Rogue Bonds

We received a couple of calls late last week about the securitization structure (or catastrophe or "cat" bond) deal that Credit Suisse is preparing.

We haven't seen the deal docs, but from what we understand and have read, the concept is interesting:

Credit Suisse would free up some capital by insuring itself (by way of the bond sale) against certain operational risks, like fraudulent transactions, trade processing errors, regulatory or compliance shortcomings ... or the all-important concern of rogue trading, which caused JPMorgan and SocGen a pretty penny (just look up London Whale or Jérôme Kerviel).

We understand that CS would issue a two-tranche securitization, reportedly backed by a 700 million franc policy from Zurich Insurance Group.  Zurich would retain the first 10% of the risk, with the senior notes being sold off by way of a Bermuda vehicle.  From the reports we've seen, the senior notes would attach at losses of $3.6 billion and detach at losses of $4.3 bn. It's not immediately clear to us whether Credit Suisse would stomach losses above $4.3 billion, but that would seem unlikely ... we assume there's more to it than is publicly known at this time. 

Operational Risk, or What Credit Suisse Will

There are some serious questions.

It would seem Credit Suisse would have a massive informational advantage over the other side: they would know their operational strengths and weaknesses better than anybody else.   That's okay, as long as it's well understood.  

But the real questions start when there is a loss, 

Can one always put a value on the operational portion of the cost, easily separating out all of the factors?   Suppose for example that a loss is magnified as the market turns against a bank while it was slowly extricating itself from a large, unauthorized trade -- as happened in the case of JPM's London Whale?  Is that additional writedown the fault of the bank or the operational shortcoming?  How much of the supposedly unauthorized trade would have been "okay" and how much was "unauthorized"?  One issue here is that the party that knows best if probably Credit Suisse ... but it may often be a conflicted party, benefiting directly or indirectly through the decisions in makes in quantifying the losses.  

Next, the category of operational risk can be difficult to define, and items may fall in the grey zone. Might CS, knowing it has insurance, be more likely to categorize the marginal loss as operational?

And might it change Credit Suisse's approach to fixing up an issue to the extent it knows of certain insurance providers' interests or exposure?  At worst, knowing that they're insured, might they be less particular about buffering against the risk?  Could that create an adverse incentive from a cultural perspective? 

Banks might not need a second invitation!

If this all goes wrong ... we're insured!  Double down!  Lock and load!

Restudying Student Loan ABS

What ever happened to Student Loan ABS deals (aka SLABS)?

Back in 2005 they were "[displaying] exceptionally strong credit quality."  But those same deals -- not just 2005-2006 vintage subprime crisis era concoctions -- have taken a turn for the worse. The storm of circumstances surrounding SLABS that is now coming to light and causing losses and downgrades is not dissimilar to that which surrounded crisis-era RMBS deals.

We visited 18 trusts from the National Collegiate Student Loan Trust (NCSLT) shelf, comprising a total of 140 tranches.

Not all tranches performed poorly.  Several of those tranches had paid down in full.  But all 18 trusts have tranches outstanding (89 in total) and all of these outstanding tranches, including those initially rated AAA, are currently rated in junk territory or deep junk territory by both Fitch and S&P.   (However, Moody’s has held some in the investment-grade region, and for full disclosure, some downgraded securities are on S&P's watchlist for possible upgrade.)

Anatomy of a SLABS

Let’s take a closer look at one tranche of one deal in particular, The National Collegiate Student Loan Trust 2003-1 A-7, an originally-rated AAA tranche of a 2003 vintage deal ... a deal that started accumulating losses in 2004.

The following table shows the initial and current ratings of the four outstanding NCSLT 2003-1 tranches:

This trust is not atypical, and thus worthwhile to examine as a representative deal. Tranche A-7 consists of floating rate notes with a notional of $250 million and a maturity of 8/25/30.  At the time of issuance, the principal and interest of these private student loans were 100% guaranteed by The Education Resources Institute, Inc. (TERI), which was at the time of closing rated Baa3 by Moody’s. TERI subsequently folded into bankruptcy, but that's only part of the story, and not a central concern, at least for the A-7s.

In addition to TERI's support, at initiation, tranche A-7’s credit support additionally consisted of subordinate tranches B-1 and B-2 ($41.25 million each) plus a reserve fund of some $88 mm.

The AAA ratings started to disappear in 2008 -- Moody's began downgrading in 2008, with Fitch and S&P following suit in 2010 --  and the ratings deterioration has continued since then.

By June 2013, Moody's reported that their projected lifetime default % of the original pool NCSLT 2003-1 was at the time at 40%, higher than the break-even lifetime default rate of 34%. Thus, per Moody's, our beloved A-7 tranche would not fully repay by its maturity date.

A full timeline of activity follows at the bottom of this post.

Meanwhile, in Ohio...

Adam Beverly reportedly took out a $30,000 student loan from Bank One, N.A. in September 2003. His mother, Linda Beverly, acted as cosigner of the loan.

According to one of Bloomberg News’ sources Beverly’s monthly payments were initially around $120 when he entered repayment and subsequently increased to more than $600. The story has it that he was reportedly bounced back and forth between First Marblehead and National Collegiate when he tried to discuss his payments, and he stopped making payments in 2009. The Beverlys reportedly hired a debt negotiation company, Student Loan Relief Organization (“SLRO”) to negotiate payment arrangements for the loan.

On April 16, 2012, the National Collegiate Student Loan Trust 2003-1 Trust filed a lawsuit against Adam Beverly and his mother Linda demanding repayment of the loans. Upon receipt of the summons, Linda Beverly called their SLRO contact, who said he would “take care of it.” After several weeks passed, her contact stated that SLRO would be unable to accomplish anything on the loan.

Linda and Adam Beverly purportedly attempted to contact the attorney representing NCSLT 2003-1 and Ms. Beverly also spoke directly to individuals at the National Collegiate Student Loan Trust who could not find any record of the loans.

The trial court granted default judgment against Adam and Linda Beverly on June 25, 2012. The default judgment awarded the 2003 Trust damages of $43,713.22, accrued interest of $5,017.42 through April 4, 2012, and interest at a variable interest rate from April 5, 2012.

Adam and Linda Beverly appealed, and a panel of Ohio Supreme Court judges vacated the default judgment on September 30, 2014. They found that NCSLT filed a complaint in its own name, on notes payable to someone else, without alleging or proving assignment of the notes. In other words, NCSLT could not produce any documents showing that it owned the Beverly student loan. 

NCSLT also sued Adam Beverly for a loan taken out in 2005 and packaged in NCSLT 2006-1, with a similar result.

The Takeaway

A difficult economy and high unemployment among graduates has led to a high level of defaults in the loans underlying NCSLT 2003-1. If Adam Beverly’s case is at all representative of NCSLT or FMC’s standard practices, the negotiation process (outside of the courts, at least) has not exactly been mastered. Indeed National Collegiate trusts have filed more than 4,000 lawsuits since 2011. Student debtors are fighting back as well, with judges in several states finding that the trusts haven’t proved they own the debt.

We see shades of the RMBS debacle here, with sloppy record-keeping.  Massachusetts AG Maura Healey, who likely has a wider lens, reportedly labels them “abusive loan debt-collection tactics."

These factors are leaving some borrowers without relief, and trusts at times with no legal recourse to collect on their debt. Not to mention some investors in AAA rated debt have been stuck with the resultant junk.

