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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.

3 comments:

Guru said...

Nice piece but the likelihood of a deferring TruPS CDO tranche ever getting paid is in 0% to 1% range :)

Anonymous said...

i invested in several trups deal. do you think i could go after the banks that created these deals because of this issue? your feedback is very much appreciated. thanks.

GP said...

@ Anonymous,

Interestingly, there have been a number of recent cases that center on model failures and litigation concerns that came with structured finance investments (aside, of course, for credit losses themselves).

For example, though it's only lightly related, AXA Rosenberg Group recently settled fraud charges with the SEC for failure to disclose an error in a quant model.

We unfortunately cannot provide you with legal counsel, but send us an email at info@pf2se.com and we would be happy to discuss your situation further.