Friday, January 28, 2011

Corporate Governance for the Shareholders (Part 1)

2010 and the Dodd-Frank Act ("DFA") brought to the fore Say-on-Pay and certain other delights for those investing in shares of financial institutions.

DFA enhances the SEC's enforcement abilities, while creating an additional watchdog (the Consumer Financial Protection Bureau) which has both examination and enforcement capabilities. It also demands that both companies and regulators reduce their dependence on credit ratings: over-reliance on credit ratings served to exacerbate the depth of the financial crisis, as rating downgrades precipitated further pricing pressures.

Indeed, in our experience several regulatory bodies have approached the new regulatory landscape with a zest and energy that was perhaps absent in the years leading up to the crisis.

Having said that, many critics feel that financial reform measures fell short; some are critical of the regulators' enforcement intent (see here and here), especially as they experience budget constraints; others are skeptical of the newly-created FSOC's ability to even define systemic risk, never mind recognize or measure it.

What other improvements, then, can be introduced to protect against large-scale business risks at financial institutions?

Risk Must Have a Voice

We would like to see Risk have a voice. Certainly, many risk managers were very good at measuring risk. But their institutions failed anyway. Why? Often, the objectives of risk management (preservation of capital reserves) run counter to the growth objectives of the CEO, who is incentivized to put capital to work. One could argue that the too-big-to-fail banks are or were long risk, knowing that they had large potential short-term upside and low downside given the (implicit) government guarantee. The government or the taxpayer, in this scenario, is short risk. One option is to ensure that the chief risk officer reports directly to the board, rather than to the CEO. Again, if the CEO is the chairman of the board, risk's voice may be dampened and this may provide a warning sign.

Risk and Compliance Must be Independent

Similarly, it is crucial that risk managers and compliance officers are incentivized, and safe, to voice their concerns. As a cost center with relatively limited bonus potential, shareholders ought to recognize that "at-will" risk and compliance managers -- especially if they are (intentionally) over-paid -- often have little advantage for being right but significant downside for being wrong. (Click here for an example of objections ending poorly for "at will" employees.)

-End Part 1

We will be exploring further avenues for improvement in subsequent pieces of this series, including a discussion of management's communication of its risk appetite. If you have any corporate governance suggestions you would like us to consider or include, feel free to email them to us or leave them in the comments section below this post.

Wednesday, January 5, 2011

Deferred 4 Ever

One of the problems we come across when we examine the models our clients rely on is the incorrect modeling of the payment of deferred, or capitalized interest.

What do I mean?

If you model enough CDO deals, you'll notice that it's not always clear when a deal should be paying the deferred interest on a PIK-able bond. Obviously, in good times, this isn't a big worry but, in bad times this could make the difference between having a noteholder receiving some return vs. no return on his investment.

This is especially meaningful in TruPS CDO world where a good portion of mezzanine bonds are currently in deferral.

I pulled the following steps from a TruPS CDO's Priority of Payments (that section is found in the deal’s Offering Memorandum and defines how the liabilities are paid on each distribution date):

The B1s are entitled to receive interest here:
“SIXTH: to pay Periodic Interest on the Class B-1 Notes at the Applicable Periodic Rate and the Class B-2 Notes at the Applicable Periodic Rate, pro rata based on the amounts of Periodic Interest due;”
And principal here:
“EIGHTH: to pay an aggregate amount equal to the Optimal Principal Distribution Amount, in the following order, (a) principal of the Class A-1 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (b) principal of the Class A-2 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (c) principal of the Class B-1 Notes and Class B-2 Notes, pro rata, until the Aggregate Principal Amount of such [B-1 and B-2] Notes has been reduced to zero;”
Where does deferred interest fit in, in the above steps?

Well not under the definition of Periodic Interest:
“With respect to the Class A-1 Notes, the Class A-2 Notes, the Class B-1 Notes and the Class B-2 Notes, in each case interest payable on each Payment Date on such Notes and accruing during each Periodic Interest Accrual Period at the Applicable Periodic Rate.”
Nor the definition of Aggregate Principal Amount:
“With respect to any date of determination, (a) when used with respect to any Pledged Securities, the aggregate Principal Balance of such Pledged Securities on such date of determination; (b) when used with respect to any class of Notes, as of such date of determination, the original principal amount of such class reduced by all prior payments, if any, made with respect to principal of such class; and (c) when used with respect to the Notes, the sum of the Aggregate Principal Amount of the Senior Notes, the Aggregate Principal Amount of the Senior Subordinate Notes and the Aggregate Principal Amount of the Income Notes.”
Why does any of this matter? Can’t deferred interest be paid in either step?

Sure but the problem here is that choosing to pay deferred interest in one step over the other could have a huge impact on the cash flow to various notes.

Imagine the B-1s have $30 million in deferred interest. If that amount is paid under step SIX then the B-1s’ deferred interest is prioritized over the senior notes’ principal. If you go with step EIGHT, the opposite occurs. It’s a zero sum game, but either way, someone loses a good chunk of change based on the adopted interpretation of this vague language.

P.S. this is a common issue that you’ll find in CDOs backed by all types of assets (not just TruPS) so make sure your forecasting models are tuned to this properly.