Disclosure, or What You Will

Seven years after the demise of Lehman Brothers, lawsuits on related financial products are heating up, with a number of RMBS and CDO cases seeing reversals of fortune. 

But first, some background. 

This may seem odd – but so far most of the arguments have had little to do with whether the defendants did anything wrong.[1]  

Rather, the focus has been on peripheral issues, like: (1) jurisdiction; (2) whether the plaintiffs had standing to sue; (3) whether the plaintiffs sued within the permissible time frame; (4) whether the defendants were indeed obligated to fulfill any of the duties they are accused of violating; and (5) whether the investment risks were appropriately disclosed. 

Recent rulings have focused on this final element, and have been rendered in a way largely favorable to the plaintiffs. This is the focal point of today’s post. 

Disclosures and Disclosures – Five Shades of Grey 

Disclosures are subjective issues; they are forms of art. And, most importantly, they are not Boolean – they are not simply present or absent. 

There are various shades of grey. Consider for example the following possible disclosures regarding a bridge: 

1. Cross bridge at your own risk 
2. We have performed one or more tests and happen to believe that this bridge is particularly risky, or more risky than other bridges 
3. This bridge fails to satisfy the criteria set for bridges by the relevant architectural/building standards and safety boards 
4. We built this bridge and know that it suffers from certain structural flaws 
5. This may look like a bridge, but it is made of straw and has simply been dressed up to look like a bridge. Do not cross! 

These disclosures differ greatly, and one cannot reasonably argue that all provide the same informational content. 

Of course, it may be okay to sell a distressed asset or a structurally flawed house, as long as its known shortcomings are appropriately disclosed; but when a particular risk is known to one party (often the seller) we argue that the material information needs to be properly disclosed. 

For our purposes, it may be helpful to break disclosures down into three broad categories: 

1. Those that are general (non-specific) and describe overall risk
2. Those that describe particular risk(s)
3. Those that describe the advanced knowledge that one party to an agreement has (over the other) pertaining to particular risk(s) 

Reliance – A Practitioner’s Perspective[2] 

The recent rulings, which we’ll get to in a moment, give us some confidence that the legal system is supporting the essence of what investing in the US financial markets is all about. 

The defenses that “it was disclosed that the investment contained risk” or that “we warned the investor to perform his own due diligence” seem to us to be off-point and insufficient. 

From a practitioner’s perspective, it should be noted that investors are just about always warned that investments contain risks. Of course they do – there’s seldom a reason to invest without the expectation of a positive return[3], and risk and return go hand in hand. And due diligence can often be impractical or prohibitively expensive, and even if it can be performed it may not uncover the true nature of hidden risks, especially if they are known only to certain insiders. 

But in this “trust -but-verify” bargain, is the “trust” element still there? 

Let’s suppose that due diligence could be performed. Should investors have to check everything – every piece of data represented to them to be true and accurate, every potential conflict disclosed or undisclosed, every legal opinion upon which the transaction’s solidity is based, and every accounting record? What is the purpose of a representation or warranty, if the onus remains on the person accepting the representation or warranty? 

In short, shouldn’t investors be allowed to rely on some things? 

Buying a new car encourages some level of diligence too – one may want to take it for a test-drive. But is it healthy to expect or require each car buyer to have advanced engineering or mechanical skills and to test each part for herself? 

We argue it isn’t: such due diligence, while commendable, defeats the purpose. When buying a new car, a purchaser ought to be able to rest easy, relying on her property rights and on the manufacturer’s name and representations, and fairly assume that the parts used are new, in working order, and are expected (certainly by the manufacturer) to last. 

Similarly, when buying a financial product that has been structured by a bank, it would promote market efficiency and be most expedient if investors were able to freely rely on representations and warranties made to them by the banks about the collateral supporting the product. And when a representation turns out to have been faulty, investors could then expect to have recourse through the court system – one of the very reasons overseas investors invest in US-based financial products! 

Decisions, Decisions… 

On the RMBS/CDO side, a recent lower court ruling and a slew of higher court rulings have ended favorably for plaintiffs, finding that the disclosures and disclaimers[4]  provided were not specific enough – reversing decisions made by lower courts that those disclosures had been sufficiently specific. 

Various groups of defendants, in different litigation matters, had regularly made the argument that they had disclosed that some of the thousands of loans that made their way into the mortgage pool may fail to comply with the representations and warranties made of them. Well that’s fair enough – there may have been a data error here or there that is yet to be discovered. 

But at the time of writing this disclosure that “some” loans “may” fail, the truth was very different. Often some loans were already failing (and known to have been failing) to meet one or more of the criteria needed to pass. Moreover, and importantly, it was even the expectation of some defendants at that time that several other loans would imminently be found to fail too. 

In other words, several defendants made the weakest possible disclosure: that something may possibly happen. Meanwhile, defendants often already knew that it was happening, and often en masse. Disclosing that a violation may occur is different from disclosing (1) that violations are known to be occurring, or (2) that the procedures employed leave ample room for the occurrence of violations (and so forthcoming violations should be expected).[5] 

As it happens, in some cases defendants had set up tests to identify noncompliance in loans sampled within the pool. When they found that a high percentage of the sampled loans failed to comply with the representations and warranties, they failed to re-examine the non-sampled loans, but waived them into the securitization trusts anyway. Thus, they knew, or should have known, that a high percentage of the non-sampled loans would fail to meet the criteria upon which they were being purchased into the trusts. In FHFA v Nomura, the court examined the true nature of the mortgage loans being waived into the trust as conforming collateral: 

"Measured conservatively, the deviations from originators’ guidelines made anywhere from 45% to 59% of the loans in each [supporting loan group] materially defective, with underwriting defects that substantially increased the credit risk of the loan."[6] 

Some Examples – Decisions Favorable to Plaintiffs 

     Basis Yield v Goldman (CDO) [7]

The First Department decided that the disclosures were “boilerplate statements” that failed to put the investors on notice of the nature of the risks inherent in the investment (as alleged by the plaintiffs) [8]. The court held that if “plaintiff's allegations are accepted as true, there is a ‘vast gap’ between the speculative picture Goldman presented to investors and the events Goldman knew had already occurred.”[9]  

     ACA v Goldman (CDO) 

In May 2015, the New York Court of Appeals – the state’s highest court – reversed an order by the Appellate Division, holding that “plaintiff here claims that defendant knew that [co-defendant] Paulson was taking a position contrary to plaintiff's interest, but withheld that information, despite plaintiff's inquiries.”[10] 

     FHFA v Nomura (RMBS) 

In this bench trial, the court honed in on the direct issue at hand, ruling in favor of the plaintiff: 

“This case is complex from almost any angle, but at its core there is a single, simple question. Did defendants accurately describe the home mortgages in the Offering Documents for the securities they sold that were backed by those mortgages?”[11] 

     Basis Yield v Morgan Stanley (CDO) 

The court leaned heavily on several prior rulings[12] of the First Department which had recently rejected most of the contentions raised by Morgan Stanley, similar to those advanced in the same court. 

In the court’s words, “The First Department held that New York law is ‘abundantly clear’ that ‘a buyer’s disclaimer of reliance cannot preclude a claim of justifiable reliance on the seller’s misrepresentations or omissions unless (1) the disclaimer is made sufficiently specific to the particular type of fact misrepresented or undisclosed; and (2) the alleged misrepresentations or omissions did not concern facts peculiarly within the seller’s knowledge.” 

