TruPS CDOs: What Virus?

While the rating agencies have been actively downgrading bonds across almost all sectors, we thought it may be fun to compare the performance of regional US banks during COVID-19 against their performance during the 2007-2008 financial crisis.

Bank TruPS CDOs are deals supported by trust preferred securities issued by regional/community banks.   Interestingly enough, since the onset of the coronavirus, the TruPS CDOs (if anything) have been going up from a ratings perspective.

Yesterday, Kroll Bond Rating Agency affirmed the ratings of a 2018 deal, without making any mention of the coronavirus.  Meanwhile in a series of (we count four) ratings releases since March, Fitch has upgraded dozens of tranches, and affirmed many others too. No downgrades, and no mention of COVID-19.

So why the upgrades?  The likely answer is that many of the upgrades have been lingering for a few years, and just had to happen at some stage, so why not now?

Here's one of the more interesting bonds, the $70mm top tranche (originally AAA) of a 2005 deal called Regional Diversified Funding 2005-1, which has seen both crises.  

Read the chart from the bottom up.  Pre-crisis, Fitch has it at AAA, until it was (rather dramatically) downgraded on a single day to CCC in 2009.  That's incredible.  Okay, fast forward and it's single C in 2010, Fitch's lowest rating: an expectation of full or almost full wipeout. 

Since it had gone from AAA (sacrosanct) to C (a dead-beat) it's just as incredible that it has since marched back up to CC (in 2015, of all times) and then CCC, BB and now A (as of yesterday), which is a serious investment grade rating.  

Nevermind the coronavirus!

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

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).

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."

A TruPS UPdate

The TruPS CDO market has shown renewed signs of life over the last six or so months, for the first time really since 2007.

While the rating agencies continue to downgrade these bonds, and while certain serious risks remain to their performance, the market is (finally?) reacting to a number of positive developments in the underlying bank market. Several TruPS CDO securities, we believe, are now grossly mis-rated by the rating agencies. Our analysis suggests that many securities rated CCC or below will pay off in excess of their ratings-implied losses; some are likely to pay off in full.

Default Risk

A key risk for TruPS CDOs remains the default rate on smaller banking institutions. (Aside from banks strictly being pulled into receivership, TruPS CDO noteholders remain exposed to losses that may result on their preferreds to the extent troubled banks restructure, recapitalize or file voluntary petitions for relief under Ch. 11 of the Bankruptcy Code – see for example the cases of AmericanWest, or Builders Bank.)

On the plus side, the rate of bank failures has gone down from 2010. Adjusting for the cohort size – depending on the number of institutions reporting – we’re down from a default rate of approximately 2.05% last year to 1.37% annualized this year, based on the FDIC’s most recent quarterly report (March-end 2011).

This difference is substantial. From the looks of it, one of the key components of this reduction was that bank regulators were more successful in having banks absorbed through a merger process, evading failure: if we consider mergers plus failures, the sum is little different, from 4.62% in 2010 to 4.33% annualized for Q1 2011. But the distribution is now heavier towards the merger side of this equation, implying in the reduced bank failure rate.

The staving off of default, through the merger process or otherwise, almost always proves advantageous to TruPS CDO noteholders.

Balance Sheet Conditions & Outlook

The FDIC notes that “[more] than half of all institutions (56.2 percent) reported improved earnings, and fewer institutions were unprofitable (15.4 percent, compared to 19.3 percent in first quarter 2010),” and that net loan charge-offs (NCOs) have declined for the third consecutive quarter, resulting in an overall 37.5% reduction since March-end 2010. Deposit growth remains strong and the net operating revenues reductions were concentrated at the larger institutions – less of a concern for the average TruPS CDOs which are more heavily exposed to smaller rather than larger banks.

Banks' balance sheets, too, are in better condition: the ratio of noncurrent assets plus other real estate owned assets to assets decreased from 3.44% in 2010 to 2.95%. Also, while the overall employment of derivatives has increased almost 13% over the last year, the heightened exposure is more heavily concentrated among the larger banks. Based on PF2's calculations, if you exclude banks with more than $10bn in assets, you’ll notice a reduction of almost 30% in derivatives exposure over the last year.

