, 2009

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 of 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.

Monday, November 2, 2009

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
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."