In denying Morgan Stanley’s motion to dismiss, the court held that, assuming plaintiff’s allegations to be true, the disclosures “did not apprise investors that Morgan Stanley had deliberately sabotaged assets in the CDO to profit from its short positions.”[13] 

Some Examples – Decisions Favorable to Defendants 

     HSH Nordbank v UBS AG (RMBS) 

HSH Nordbank is one example of an RMBS ruling that went the way of defendants. 

The court ruled that “Here, the core subject of the complained-of representations was the reliability of the credit ratings used to define the permissible composition of the reference pool. The reliability of those ratings was the premise on which the entire deal was sold to HSH. Far from being peculiarly within UBS's knowledge, the reliability of the credit ratings could be tested against the public market's valuation of rated securities.” 

In other words, plaintiff HSH could reasonably have uncovered that the ratings were misrepresented had HSH exercised the necessary due diligence.[14] 

     Lanier v BATS (HFT) 

Lanier, a case concerning high-frequency trading (or HFT), presents a more recent set-back for plaintiffs. 

Lanier’s argument, to a degree, is this: Lanier paid for time-sensitive trading information from NASDAQ; NASDAQ has other clients who paid more, and so they got this time-sensitive information before Lanier did, rendering the information stale and inaccurate by the time it arrived at Lanier’s desk. Lanier argues that he was not appropriately informed that he was being trumped – and that the spirit of the agreement was that nobody would get information before him. 

To use the court’s words, Lanier’s argument is that “when defendants make market data available to preferred data customers more quickly than other customers, they violate Regulation NMS, which is incorporated by reference into contracts between plaintiff Lanier and defendants.” In his words, he seeks “redress for a violation of a contractual commitment prohibiting defendants from providing earlier access to market data to Preferred Data Customers” and as a result, the sale of stale data to him. 

In Lanier’s words, “The Preferred Data Customers are then able to cancel orders and execute trades before Subscribers [like Lanier] even receive the market data.” 

But the court sympathized with the provision of what seems to us to be an extraordinarily weak form of disclosure. The court viewed the following paragraph in the subscription agreement to have been, in the court’s words, “pertinent.” 

“Neither NYSE, any Authorizing SRO nor the Processor (the “disseminating parties”) guarantees the timeliness, sequence, accuracy, or completeness of Market Data or other market information or messages disseminated by any disseminating party. No disseminating party shall be liable in any way to Subscriber or to any other person for (a) any inaccuracy, error or delay in, or omission of, (i) any such data, information, or message, or (ii) the transmission or delivery of any such data, information or message, or (b) any loss or damage arising from or occasioned by (i) any such inaccuracy, error, delay or omission, [or] (ii) non-performance . . . .” (emphasis added by the court) [15]

The court also took particular comfort in the provision within the Nasdaq Subscriber Agreement of a disclosure that reads “STOCK QUOTES MIGHT NOT BE CURRENT OR ACCURATE” and grants the motion to dismiss, preventing any further discovery.[16] 

 Indeed Nasdaq warranted to Lanier that it would “endeavor to offer the Information as promptly and accurately as is reasonably practicable.” If we take plaintiff’s allegations to be true, as we must at the motion to dismiss stage, then clearly NASDAQ did not provide it to Lanier as promptly as reasonably practicable, and it knew it wasn’t doing so. 

The court asserted that Lanier’s “argument misreads the Subscriber Agreements, which promise one thing: the provision of consolidated market data to Lanier and other subscribers like him. The contracts do not prohibit provision of the same data in different forms to different kinds of customers, whether in consolidated or unconsolidated form. And in general the duty of good faith and fair dealing does not provide a cause of action separate from a breach of contract claim, as “breach of that duty is merely a breach of the underlying contract.” 

Sadly, in rendering its opinion the court ignores the spirit of the agreement – the intent – and probably the content too. 

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FOOTNOTES

[1] For example, in a bench trial (FHFA v Nomura), the court noted that no real defense was presented as to the inappropriateness of defendants’ actions. “Today, defendants do not defend the underwriting practices of their originators. They did not seek at trial to show that the loans within the SLGs were actually underwritten in compliance with their originators’ guidelines. At summation, defense counsel essentially argued that everyone understood back in 2005 to 2007 that the loans were lousy and had not been properly underwritten.” Opinion at page 267. 

[2] Our goal here is to share a practitioner’s perspective. We do not provide advice of any kind –certainly not legal advice. 

[3] As scientists we must disclose our awareness of several situations in which investments are made without the expectation of a directly positive return, above 0%. While such examples exist, they are in the great minority of investments. For example, 5-year Swiss government bonds currently yield negative 0.539%, and there do exist rational arguments for investing in a negative yielding instrument, including for lack of available alternatives.) 

[4] Hereafter, we will use the short-hand “disclosures” to describe both disclosures and disclaimers. 

[5] An argument could be made that disclosure is faulty when it describes an occurrence as a remote possibility, when it’s known to be likely or inevitable – akin to a form of false advertising. Such disclosure disguises the true nature of the possibility. 

[6] Opinion at page 171 

[7] First Department decision and opinion at page 9 (1/30/2014) 

[8] In the court’s words “These disclaimers and disclosures, in our view, fall well short of tracking the particular misrepresentations and omissions alleged by plaintiff.” 

[9] A similar finding was made by the First Department in Loreley v Citigroup. 

[10] ACA Financial Guaranty Corp., Appellant, v. Goldman, Sachs & Co., Respondent, Paulson & Co., Inc. et al., NY INDEX NO. 650027/2011; Court of Appeals, No. 49, at page 4 (5/7/2015). Importantly, the court notes that ACA’s case differs from a prior case, in which the plaintiffs "knew that defendants had not supplied them with the financial information to which they were entitled, triggering 'a heightened degree of diligence.'" (Pappas v Tzolis, 20 NY3d 228, 232-233 [2012], quoting Centro Empresarial Cempresa S.A. 17 NY3d at 279). 

[11] Opinion and order at page 7

[12] Specifically, Loreley v Citigroup; Loreley v Merrill Lynch; Basis Yield v Goldman; and CDIB v Morgan Stanley 

[13] For example, the court specifically notes that the disclosure that Morgan Stanley would be acting in ‘its own commercial interest’ was … insufficient to put the Fund on notice of Morgan Stanley’s intent to offload low-rated RMBS from its books.” 

[14] For what it’s worth, our opinion is that it is impractical to have to second guess every party to a transaction; and having tried to, we can argue that it is very difficult if not impossible for a non-rating agency expert (and possibly even for a ratings expert) to effectively reverse-engineer ratings agencies’ complex models – which are often black-boxes, driven by and reliant on internal assumptions that cannot be seen by the most sophisticated of users. Having said that, the court raised its concern that, according to its reading of the amended complaint, HSH may not have provided sufficient factual information to support such the allegation, in the court’s words, “that the credit rating conferred on a security by a rating agency did not necessarily correspond to the security's risk level as perceived by the market.” 

[15] Ruling at page 26

[16] Here we have the same issue: Does disclosing the potential for delays in data distribution appropriately notify the subscriber that the data provided to him was always or regularly or intentionally being delayed? Aside from the omissions complained of, this disclosure, itself seems untruthful. Is it not misleading to state that “a quote might not be current,” when knowing that it is not current? If one wanted to be honest, one would disclose: “quotes are not current – beware!” 