These numbers are still much worse than pre-crisis numbers. Historically banks defaulted at an annual rate of approximately 0.36%, on a count basis. We’re at roughly four times that number now. Back in ’06, fewer than 8% of reporting institutions were unprofitable. We’re still at double that number. The ratio of noncurrent assets plus OREO assets to assets was slightly below 0.5% in 2006. We’re sitting at six times that level. But the trends are moving in the right direction – certainly if you’re an investor in the average TruPS CDO.

On the downside, the FDIC’s problem bank list has grown by a not-insignificant amount, from 775 banks (or 10.12% of the cohort) in 2010 to 888 banks (11.72% of cohort) as of March 31, 2011. TruPS CDO noteholders will doubtless hope that these troubled institutions turn around, or are merged or resolved in any other fashion that circumvents default on their trust preferred securities. (For TruPS CDO noteholders exposed to deferring underlying preferreds, the acquisition or merging of the deferring bank by or with a better-capitalized bank brings with it the possibility of the deferral’s cure.)

With the downward trend of bank default rates (and the possibility of deferrals curing), some of the more Draconian bank default probability assumptions can be relaxed, boosting values on TruPS CDO tranches.

We think the market is starting to appreciate this additional "value."

Adverse Selection? No Problem!

A section from their rating methodology piece "Moody’s Approach To Rating U.S. Bank Trust Preferred Security CDOs" describes its procedures for ensuring the quality of bank preferreds being bought by CDO managers (S&P / Fitch have something similar). The section reads:

"In order to control for [adverse selection of banks by the arranger of CDOs], Moody's takes a four-step approach for banks that are not rated by Moody's.

First, each bank should satisfy the following prescreening attributes:

• Financial Institution insured by the Bank Insurance Fund or Saving Association Insurance Fund.

• Five years minimum of operating history.

• Minimum asset size of $100 million.

• Not under investigation by any regulatory body.

• No restrictions placed on its operations by any regulatory body."

[additional steps omitted in the name of brevity]

Alas...

Central Pricing Solution

It continues to worry us that asset prices can be, or are, subject to conflicts of interests and inflationary pressures.

As an independent valuation consultancy we’re naturally disagreeable about market participants seeking valuations from biased counterparties like asset managers or even the broker dealers who sold them the bonds or are funding their holding of the bond. Scion Capital’s Michael Burry explained in The Big Short: “Whatever the banks’ net position was would determine the mark.”

But even aside from potentially conflicted external parties, we’re acutely aware of the inflationary pressures independent parties such as ourselves may face when evaluating a security. Similar to “ratings shopping” opportunistic market participants often seek out the provider willing to give the highest prices.

The incentive is clear: higher asset prices translate into stronger performance. Stronger performance may directly benefit an executive or employee (to the extent performance fees or bonuses are based on returns) or even indirectly improve a fund’s prospects (heightened ability to raise capital or negotiate decreased margin requirements on the back of strong performance).

While prices have been regularly contested problems are starting to crop up more and more regularly, with questions about mutual funds’ municipal bond pricings and Berkshire Hathaway’s pricing and writedown practices finding their way into the news in the last two months.

There’s no easy solution, but one we feel strongly about is the creation of a centralized analytical (read pricing) solution.



The cost of creating such a system could be shared among its users. The advantages are numerous. Here are a few:

• If all holders were required to hold the same security at the same price, the result would be greater balance sheet consistency (across funds, companies)

• Regulators, auditors and examiners would have an easier time analyzing their constituents’ books: they would be able to rely on a single, consistent model that is widely used. (The prevailing, seemingly inefficient alternative is to have each regulator/ auditor/examiner familiarize herself with the methodologies employed by each and every pricing provider used by each company scrutinized. This is no mean feat, especially across different asset classes, and so naturally a lot will slip through the cracks.)

• Pricing consistency helps reduce portfolio-level variability and also helps the market overcome some of the uncertainties that come with informational asymmetries and modeling complexities in today’s market. Consistency and confidence together help promote market liquidity.

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.

