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

ARTICLE XII

SALE OF UNDERLYING ASSETS; SUBSTITUTION

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.