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CASE CAPTIONS (links can be clicked to download opinions)

ACA v Goldman: ACA Financial Guaranty Corp., Appellant, v. Goldman, Sachs & Co., Respondent, Paulson & Co., Inc. et al., NY INDEX NO. 650027/2011 

Basis Yield v Goldman: Basis Yield Alpha Fund (Master) v Goldman Sachs Group, Inc., NY INDEX NO. 652996/2011; 2014 NY Slip Op 00587 

Basis Yield v Morgan Stanley: Basis Yield Alpha Fund Master v Morgan Stanley, NY INDEX NO. 652129/2012 

CDIB v Morgan Stanley: China Development Industrial Bank v Morgan Stanley & Co. Incorporated et al, NY INDEX NO. 650957/2010 

FHFA v Nomura: Federal Housing Finance Agency (“FHFA”) v Nomura Holding America, Inc., et al, 11-cv-06201-DLC 

HSH Nordbank: HSH Nordbank AG v UBS AG et al, 2012 NY Slip Op 02276 

Lanier v BATS: HAROLD R. LANIER, on behalf of himself individually and on behalf of others similarly situated v BATS Exchange, Inc. et al, 14-cv-03865-KBF 

Loreley v Citigroup: Loreley Financing (Jersey) No. 3 Ltd., et al v Citigroup Global Markets Inc., et al, NY INDEX NO. 650212/2012; 2014 N.Y. Slip Op. 03358 (N.Y. App. Div. 2014) 

Loreley v Merrill Lynch: Loreley Financing (Jersey) No. 28, Limited v Merrill Lynch, Pierce, Fenner & Smith Incorporated, et al., NY INDEX NO. 652732/2011; 2014 NY Slip Op 03326 (N.Y. App. Div. 2014) 

DISCLAIMER:  This blog has been posted for informational purposes only.  PF2 does not provide advice of any kind.

TruPS CDOs - Still Underrated?

Hello readers, and welcome to 2014!

In our first post of the year, we're going to continue with a theme we've been commenting on for years: we're noticing that many TruPS CDOs languish at deflated ratings levels, not having been adequately attended to by the rating agencies since their 2009 downgrades.  

Consider for example this first pay, amortizing bond (CUSIP 903329AB6) from one deal (US Capital Funding I) -- which has strengthened dramatically since its original Aaa/AAA ratings were provided back in 2004. It now has much more than 100% principal cushion! Yet, oddly enough, the ratings remain much lower to this date.  S&P still has this in deep junk territory, at B+, albeit on "watch" for upgrade.

Let us know if you would like to join the call for appropriate upgrades in 2014!

~PF2

The JPMorgan Settlement

Following on from our prior RMBS litigation coverage (FHFA RMBS Litigation Totals and A Proliferating "Putback" Problemo) we wanted to add some color to the recent $13bn settlement by JPMorgan.

Initial settlement details:

1. JPMorgan may not pursue indemnification claims from the FDIC for any matters covered by the settlement. 
2. Included in the settlement is the $4 billion FHFA settlement regarding private-label RMBS losses ($1.26 billion to Fannie Mae; $2.74 billion to Freddie Mac). 
3. Previously mentioned $680mm and $480mm rep & warranty settlements with Fannie Mae and Freddie Mac, respectively, are not included in this agreement. (This leaves open the possibility for JPM to claim that the FDIC is responsible for WaMu originations in the rep & warranty settlement.) This could impact the net result of Deutsche Bank National Trust Co. v. Federal Deposit Insurance Corp. et al. 
4. Criminal probe is not closed. 
5. Acknowledgment of misrepresentation, but no explicit admission of wrongdoing.

Our additions are in blue within the table. Sources are at the end.

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http://www.justice.gov/opa/pr/2013/November/13-ag-1237.html http://www.fhfa.gov/webfiles/25649/FHFAJPMorganSettlementAgreement.pdf http://www.justice.gov/iso/opa/resources/61620131119191331856335.pdf http://www.ncua.gov/News/Pages/NW20131119JPMorganChase.aspx http://www.justice.gov/iso/opa/resources/72420131119202254491668.pdf http://www.fdic.gov/news/news/press/2013/pr13103.html http://www.justice.gov/iso/opa/resources/51720131119202421482972.pdf 
https://oag.ca.gov/news/press-releases/attorney-general-kamala-d-harris-announces-300-million-settlement-jp-morgan http://www.businesswire.com/news/sacbee/20131119006821/en http://news.delaware.gov/2013/11/19/biden-secures-nearly-20-million-for-delaware/ 
http://www.chicagobusiness.com/article/20131119/BLOGS02/131119738/illinois-pension-funds-get-100-million-in-chase-settlement# 
 http://www.mass.gov/ago/news-and-updates/press-releases/2013/2013-11-19-jpmorgan-settlement.html http://www.ag.ny.gov/press-release/ag-schneiderman-led-state-federal-working-group-announces-13-billion-settlement http://www.justice.gov/iso/opa/resources/64420131119164759163425.pdf

FHFA RMBS Litigation Totals

From complaints (and amended complaints) and settlements we were able to string together this table of potential litigation costs that may be be borne by some of the major financial institutions who sold RMBS securities to FHFA -- based on a basic extrapolation of settlement expenses from the two data points that have been disclosed.  

This covers only RMBS purchase litigation -- not the mortgage repurchases, or "put-backs."  The totals potentially due to FHFA, on behalf of Fannie and Freddie, also ignore any potential settlements the FHFA might strike with other parties which they have not sued, like Wells Fargo. Numbers in the right-hand columns are in billions.

Richmond's Million Dollar Eminent Domain Homes

Three of the mortgages Richmond, California is threatening to acquire through eminent domain have balances in excess of $880,000 - suggesting that the underlying properties were worth over $1 million at the peak of the housing boom. Public records show that two of the three properties did, in fact, change hands at prices in excess of $1 million several years ago. (On the 624 loans up for acquisition, the median and average outstanding balances are roughly $380,000.)

The three homes are all in the tony Point Richmond neighborhood. The accompanying picture, taken from Google maps, shows the house carrying the third largest mortgage in the eminent domain pool. The other two homes were apparently too far back from the road for Google’s van to photograph.

The biggest mortgage, with a balance of slightly over $1.1 million, is on a property that sold for $1.4 million in 2001 - well before the housing boom crested in 2006. The property currently has an assessed value of about $750,000 and Richmond is proposing to buy the mortgage for $680,000. The three bedroom waterfront home is 2500 square feet and sits on a 17,000 square foot lot - quite large by San Francisco Bay Area standards.

While this particular homeowner appears to be underwater, appraisals for such unique homes are prone to both error and volatility given the lack of recent comparables. Thus, the city’s “offer” to mortgage backed security holders may be significantly less than the homeowner could receive on the open market.

More importantly, the fact that such expensive homes are included in Richmond’s eminent domain initiative raises the question of what public interest is being served. Point Richmond is not a blighted neighborhood and any foreclosed home would likely sell very quickly. Further, anyone in a million dollar home is probably not poor - at least not by any conventional definition of the word poor.

Proponents of the use of eminent domain to resolve underwater mortgages see this as a way for the little guy to “take it” to Wall Street. While it is true that Wall Street made substantial profits packaging up pools of dodgy mortgages, Richmond’s action does not address that injustice. Those profits have already been taken: what remains are mortgage borrowers and MBS investors, many of whom are public employee pension funds.

So the question really is: Should the city of Richmond use eminent domain to transfer wealth from public employees (and the taxpayers that fund their pensions) to affluent homeowners who took on more mortgage debt than they should have?

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For an update on this, visit the Wall Street Journal's coverage or the San Francisco Chronicle's coverage.