The Psychological Biases of Holding Downgraded Bonds

The early days of this economic slowdown brought to our attention a plethora of examples of investors choosing to hold on to downgraded bonds in the belief that “they will come back again,” and that “it is only a temporary market dislocation.”

(Incidentally, it is not traders alone who fall prey to the “return-to-normalcy” ideology. Many of us carry the internal belief, for example, that all will be well immediately a blundering institution recognizes its folly. Being exposed to one’s folly, and fixing it, however are two different things. Thus, history tends to be allowed to repeat itself.)

From a strict utility function perspective, opting to hold on ought probably to prove the inferior choice: downgraded bonds tend to be more likely to be downgraded (again) versus comparably-rated bonds that have yet to be downgraded; moreover, the risk of an associated exponential increase to reg. capital radically changes the risk-return profile of the investment.

But there are a number of psychological forces in play that make investors particularly vulnerable to the need to hold downgraded securities whose market value is quickly diminishing.

Psychological Biases

First is the obvious — that investors exhibit risk-seeking behavior in the face of losses while being risk-averse in the face of gains.

Next, investors originally held some derivative of an innate belief that the rating agencies possessed magical capabilities and material non-public information which resulted in their original ratings being correct and any subsequent rating changes posing mere caveats before the return to normalcy. This “everything will come back again” mentality demonstrates at least two behavioral biases: (i) representativeness, the willingness of investors to base their decisions of superficial (or artificial) characteristics as opposed to underlying probabilities, and (ii) conservatism, the willingness to cling to a prior belief despite the receipt of new information.


Were They Right?

The answer is... sometimes.

Here are certain factors that should be taken into account, followed by a solution to the quandary:

First, rating agencies’ actions are often retroactive: the rating action only occurs well after the fact. In some cases, that means that as an investor you can look directly at the current situation to gauge whether subsequent upgrades are imminent.

Example: according to information we have been provided, one rating agency began downgrading collateralized loan obligation (CLO) securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to “normal” levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.

According to JPMorgan data, the spread levels on 5yr LCDX tightened from 556 basis points to 377 basis points over the relevant Sep. ’09 to May ’10 period, demonstrating the market’s interpretation of decreased credit risk on similar loans to the ones in CLOs. Next, Wells Fargo data show that whereas almost half (49.3%) of CLOs were failing their junior par coverage test as of mid Sept. 09, less than one fifth (18.86%) were still failing as of early May 2010. This key ratio perhaps best describes the improved performance of CLO securities.

Thus, in a market when the rating agency should have been upgrading bonds on a net basis, it (perhaps retroactively) downgraded more than 75% of all CLO bonds rated by them, including 76.27% of all triple A securities they rated, the market was already well into its turnaround and continued to improve. Those downgraded bonds are now being swiftly upgraded.

In other cases the “hold-to-normalcy” trade hasn’t worked as well: trust preferred (TruPS) CDOs seem continuously to be downgraded, as bank failures and bank deferrals continue to plague this market. While in certain markets default rates were significantly lower in 2010 than 2009, there has been an approximately 20% increase in bank defaults this year (annualized) versus in 2009. The credit performance of certain tranches, unfortunately, may never return to their pre-crisis levels.

In it in this light that S&P’s announcement last week was so interesting to us. S&P placed 1196 bonds on CreditWatch negative as they “incorrectly analyzed the timely interest payments, and did not incorporate an analysis of the effect of interest paid pro rata on the senior securities (that, all else being equal, inherently contain lower credit protection than those in which the interest is paid sequentially) for those transactions that have this structural feature. Approximately two-thirds of the classes affected by this CreditWatch action are from transactions issued in 2010 and approximately one-quarter were issued in 2009.”

(To be clear, their misrating of RMBS re-REMICs was not the interesting element. A week prior to this announcement we submitted to the Financial Times a comment letter that described the continued misrating of these securities, click here www.ft.com/cms/s/0/c51bb428-072c-11e0-94f1-00144feabdc0.html. We cite a Re-REMIC rated AAA in 2008 that currently languishes in the CC region.)

