Cross-Border Collateral Complexities

by PF2 consultant Rick Michalek

It's 11:59pm. Do you know where your collateral is?

The question of how to locate and ensure the realization of security is often asked, but rarely definitively answered, particularly in international complex derivative transactions. In an ever increasing number of cases, lenders - and counterparties and their insurers - have been forced to ask exactly this question.

The question is becoming increasingly relevant. Consider the following from a recent Press Release from the Office of the Trustee for the Liquidation of MF Global Inc. (published 11/21/2011)

"Further complicating matters, assets located in foreign depositories for customers that traded in foreign futures are now under the control of foreign bankruptcy trustees, and while the Trustee will pursue them vigorously, it has been his experience that recovery of these foreign assets may take more time. The Trustee's counsel has also stated in open court that the Trustee has only relatively nominal proprietary - that is non-customer - assets in his immediate control."

The "recovery of foreign assets may take more time...." is the key issue, and one that remains despite the wholehearted attempts by the regulatory bodies both in the US, the UK and elsewhere, to address the long standing challenge of rationalizing international and inter- jurisdictional processes for the realization of posted and pledged collateral.

Those experienced with derivative structured finance transactions will recall the litany of "assumptions" contained in the typical security interest opinion delivered by deal counsel and relied upon by the transacting parties. The utility and reliability of that legal opinion was conditioned on every single one of those assumptions being true at the time of delivery. The diligence required in verifying those assumptions was often "delegated down", and whether that diligence was fully and accurately performed - often under the pressure of a closing deadline - is critical to the ultimate outcome when pursuing collateral.

Mirroring those assumptions, the deal's legal opinions will also include critical "qualifications", including those related to the location of the collateral. Exceptions would inevitably be made to cover the possibility of collateral being moved out of relevant jurisdictions after the date of closing (particularly relevant to those secured by physical notes or other forms of indebtedness).

In multi-jurisdictional transactions, involving collateral originated in legal jurisdictions lacking well-developed protocols for settling competing interests of creditors residing in different jurisdictions, a trustee may be faced deciding which of the mutually inconsistent judgments it will recognize and honor. Creditors thinking of suing might want to delve deeply into the documentation - a decision that may make the difference between covering the costs of litigation or suffering the sting of a pyrrhic victory of having paid to prevail.

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To get in touch with the author of this piece, email Rick at rm@pf2se.com

Return of the TruPS CDO

The good news, for investors in TruPS CDOs, is that at least one rating agency has responded to our calls for upgrades.

Moody’s, in two separate actions over the last two weeks, upgraded three tranches of Trapeza CDO VI and two tranches of Alesco Preferred Funding CDO I.

All five of the upgraded Alesco and Trapeza bonds were previously downgraded on July 13, 2010.

When you analyze ratings migrations, you notice raters have a tendency to inflate the initial ratings on new structures (the “Type I” error). When things go wrong, rating agencies then tend to exaggerate their downgrades to avoid being caught looking foolish when AAA or AA securities default. But they then run the second risk, which is seldom monitored or advertised, of the “Type II” error – the rating too low of a security that pays off in full. Both of these errors have the potential to be damaging to investors: investors get insufficient coupon reward for taking outsized risks at the beginning, and then they pay too much, in ratings-based margin, for holding under-rated bonds after the magnified downgrades.

We felt we had noticed the exaggeration of downgrades for at least some TruPS CDO bonds. We expect certain of the bonds that have been downgraded, to as low as CCC, to pay off in full. We therefore called for upgrades, of at least certain of these bonds, after noticing a growing disconnect between the actual asset-level performance of TruPS CDOs and the ratings performance of the asset class.

Upgrading bonds is a good thing for TruPS CDO investors: it may provide the support needed to mark them up, or to reduce capital reserves (or margin) held against them. In the best case, for bonds expected to ultimately pay out in full, the upgrade provides “leverage” for small bank managers to justify holding these securities at par in hold-to-maturity accounts; or to combat regulatory pressure to mark them to fair value based on an OTTI write-down.

While Moody’s upgrading intentions are a healthy sign, they do not always precipitate a similar response from the other rating agencies in the short term:

- The upgrades are due, in no small part, to the generation of excess spread by the underlying assets. Fitch, for one, does not model these structures and so by definition cannot adequately capture, in their ratings, the effects of this excess spread. It may thus be reasonable to expect Fitch’s TruPS CDO ratings to linger in this regard, until they ultimately follow the direction of the other rating agencies. (To be fair to Fitch, Fitch did in its September review retroactively upgrade a single tranche when Fitch saw the tranche was being paid down – but it also downgraded seven tranches and affirmed the ratings of 488 tranches. The A2 tranche of PreTSL 8 was upgraded, wait for it, from CC to B, less than one year after it was downgraded from B to CC. The bond was originally rated AAA by Fitch.)

- Rating agencies also, understandably, have a natural tendency to want to avoid flip-flopping on their ratings. The CLO downgrade-turn-upgrades within a year have caused the raters significant embarrassment. How will they look if, so soon after downgrading these 30 year TruPS CDOS, they then re-upgrade them? The market may be led to believe that the raters’ economic models hold little predictive content.

Trading in TruPS CDOs presents serious money-making opportunities, heightened somewhat by the ratings arbitrage available: for example, the recently upgraded A1A tranche of Trapeza VI is now rated Aa3 by Moody's, A by Fitch, while rated CCC+ by S&P. This dynamic should also provide holders with all the encouragement they need to examine the “true” flow of funds of their TruPS CDOs, rather than relying purely on their ratings (and succumbing to associated regulatory pressure to boost reserves).