AAAs still Junk -- in 2013!

Breaking news: Several securities, boasting ratings higher than France and Britain as of two weeks ago, are now thought quite likely to default.

Moody's changed its opinion on a number of residential mortgage-backed securities (RMBS), with about 13 of them being downgraded from Aaa to Caa1.

The explanation provided: "Today's rating action concludes the review actions announced in March 2013 relating to the existence of errors in the Structured Finance Workstation (SFW) cash flow models used in rating these transactions. The rating action also reflects recent performance of the underlying pools and Moody's updated expected losses on the pools."

In short: the model was wrong - oops!  ($1.5bn, yes that's billion, in securities were affected by the announced ratings change, with the vast majority being downgraded.)

Okay, so everybody gets it wrong some time or other.  What's the big deal?  The answer is there's no big deal.  You probably won't hear a squirmish about this - nothing in the papers.  Life will go on.  The collection of annual monitoring fees on the deal will continue unabated and no previously undeserved fees will be returned. Some investors may be a little annoyed at the sudden, shock movement, but so what, right?  They should have modeled this anyway, they might be told, and should not be relying on the rating.  (But why are they paying, out of the deal's proceeds, for rating agencies to monitor the deals' ratings?)

What is almost interesting (again no big deal) is that these erroneously modeled deals were rated between 2004 and 2007.  So roughly six or more years ago.  And for the most part, if not always, their rating has been verified or revisited at several junctures since the initial "mis-modeled" rating was provided.  How does that happen without the model being validated?

A little more interesting is that in many or most cases, Fitch and S&P had already downgraded these same securities to CCC or even C levels, years ago!  So the warning was out there.  One rating agency says triple A; the other(s) have it deep in "junk" territory.  Worth checking the model?  Sadly not - it's probably not "worth" checking.  This, finally, is our point: absent a reputational model to differentiate among the players in the ratings oligopoly, the existing raters have no incentive to check their work. There's no "payment" for checking, or for being accurate.

Rather, it pays to leave the skeletons buried for as long as possible.

---------------

For more on rating agencies disagreeing on credit ratings by wide differentials, click here.
For more on model risk or model error, click here.

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Snapshot of certain affected securities (data from Bloomberg)

Rated vs. Unrated Bonds

One of PF2's experts recently testified that a rated bond is worth more than an unrated bond. Was he right?

Let's consider this from the perspective of structured finance. One often hears the question: "how can you take all this sub-prime and make AAA out of it?" Of course, that's the whole premise of structured finance - that one can take a portfolio of (more) credit risky assets and create at least some less credit risky (AAA) assets out of it. 

But if we dig deeper into what's happening, we see it's simply a ratings transformation that's taking place. The securitization process enables a bundle of unrated securities (e.g. mortgage loans or credit card receivables) to be "converted" into a set of (tranched) rated notes. 

The rated notes - in higher demand, more liquid, and demanding less regulatory capital - are cheaper to issue, creating the so-called "excess spread." In sum, acquiring a cheap rating enables the wider dissemination of all sorts of securities, through the securitization process. 

The rating provides this value - liquidity, increased demand, lower capital requirements. And so a rated bond is worth more than an unrated bond. What do you think?

----------------------------

Note: Keep in mind the argument is not that ALL rated bonds are worth more than ALL unrated bonds, but that all things equal the rated bonds are worth more: that the rating, reliable or not, provides a value.

Agency Shortcuts and Shortfalls

Investors in certain "AAA" resecuritizations won't be happy. Late last night, Moody's downgraded a bunch of securities, even though they are supported by Agency-guaranteed RMBS.

Many of these were downgraded from Aaa to junk (some at Ba1, others all the way to B1) in one fell swoop, while others went only to A1.  (It looks like S&P still carries most of these securities at AA+, which is lower than Moody's Aaa as S&P has downgraded the United States to AA+.)

What's most interesting here is the reason.  It's not the case that either Fannie or Freddie hasn't paid up on their guarantees, but it looks like the deals may not have been modeled (possibly ever!) - or at least may not have been modeled correctly.  According to their press release, the resecuritization vehicles seem not to have the necessary protections in place to support the bonds issued, or the ratings provided.  Some of these deals were structured in 2007 and even late 2008.  Many of these deals are already suffering shortfalls.

From Moody's press release:

"The downgrade rating actions on the bonds are a result of continual interest shortfalls or lack of adequate structural mechanisms to prevent future interest shortfalls should the deals incur any extraordinary expenses."

... and ...

"Interest due on the resecuritization bonds is not subject to any net weighted average coupon (WAC) cap whereas interest due on some of the underlying bonds backing these deals is subject to a net WAC cap."

... and ...

"Since the coupon on the resecuritization bonds is currently higher than that of the underlying bonds, the resecuritization bonds are experiencing interest shortfalls which on a deal basis are accruing steadily."

Total issuance of $483mm affected, according to Moody's. Deals are of Structured Asset Securities Corp. and Structured Asset Mortgage Investments shelves.

Relevant CUSIPs Downgraded Last Night
86363TAA4
86363TAC0
86363TAD8
86363TAF3
86363TAG1
86363TAB2
86363TAH9
86363TAJ5
86365HAA8
86365HAB6
86365HAD2
86365HAG5
86365GAA0
863594AA5
86359LPA1
86359LPB9
86359LPC7

Withdrawing, Confidently

As structured finance deals wind down and the asset pools grow smaller, the situation often arises that the effectiveness of outstanding tranche ratings – previously based on a portfolio-level diversification – can hinge on the performance of one or two bonds. The problem is compounded, of course, in that many of the models work best for large, diverse, portfolios and often break down when the portfolios become arbitrarily small.

The question then becomes, if a rated tranche can just as easily be rated AAA or D, what does one do?

This tricky situation, now part skill, part luck, calls into question the predictive content of highly sophisticated ratings models when the outcome is really not a model-driven result, but simply a short-term occurrence (e.g., a payoff or a default) or the lack of an occurrence, in a credit-default swap environment.

Moody’s and S&P suffered severe blushes in January when a well-structured CDO, backed heavily by other CDOs and RMBS (including substantial subprime, yes subprime), paid off in full ­– with their outstanding ratings on all tranches having been in the CC to CCC range. What was interesting was that both ratings agencies had visited this deal as recently as June of last year.
From our conversation with analysts at one of the agencies, what happened here was simply that as the deal was winding down, the manager was able to sell the few remaining assets at prices high enough to pay down all the notes, rendering irrelevant the Monte Carlo default simulation trials being run by the raters. In other words, the model let them down.

In an interesting, perhaps prudent decision, S&P took a different course in an announcement they made earlier today, entitled “S&P Takes Various Ratings Actions on 30 U.S. RMBS Deals.” As certain deals dwindled down, compromising the predictive content of their ratings, they chose to simply withdraw the ratings.

“We subsequently withdrew our ratings on certain affected classes that are backed by a pool with a small number of remaining loans. If any of the remaining loans in these pools default, the resulting loss could have a greater effect on the pool's performance than if the pool consisted of a larger number of loans. Because this performance volatility may have an adverse affect on our outstanding ratings, we withdrew our ratings on the related transactions.”

While it may cause frustration to note holders to see the ratings withdrawn, it augurs well that a rating agency is able and willing to say that it cannot have confidence in the outcome, and therefore chooses to withdraw its rating rather than have investors rely, perhaps falsely, on a rating in which it does not have confidence.