The magnitude is certainly severe, but the confession is the focal point, as it allows investors to immediately recognize that, wait, these bonds were incorrectly rated and contain risk in excess of that originally estimated by S&P. In publicly admitting to their error, a true “investor service” was provided to the investors by S&P. Naturally, one might be less enthusiastic about this announcement if one were to own a to-be-downgraded bond.

The next question, of course, is who else rated these bonds? And which rating agencies chose not to rate the bonds as a result of their model not being able to achieve the high ratings S&P's model produced?


The Solution

If you’re an investor, we suggest due diligence. Look into the assets being downgraded. If reg. capital is a question for you as a bank or insurance companies — or margin for leveraged funds — build a model to capture probabilities of being right versus wrong, pre-decision. Work out the probability that a large downgrade is to be followed by an upgrade, versus subsequent downgrades, asset-class by asset-class.

Welcome to the brave new world of investor due diligence.

Warning: Insurance TruPS

In an atypical, ominous maneuver, rating agency A.M. Best has today placed on negative watch the ratings of (we believe) all tranches of all trust preferred CDOs rated by them. From the most junior notes to the most senior notes, all in one fell swoop.

The insurance trust preferred CDO securities -- the area in which A.M. Best focused -- have thus far outperformed their bank or REIT TruPS counterparts, which is one of the reasons behind the comparatively stronger performance of A.M. Best's ratings versus others in the TruPS CDO space, thus far (click here for details).

The reason for the negative attention according to A.M. Best?

The rating actions reflect concerns in a number of areas including (1) the growing number of “defaulted securities” and capital securities whose periodic interest payments are in a deferral mode in the various pools; (2) capital securities redemption activity occurring in the pools; (3) increased stress upon the various credit support/enhancement mechanisms; and (4) deterioration in the issuer credit ratings of individual insurance companies and deposit taking institutions within the transaction pools.

Trust Preferred CDO Update

We ended last year with a special report on what we saw as the changing nature of banks’ “choice” to defer. Our piece, entitled “The Tripping Point” concluded as follows:

“…while data remain scarce for the illiquid, opaque world of bank trust preferred securities in TruPS CDOs, our preliminary analyses tend to support the theory that not all deferring banks are poorly positioned, under-capitalized institutions. As we monitor the situation and continue to gather further evidence to either support or reject this argument, we eagerly anticipate a conclusion that not all deferring banks are doomed to fail.”

Since January 1, 2010, we have an increasing DEFAULT rate on banks in general. Using the FDIC’s cohort of 8,012 FDIC-insured financial institutions as of 12/31/09, we calculate a roughly 2.24% annualized default rate as of June 18, 2010. This default rate constitutes a 46% increase since the September 30, 2009 annualized default rate of approximately 1.53%, which was based off a 12/31/08 cohort of 8,305 FDIC-insured financial institutions.

(PF2’s base projections anticipated a roughly 50% weighted average increase of this 1.53% default probability over the forthcoming two years. Having realized this 46% increase, and from our various conversations with market participants and regulators, our best guess estimate is to anticipate another weighted average increase of 35%, over the forthcoming two year period. Thus, over the coming period, we attach an expected default probability of 3.02% to the average performing bank in our analysis of TruPS CDOs.)

We also encourage you to visit some of the excellent investigative journalism that’s been covering the TruPS market this year. Here follow some key pieces that provide insights into the differing pressures on and by banks, CDO investors, and external market participants. Amongst other things, the two June articles throw further light on the possibility that certain banks are opting to defer simply as a ploy to encourage investors to allow them to pre-pay their preferred securities at a discounted. (Of course this is not always the case, and banks certainly have the right to defer on their preferreds.)

June 11, 2010; American Banker: Blocking Rescues, or Challenging Bum Deals?

June 8, 2010; Bloomberg: Banks in `Downward Spiral' Buying Capital in CDOs

March 19, 2010; Bloomberg BusinessWeek: CDO ‘Samaritan’ Hildene Duels Funds Over Collateral

April 27, 2010; American Banker: TruPS Leave Buyers in CDO Limbo;

TruPS CDO Ratings Performance

Click on the diagram to enlarge it

Notes

(1) Performance includes bank, insurance and REIT TruPS CDOs.

(2) The data show no upgrades on any tranches by any of the rating agencies.

(3) The migration tables indicate an average downgrade in the region of 12 rating subcategories; downgrades are continuing to this day.

(4) Often the same tranche is rated by more than one rating agency.

(5) The tranche ratings exhibited, in some instances, continue to benefit from the rating of the insurer, to the extent the insurer's rating remains stronger than that of the underlying tranche.

(6) The vast majority (91.76%) of the deals closed in the region between 2003 and late 2007.

(7) Please visit cdodatabase.com for more information on TruPS CDOs.

(8) Data on TruPS CDO issuance can be found here.

The Winter of Our Disconnect

Asset-Backed Alert has been kind enough to allow us to republish their one article from this morning's edition. It brings to the fore various of the topical issues that face and undermine the future securitization as a whole: lack of transparency, lack of supervision, and an unwillingness for market participants to take responsibility for anything that isn't explicitly defined to fit within their specified, direct jurisdiction. Without further ado, I hand you over to Asset-Backed Alert (all emphasis added by them):

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BONY Keeps Distance From CDO Tussle

Hildene Capital has hit a snag as it tries to have Cohen & Co. removed as manager of four collateralized debt obligations.

Hildene, which has been butting heads with Cohen for about two months, fired its latest salvo last month by trying to organize a vote among noteholders. But trustee Bank of New York balked when Hildene asked it to help arrange the ballot, saying it’s not the bank’s job to circulate such proposals.

The matter underscores an ongoing debate among market players about the roles trustees should play, especially when it comes to serving as a conduit of information and policing potential indenture violations. Some believe those shops are best suited to handle requests like the one from New York-based Hildene, as investors are often unaware of the identities of other bondholders.

Hildene holds junior paper from the Cohen deals — Alesco Preferred Funding 1, 2, 3 and 4 — and has nominated itself to step in as manager. The deals, issued in 2003 and 2004, were each backed by trust-preferred shares. Their combined face value was initially almost $1.5 billion.

At issue is a practice in which Cohen has moved collateral in and out of the transactions even though the underlying asset pools are supposed to be static. Cohen has said that it acted properly. But Hildene, which bought its interests on the secondary market, insists that Cohen’s moves are grounds for the Philadelphia firm’s dismissal.

Hildene’s complaint revolves around the idea that it was misled into basing its purchases on evaluations of the Alesco issues’ original obligors, as Cohen wasn’t supposed to trade the underlying collateral. Hildene cites an example in which Cohen removed $24 million of shares issued by FBR Capital from one of the deals this year and replaced them with $25 million of shares from Colonial Bank, which was subsequently seized by the FDIC.

Hildene said in an Oct. 5 letter to Bank of New York that such swaps violate the transactions’ indentures, and thus are illegal. The firm followed up on Nov. 25 by sending a letter to investors that it knows to hold stakes in the Alesco issues, requesting that they cast ballots to fire Cohen from its management role. It asked for Bank of New York’s help in the voting process around the same time.

Cohen, meanwhile, responded by asking Bank of New York to distribute a Dec. 7 letter in which it proposes to stop trading the deals’ underlying shares unless it receives investor approval. The firm also promises to direct any proceeds from such sales to investors, including all fees.

Cohen’s letter reiterates the firm’s denials of wrongdoing and reaffirms that it had the right to carry out the trades Hildene is disputing. “Moreover, we believe that asset exchanges helped to stabilize the portfolio and resulted in an enhancement of the financial interests of our investors,”
Cohen wrote.

The Alesco deals were among 17 that Cohen issued under that banner.

Piercing the Securitization

Wells Fargo is cursing the day it agreed to act as trustee on the Tropic and the Soloso TruPS CDO series...

For those not following, TPG found a loophole in the deal docs which allows it to cherry pick assets directly out of the CDO's portfolio, at ridiculously discounted prices, if 66.66+% of the CDO’s equity agrees to it.

TPG aims to secure the equity’s vote by paying them a consent fee* – obviously, this is bad for all the rated notes (who were hoping for par or at the very least a real market price).