Analysis of The Shortcomings of Statistical Sampling in the Mortgage Loan Due Diligence Process

This is a popular litigation-related piece on our website we thought we'd share through this post (pdf version available here) - enjoy the read.



Introduction

Financial institutions, when assembling mortgage pools for the purpose of inclusion in residential mortgage-backed securities (RMBS), often hire independent analytical companies, like Clayton Holdings LLC (“Clayton”), to perform due diligence on the loans and flag any that are problematic.

Leading up to the financial downturn, Clayton reviewed mortgages for its clients - investment and commercial banks and lending platforms, including those of Bear Stearns, Barclays, Bank of America, C-Bass, Countrywide, Credit Suisse, Citigroup, Deutsche Bank, Doral, Ellington, Freddie Mac, Greenwich, Goldman, HSBC, JP Morgan, Lehman, Merrill Lynch, Morgan Stanley, Nomura, Société Générale, UBS and Washington Mutual (the “Issuers”). As such Clayton was purportedly one of the larger due diligence companies that analyzed whether these loans met specifications like loan-to-value ratios, credit scores and the income levels of borrowers.

Clayton describes, in the presentation it provided to the Financial Crisis Inquiry Commission (“FCIC”), the results of its review of a total of 911,039 mortgage loans between Q1 2006 and Q2 2007 ₁. As can be seen from the chart, of the loans shown to Clayton, Clayton determined approximately 72% of them to be in compliance, and 28% of them to be out of compliance with the standards tested, or “non-conforming.”

Upon determining that a loan failed to meet its guidelines, an Issuer (i.e., Clayton’s client) would have the ability to exercise their contractual right in “putting back” these non-conforming loans to the mortgage lenders – New Century, Fremont, Countrywide, Decision One Mortgage – rather than include them in securitizations.

The regulatory bodies, and the media, have concentrated heavily on the sizeable portions of non-conforming loans, and the lowering of underwriting standards throughout this period; but for this analysis, we concentrate on a more illuminating aspect of the way in which non-conforming loans ultimately found their way into the securitized RMBS pools.

There are at least two ways that non-conforming loans can find their way into the securitizations:

• First, the Issuer may choose to waive the loan back into the pool, despite its being originally rejected by Clayton.

• Second, a more overwhelming mechanism, is to not show the loan to Clayton.

The Intricacies of Loan Sampling

Importantly, it seems to have been common practice for Issuers to show only a sample of the loans to Clayton. A sample risks being unreflective of the population of loans, but random sampling can provide an effective statistical approximation under very strict conditions. It can be a cheaper process and, if the sample is well chosen, can accurately reflect the pool.

The objective of sampling is satisfied if the randomly-selected sample is sufficiently large, and is deemed to be in order. Alternatively, if the sample fails to meet expectations, the entire portfolio ought to be revisited. However, in the mortgage due diligence process the samples were often deemed to be problematic – they resulted in an average of 28% of loans failing their criteria. Importantly, the samples were then adjusted, as we understand it, but the original portfolios were not: the Issuers would only put back certain non-conforming loans from that sample.

In this case, the resulting sample, after throwing out certain non-conforming loans, fails to accurately depict the remaining portfolio of loans it was chosen to represent.



How the Sampling Process Worked, and Difficulties Therewith

Former President and COO of Clayton, D. Keith Johnson, explained to the FCIC committee, during their hearing of September 2010, that in the 2004 to 2006 time period, sample sizes went down to the region of two to three percent₂. As the sample size decreases, which it did, the effect of the sampling process alone begins to undermine the effectiveness of the due diligence process.

The media have focused their attentions on what happened to the 28% non-conforming loans – the slices in red in the associated charts. Indeed, many of these non-conforming loans, approximately 39%, were not “kicked out” or put back to the mortgage lenders, but were “waived” back in to the to-be-securitized portfolio. This 39% is substantial, and a factor worthy of the media’s attentions.

But the game-changing fact is not among these 28% non-conformers, or the 39% of them which remained in the securitized pool. These are only part of a sample, and when the sample becomes insignificantly small, its overall contribution to the portfolio as a whole is rendered less meaningful. Rather, it is more prudent to consider the composition of the pool as a whole.

For illustrative purposes, let us assume that the sample loans shown to Clayton represented 3% of the pools, on the higher end of those referred to in the abovementioned Johnson hearing. Let us conservatively assume that the sample provided to Clayton was truly randomly selected.₃

For a pool of 10,000 loans, Clayton would have been presented with approximately 300 loans, or 3%.

As we can see from the analysis performed, the effect of “throwing out” 61% of all non-conforming loans is marginal: the pool’s overall composition decreased only from 28% non-conforming to 27.67% non-conforming thanks to the due diligence process. Even had the Issuers returned all 84 non-conforming loans, the overall portfolio would not have been greatly altered –non-conforming loans would have declined from 28% to 27.16%.

When a random sample is tampered with, the final product, by definition, no longer represents the original pool. Here, the sample reflects that ultimately 89% of the pool is conforming and 11% are non-conforming (11% = 28% x 39%). But given the reality of the situation, with the original pool remaining status quo, in fact 27.76%, not 11%, of the overall pool was non-conforming, even after the put backs administered as part of the due diligence process.

A well-selected random sample can effectively capture the characteristics of a pool under certain conditions. But an altered sample seldom accurately reflects the original pool.



1 http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0923-Clayton-All-Trending-Report.pdf
2 http://fcic.law.stanford.edu/resource/interviews#J
3 course, the sample sizes used and the percentages rejected by Clayton will differ from Issuer to Issuer. So too will the waiver rate.

Illinois Attorney General Sues S&P – Initial Thoughts

Credit risk ratings are becoming a risky business.

Yesterday’s filing of the complaint against S&P (MHP) centers, in essence, on the allegation of false advertising. Stepping in to this issue for a moment, one of the key defenses offered by the raters is that their ratings are protected under the First Amendment rights to express an opinion (their “speech”). But as law professor Eugene Volokh opines in his letter to the House Committee (May 2009) it is within the framework of commercial advertising that “speech aimed at proposing a commercial transaction – is much less constitutionally protected than other kinds of speech.”

In this case, the AG is not really focusing wholly on whether the ratings were wrong, as much as it’s saying that S&P advertised that it was following a certain code in ensuring the appropriate levels of independence and integrity were being brought to the ratings process.

A former SEC enforcement official, Pat Huddleston, once explained that "[when] I say the [financial] industry is dirty, I don't mean to imply everyone in the industry is dirty," … "[only] that the industry typically promises something it has no intention of delivering, which is a client-first way of operating." This is essentially what the complaint argues: that S&P “misrepresented its objectivity” while offering a service that was “materially different from what it purported to provide to the marketplace.”

This goes back, really, to the key reform measure Mark proposed before the Senate in 2009 – that rating agencies would do well to separate themselves from commercial interests, by building a formidable barrier around the ratings process.

First, put a “fire wall” around ratings analysis. The agencies have already separated their rating and non-rating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an “ivory tower,” and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance and promotions.

Two other elements jump out immediately from the complaint:

First, the complaint specifically argues that the rating agency “misrepresented the factors it considered when evaluating structured finance securities.” Next, the complaint tries to tie S&P’s actions to its publicly-advertised code of conduct, arguing that its actions were inconsistent with the advertised code.