* bribe

Read more here.

Tropic IV CDO Ltd.'s equity has voted. No surprise there, the equity went with yes.

Whether or not to execute, on the equity’s yes, is now Wells Fargo’s call - this leaves them in a bit of an awkward position: (1) accept and get sued by the rated notes, (2) reject and get sued by the equity.

This past Monday, Wells Fargo turned to a higher power, the United States District Court Southern District of New York, to protect itself against/resolve the Tropic IV CDO Ltd. dispute and all related future disputes.

Only have a hard copy of the Wells Fargo's interpleader complaint. Will update with a link soon.

The complaint discloses some of the participants involved in the Tropic IV CDO Ltd. dispute – see below.

The Imperfect Hedge

The outlook continues to be bleak for trust preferred securities CDOs (TruPS CDOs).

Not only does the FDIC continue to seize bank after bank, but the rate of bank failure continues to increase. By our calculations, using FDIC data, we moved from an annualized FDIC-insured institution default rate of 1.1% as of mid-year 2009 to 1.53% as of quarter-end September 31.

These default rates appear to be relatively mild versus say corporate bond default rates (which are well north of 10%); but we must remember that TruPS CDOs were structured based on the implied and historically-observed lower default rates of banks, due to their operating in a more heavily regulated environment. Thus, TruPS CDOs were able to be arranged with comparatively low levels of subordination, despite the low recovery rate on TruPS CDOs' deeply subordinated underlying asset class: trust preferred securities. In other words, built to protect against annualized default rates around 0.35%, TruPS CDOs find themselves ill-positioned to stomach the exponentially higher default rates.

Nor does it help that the FDIC might be incentivized to close all banks -- that is, including the well-capitalized banks -- if they operate under the same bank holding company umbrella. With the FDIC's deposit insurance fund running low, the FDIC's ability to exercise their cross-guarantee authority results in this unfortunate consequence for the better performing banks, as was the case with Citizens National Bank (Teague, TX) and Park National Bank (Chicago, IL) who were brought down along with FBOP. Both Citizens and Park National are considered "Average" performing banks by PF2's internal analysis, based on 6/30 call report data.

With bank default and deferral rates moving up, resulting in deal-wide decreases in "excess spread" levels, many TruPS CDOs have become increasingly sensitive to their interest rate hedges.

In our July 22 report we noted that:

"With TruPS CDOs already being pressured by the lack of interest generation by the defaulted and deferring securities they’re holding, the additional burden caused by the deals’ interest rate hedges is becoming increasingly torturous. TruPS CDOs usually have asset‐level swaps (although sometimes the swap has been implemented on the deal level) that exchange a pre‐negotiated fixed rate for LIBOR. With LIBOR being low, the cost of the swaps to the deal becomes tangible, on average accounting for 1.23% of the total deal portfolio size on an annual basis, or 1.45% of the performing deal size. (The median cost is 1.31% of total or 1.58% of the performing
balance.)"

These detrimental interest rate hedges -- almost always at the top of the waterfall BEFORE any payments are made even to the most senior rated notes -- are now coming under scrutiny by the rating agencies. For the first time (as far as we're aware)Moody's explained in a press release on Friday that the interest rate swap in Soloso2007-1 may negatively affect the performance of the original senior Aaa tranche, Class A-1L, prompting its downgrade to sub-investment grade (Ba1 rating). Emphasis added by us.

"Furthermore, due to the significant increase in the actual defaulted amount (an additional $17mm occurred this past month), the transaction is now negatively impacted by an unbalanced pay-fixed, receive-floating interest rate swap that results in payments to the hedge counterparty that absorb a large portion of the excess spreads in the deal. Today's actions therefore reflect that the burden of making hedge payment over the remaining life of this transaction will significantly reduce the amount of cash available to pay Class A-1L Notes and put interest payments of Class A-1L at significant risk."

Moral of the blog: beware of the hedge.

UPDATE November 3, 2009: We have received a press release from Moody's stating that a supermajority of equity noteholders in at least one TruPS CDO, Tropic CDO IV, have voted to allow the execution of a certain problematic loophole. You can read more about the loophole here, but here's a summary: the loophole allows a third party, subject to obtaining supermajority equity vote, to purchase assets directly out of the CDO's pool at the proposed and voted-upon price. The caveat is that the equity holders are pretty much out of the money at this point in TruPS CDO world, and so for a reasonable consent fee may reasonably be induced to vote in the affirmative, having (as far as we're aware) no fiduciary responsibility to protect noteholders senior to themselves. In the case of Tropic IV, the bidder was Trust Preferred Solutions LLC, which we understand to be a Minnesota vehicle of private equity firm Texas Pacific Group (TPG). Their bid was 5 cents on the dollar for what we believe were among the better preference shares in the portfolio.

Here follows an excerpt from Moody's press release that speaks to this situation:

"In a notice dated October 30, 2009, Wells Fargo Bank, N.A., trustee for Tropic CDO IV, stated that the holders in excess of 66 2/3% of the Preferred Shares directed the trustee to accept an offer to sell certain [securities] to a third party. This offer to purchase part of the transaction collateral at a substantial discount, if executed, will have a negative impact on the rated notes. The trustee has also stated that it intends to file an interpleader action requesting a judicial determination regarding how to proceed in respect of the offer. Today's rating action reflects the uncertainty surrounding the outcome of this proceeding and the potential negative impact from the Offer. Moody's is following the development of this situation closely."

For Whom the Capital Flows

Thanks to some data mining on Bloomberg, we were able to put together a chart showing the slowing participation by U.S. banks in the Treasury's Capital Purchase Program.

As you can see from the table to the right, only approximately $1.2bn has been drawn down since mid-year, roughly 6% of the speed of the $134.2 bn NET participation witnessed since the inception of the program in October 2008. This is perhaps surprising given the increasing frequency of bank failures -- now bordering on an annualized rate of 1.5% for FDIC-insured institutions -- but may be indicative of the sharp demands made, and restrictions imposed, by the government upon its investment.

All numbers in this blog are NET of the $70.22 bn of capital contributions that had been made but have since been repaid by 36 banks, including repayments made by JPMorgan Chase, Goldman Sachs, Morgan Stanley, State Street, BoNY and U.S. Bancorp. (The most recent repayment came in January 2009.) Wells Fargo, Citigroup, BofA, Regions Financial, SunTrust and KeyCorp are among the institutions who have received large capital injections which they are yet to repay.

The following chart breaks up the capital injections by transaction type. You may notice -- after substantial squinting -- that very little investment has been made (only $0.15bn cumulatively) in pure preferred stock, without any warrants.

(Click on graph to enlarge)

Assumptions Assumptions Assumptions

"During the recent foolish-extension-of-credit period, I think there was altogether too much reliance on black boxes. Something that comes out of the computer looks quite official; it looks quite precise down to all these little digits. But the fact is, any kind of computer-based model inherently has as its basic assumption that tomorrow will look quite a lot like yesterday. The unfortunate truth is that when you get to a major inflection point, it's precisely because tomorrow does not look very much yesterday." - Wilbur Ross

The rating agencies, among other market participants, have to walk a fine line between maintaining their "long-term" views on long-term securities and being overly adaptive to changing market conditions.

I certainly don't envy them their position: A false step in either direction, and they'll be criticized from Wall Street to Washington.

Before we investigate this double-edged sword, let's consider the original premise or thought process or unspoken truth at the time of the original rating of, say, a CDO tranche. It goes a little something like this:

• this rating is a long-term rating
• given the lengthy maturity (usually more than 10 years away) of the asset, we expect it will go through different economic cycles and so our assumptions should speak neither to the peaks nor the troughs, but to the averages (based on historical data) with some volatility -- i.e., stresses -- built into our assumptions
• as long as the manager behaves as she should relative to the constrictions of the indenture, and as long as the portfolio collateral quality remains within the bounds described, we shall not downgrade you!