In respect of actions being inconsistent with the code, certain of these arguments are common-place, such as the contention that the rating agencies did not allocate adequate personnel, in opposition to what’s advertised in the code. This of course becomes a contentious issue – you can see S&P coming back with copious evidence of situations in which they did “allocate adequate personnel and financial resources.” But the complaint hones in on the factors considered in producing a rating, and it focuses on two parts of the code:

Section 2.1 of S&P’s Code states: “[S&P] shall not forbear or refrain from taking a Rating Action, if appropriate, based on the potential effect (economic, political, or otherwise) of the Rating Action on [S&P], an issuer, an investor, or other market participant.”

and…

Section 2.1 of S&P’s Code states: “The determination of a rating by a rating committee shall be based only on factors known to the rating committee that are believed by it to be relevant to the credit analysis.”

This brings back to mind, disturbingly, a recent New York Times article (Ratings Firms Misread Signs of Greek Woes) which focuses on the deliberations within Moody’s (MCO) and their concerns about the deeper repercussions of downgrading Greece – rather than the specifics of credit analysis:

“The timing and size of subsequent downgrades depended on which position would dominate in rating committees — those that thought the situation had gotten out of control, and that sharp downgrades were necessary, versus those that thought that not helping Greece or assisting it in a way that would damage confidence would be suicidal for a financially interconnected area such as the euro zone,” Mr. Cailleteau wrote in an e-mail.”

The question then, is whether rating committees were focused on credit analysis, or whether other concerns were at play, aside even from typical business interests. The concerns for rating agencies, from a legal perspective, can become quite real when the debate centers not on ratings accuracy, but on whether the rating accurately reflected their then-current publicly available methodology. There may be substantial risks, therefore, in delaying a downgrade of a systemically important sovereignty or institution (such as a too-big-to-fail bank or a key insurance company) if such downgrade is appropriate per the financial condition of the company or sovereignty, or in providing favorable treatment to certain companies or sovereignties based on the relative level of interconnectedness.

The allegations of misrepresenting factors considered in their analysis opens another can of worms for rating agencies, as they’ll subsequently be increasingly focused on disclosing the sources of the information relied upon. There’s substantial concern, to the extent they’re relying on the issuing entity (in cases in which the issuing entity is itself the paying customer), that such reliance becomes a disclosure issue to the extent the investor may otherwise have assumed the rating agency was independently verifying such information. This was a frequent problem in the world of structured finance CDOs such as those described in the AG’s complaint.

Last, but not least, the complaint focuses on the effectiveness of ratings surveillance. This is a topic of importance to us, as we feel that proper surveillance, alone, may have substantially diminished the magnitude of the crisis. At the very least, certain securitizations that ultimately failed may not have been executed had underlying ratings been appropriately monitored, and several resecuritizations may have become impossible, limiting the the proliferation of so-called toxic assets. See for example: Barriers to Adequate Ratings Surveillance

That’s all for now. There’s a lot more to this complaint, so we suggest you check it out here.

A Fair (Value) Solution

Hello readers, and a belated welcome to 2012!

In yesterday's FT Citigroup CEO Vikram Pandit advocates for heightened transparency across the banking system, enabling an apples to apples comparison that “[clears] some of the obscurity that causes people to believe the system is a game rigged against their interests.”

He is not alone. Late last year, Barclays' Group Finance Director Chris Lucas called for greater transparency in the financial reporting of liability valuations. The concept, of course, is that transparency is desired by investors, once bitten, before they can again get comfortable investing in banks.

Pandit proposes a solution that involves creating a benchmark portfolio against which banks can measure their relative risk.

Asset valuation itself has become the number one concern for the SEC in 2011: through mid-December the SEC had, according to the WSJ, issued a total of 874 “comment” letters to 802 distinct companies concerning their fair valuation and estimation of assets and contracts. Meanwhile, audit firms PwC, KPMG, Deloitte and others have been criticized as to their oversight of their clients' valuations and valuation processes (see Contested Pricing List). And so it is not surprising that banks are trying to overcome these substantial hurdles, though understandably in ways that suit them best.

The problem here is akin to the one faced by technology companies: the evaluation of their patent portfolios is no mean feat and is highly subjective – yet it is a crucial component of their stock price, especially in an acquisition or dismantling process.

Pandit’s solution is one solution. Another is more arduous, but overcomes the dual problems of inconsistency and subjectivity. It also combats the material regulatory arbitrage gaming business that has been created to minimize capital reserves. We would be able to say good-bye to a whole business of utility-free resecuritizations, structured solely to game the ratings models to achieve, or manufacture, lower reserves. It would be the end of certain Re-REMICs and perhaps even AAA-rated principal protected notes.

The solution, of course, is to evaluate each and every bond. This is already being done (to an extent) by the NAIC, and would add stability and assurance to our investor base.

Asset valuation may be more art than science, especially in the world of illiquid assets – but at least it's not a game. If well-performed, it can provide the cross-company valuation consistency even our bankers are calling for.

But it won’t be cheap.

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For our Central Pricing Solution, click here.

Covering and Uncovering the World of TruPS CDOs

The Philadelphia Fed’s June 2011 working paper provides a welcome addition to the conspicuously deficient body of literature on the topic of TruPS CDOs.

The researchers were quite thorough in detailing the creation of these notoriously opaque, private vehicles. They also tackled the valuation of these deals in an effort to estimate foreseeable losses on the tranches issued. This is no mean feat, but rather an academic exercise which helps readers and researchers better appreciate the limitations suffered by outside parties, like regulators, who are trying to get a handle on this market. For example, the researchers were limited to “[working] with information trustees make public to potential investors (or researchers like us).”

The authors nevertheless honed in on several key aspects of the market, some of which haven’t been adequately addressed in prior publications.

In terms of the creation of these instruments, they note the multidimensional roles being played by market participants who constructed these deals. They remark that several “dealers also serve as collateral managers and consult with banks on valuations” and they comment on the curious role of rating agencies whose “primary motive is to generate business.”

The researchers were also alive to the fact that “early TruPS CDO investors were relying largely on rating agency ratings and surveillance from the dealers responsible for issuing TruPS CDOs.” (Oddly, they too fall back on Moody’s data as the sole point of comparison for validating their own model – seemingly indicative of the situation many are and were faced with, in which one is forced to rely heavily on the rating agencies given their heightened access to data, and the presumed advantage rendered by this informational asymmetry. Unfortunately, given the lack of predictive content of ratings in this realm, it is perhaps difficult to find comfort in the fact that their model's outputs are similar to those produced by Moody’s.)

The researchers were also critical of the rating agencies’ assumptions and methodological changes, especially on the correlation side. They point out that “the model used to justify the zero inter-regional correlation assumption, apparently critical to the development of the single industry TruPS CDO market, was based on a model developed for an unrelated class of securities.”

They also track the increasing correlation between underlying banks over time, and admit their concern that despite the realization and disclosure of the increased concentrations, “rating agencies made few, if any, adjustments for this fact nor did we find evidence that issuers or other analysts expressed any concerns until after the TruPS CDO market came undone.” We would have liked to have seen them analyze, more critically, the validity of changes made in recovery rate assumptions over time.

Analytically, their model puts forth a number of interesting data points, not the least of which is a deferral-to-default cure rate of 2.3%. We believe this is lower than the current market rate, but it certainly runs counter to some of the punitive assumptions being applied elsewhere when analyzing these CDOs, where deferrals are often assumed to always default, with no recovery. (See The Tripping Point for more on this.)

Importantly, the lack of accessibility to certain information hinders the quality of their projections – something the researchers appreciated and candidly disclosed. They recognize that “unfortunately, we do not have information to analyze the risk profile of small banks issuing TruPS into TruPS CDOs versus those that did not. A more thorough analysis of risks at these small banks will have to wait until more information is disclosed.”

They were also cognizant of the inherent difficulties on the data side, given the “[limited] historical performance for TruPS, particularly in a stress environment, [making] forecasting future [deferrals and defaults] more an art than a science.”

Their lack of access to the underlying names leaves them at a significant disadvantage to most investors and players in this market, who have direct access to these names. Unfortunately, they also comment that they were unable to see through to the pool level assets, leaving them unable to distinguish between deferring and defaulted assets. Their inability to look through to the asset level means they must treat all pools identically, based on their overall opinion of the future of banks. This approach leaves them open to significantly underestimating or overestimating the differences between the banks included in different pools. (The FDIC’s Supervisory Insights on winter 2010 was particularly forthcoming on the reasons why banks included in TruPS significantly underperformed other banks in this crisis. We graphed this dynamic in Adverse Selection? No Problem!)

Having advocated heavily for a Central Pricing Solution for TruPS CDOs, we warmed particularly to one part of their important conclusion, which proposed that:

"Banks should also all be disclosing their securities holdings in their investment portfolios to regulators each quarter. For these, bank regulators should follow the model adopted by the National Association of Insurance Commissioners (NAIC), which receives from members CUSIPs and other information on investment portfolios so that regulators can do a full evaluation of all holdings in insurers’ investment portfolios. Applying models like the one we developed to all banks’ TruPS CDO holdings would offer a consistent, independent assessment to compare with banks’ internal analyses. Exactly this type of exercise was conducted as part of the 2008 Supervisory Capital Assessment Program (SCAP), commonly referred to as the “stress tests,” and the 2011 Comprehensive Capital Analysis and Review (CCAR) exercise for the largest banks. With a simple NAIC-style schedule, this type of analysis could be extended to smaller banks’ investment portfolios, with enormous gains in information and the quality and consistency of regulatory supervision."

Built to Fail CDOs 101: How Well Do You Know Your CDS Counterparty?

The Abacus CDO story of 2010 brought to the fore a worrisome scenario in which it could be argued that the arranging bank (Goldman Sachs) played two different roles at once, potentially serving one particular client (Paulson) at the expense of other clients (investors in the Abacus CDO). Goldman settled the case with the SEC for $550mm. What could be worse than participating in such a conflicted scenario? We are concerned that in a number of deals the arranging bank may have positioned itself directly against the CDO investors. In other words, the bank, like Paulson, may have been betting against its clients.


But first, let’s take a step back to explain how this all works…

A CDO is called a “synthetic CDO” when the underlying assets are “synthetically” referenced, rather than being held like physical corporate bonds. The underlying assets are often referenced by way of credit default swaps, or CDSs, and are called “reference obligations.” These CDSs may reference several types of asset classes, but in the synthetic CDO setting they typically reference either corporate debt or structured finance securities, such as commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), or even other CDO tranches. In the Abacus deal, the reference obligations were credit default swaps struck on RMBS.

Instead of buying physical assets that pay coupons (when current), the synthetic CDO sells protection on a portfolio of reference obligations. Much like insurance contracts, the buyers of protection on each underlying CDS make periodic “premium” payments to the CDO in exchange for compensation if and when a default, or credit event, occurs with respect to the obligation being referenced.

The CDO’s immediate counterparty on each CDS – typically the arranging bank – often plays an intermediary role between the CDO and each of its CDS transactions. It buys protection from the CDO and sells protection to the end buyer. This layout allows for the CDO to focus solely on the counterparty risk (i.e., the risk that a party will fail to fulfill its obligations under the CDS agreement) of a single party – in this case the arranging bank – as opposed to that of each end buyer (of protection).



Ideally, this dynamic ought to create an environment in which the immediate CDS counterparty (the arranging bank) is neutral to the performance of the CDO as the bank is fully hedged (as long as end buyers do not default).[1]

The imposition of an intermediary CDS counterparty often masks the identity of the end buyers from those who invest in CDO notes, potentially rendering CDO investors unable to discern which parties are ultimately short their portfolio.

Goldman Sachs’s now famous Abacus CDO illustrates a serious danger that can arise from the above confusion. The argument could be made that had investors known that Paulson was the end buyer of protection on a significant portion of Abacus’ CDS portfolio, they may have reconsidered the prudence of their investment, and potentially shunned it.


Built to Fail, Profitably

But what happens if the arranging bank chooses not to off-load all positions to an end buyer? In other words, what happens if the bank retains some or all of the short exposures to the underlying reference obligations? Here, the end buyer of protection, and the immediate CDS counterparty are one and the same: the arranging bank. The bank is now effectively short the CDO.

For example, the plaintiff in re: Space Coast Credit Union vs. Barclays Capital et al argues that:

“[the] facts here leave no doubt there was clear intent to create a very large short bet through Markov against Mezzanine CDO risk”

and that:

the “Defendants were extraordinarily determined to stuff Markov [CDO] with Mezzanine CDO risk.”

Plaintiff argues that:

“most stunning of all, [the Defendant] was so intent on Mezzanine CDO failure that it custom-built $300 million of built-to-fail Mezzanine CDOs … that [the Defendant], through Markov, could then bet against.”

While we do not seek to verify the accuracy of their contention, we are keenly aware of the material conflict such a scenario would present: the arranging bank is short the securities, meaning it would be financially rewarded if those securities were to plunder. The bank would benefit from selecting poor-quality assets. At the same time, the arranging bank is selling CDO notes, supported by these assets, to its clients. If the assets fail, the bank profits at the expense of the CDO noteholders – its clients. If the assets perform well, the bank would suffer financially.

From a higher level fiduciary perspective, the bank’s financial motive would not be aligned with the well-being of its client. Nor would the bank be even indifferent to the performance of its client. Rather, the bank’s profitability would be in direct opposition to that of its client.


While their clients were losing money on the trade, how much were bank profiting?

Removing the time value of money and the default timing as inputs to the model, we can create a simple model to estimate the bank’s profits from this trade. The model assumes that 100% of the assets are synthetically referenced.

Suppose the total premiums being paid were P, and that a bank held the super senior swap, with attachment point AP. The higher the attachment point, the greater the potential for the bank to make money: if losses exceed AP, the bank's profits are capped, as the profits from its short positions mimic identically the losses from its super-senior position.





In dollar terms, suppose the deal is of size $1bn, with an average 1% credit premium (P) on the reference obligations and a super-senior attachment point (AP) of 50%.

Suppose for simplicity that all losses occur within the first year.

If losses (AL) are lower than 1%, say they’re 0%, the bank loses 1% x $1bn = $10mm. Thus, if the portfolio is well selected, the bank stands to loses up to $10mm.

But if the portfolio is poorly selected, and suffers losses over 1%, the bank cashes in handsomely. At 5% losses, the bank makes 4% of $1bn, or $40mm. At 50% losses, the super senior attachment point, the bank caps out at 49% of $1bn, or $490mm. (Profits are maxed out at the 50% AL level as, in this example, the bank holds the super senior swap.)

A bank can either lose up to $10mm for doing a really good job of diligently selecting good assets, or the bank can make as much as $490mm for selecting really bad assets. Would you expect any bank to do the former?

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[1] If anything, the CDS counterparty ought to have a slight preference for the continued performance of each CDS contract, as a default would cause settlement and thereby cut short any intermediation fees it may be earning as a middle-man.