Now we return to the question of changing assumptions. As you can imagine, any change in assumptions may precipitate a change in ratings, and so ought to be accompanied by transparency describing the methodological change. A change in rating affects, among other things, the regulatory capital that the holder needs to post against the rated asset and the ability of certain funds to continue to hold the asset. In other words, downgrades precipitate deleveraging. And supply. And price. And therefore recovery. And I could go on and on but this circle is vicious.

From their April 23 press release:

S&P: Criteria Changes And Stressed Collateral Performance Affect TruPS CDO Ratings

We have published several revisions to our ratings criteria for TruPS since the July 2008 trust preferred CDO CreditWatch placements as a result of our observations regarding performance trends and worsening economic conditions, and our view regarding the effect those conditions might have on the performance of TruPS CDOs:

-- "Criteria: Revised Correlation Assumptions For Rtng CDO/CDS Exposed To Financial Intermediaries" published Oct. 3, 2008; this modified the correlation assumptions used for financial institutions held within or referenced by CDO transactions, including bank TruPS CDOs.

-- "Criteria: Correlation Assumptions Revised For Rating Global CDOs/CDS Exposed To Insurance Cos.," published Nov. 6, 2008; this modified the correlation assumptions used for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

-- "Criteria: Prob Of Default, Correlation Assumps Revise For Glbl CDOs/CDS Exposed To REITs/REOCs," published Nov. 6, 2008; this modified the default and correlation assumptions used by CDO Evaluator for REITs and real estate operating companies (REOCs) held within or referenced by CDO transactions, including REIT TruPS CDOs.

-- "Global Methodology For Rating Trust Preferred/Hybrid Securities Revised," published Nov. 21, 2008; this modified the assumptions Standard & Poor's uses when rating TruPS CDOs generally.

-- "Assumptions: Standard & Poor's Reclassifies Insurance Companies That Issue Debt Securities Owned Or Referenced By Rated CDOs And CDS," published Dec. 23, 2008; this modified the industry classifications used in CDO Evaluator for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

Stepping back, we're seeing at least five assumption revisions since October 2008. Is this too much? Too little?

Back on April 14, on being downgraded yet again by Moody's, Ambac Assurance responded as follows:
- "While Ambac believes that Moody's is entitled to its opinion of Ambac's financial strength, it notes that this is the tenth such opinion change since January 2008."

As we've described with the current regulation environment, in Hegelian fashion, one tends to over-regulate as a means of "compensating" for under-regulation. Each can be harmful, and hitting the sweet middle-ground is the key. Here we're seeing the responsiveness to severe criticism relating to maintaining static assumptions in a changing environment. The response, naturally, is to proactively rate.

Damned if you do, damned if you don't.

The Price is (not that) Right

The New York Times recently published an article on the risks associated with the poor valuation of Bad Bank assets.

Essentially,

Placing too low a value would force institutions selling and others holding similar investments to register crushing losses that could deplete their capital and make it harder for them to increase lending.

…

But inflated values would bail out the companies, their shareholders and executives at the expense of taxpayers, who would swallow the losses if the government could not recoup what it had paid.

The article is accompanied by a description of how the valuation of a specific toxic asset can range from 97 cents on the dollar (financial institution holding the bond) to 38 cents on the dollar (actual trading level of the bond). S&P, “the extra set of eyes,” valued it at 83 cents.

With valuations hitting nowhere close to home (actual trading levels), it’s hard to believe that the government won’t end up permanently losing hundreds of billions of dollars to the financial institutions through its Bad Bank.

We decided to dig a little deeper...

The following table contains actual valuations for a -- wait for it, regional bank's -- portfolio of TruPS CDOs (a proud member of the toxic family) obtained either through a trading desk (quite possibly the same one that originated and sold the bonds in the first place) or a rating agency. The current ratings range from A1 to Ba1 without a single bond falling south of the 30 cent line (optimistic, to say the least).

PF2 evaluated the first three bonds (TruPS CDO 1 Tranches C1 & D1; TruPS CDO 2) -- all of which came out in the single digits. In fact, we valued the TruPS CDO 1 Tranche D1 (the junior-most mezzanine bond) at only 87 bps, which reflects the tranche's continued deferral -- since March 2008 -- of its interest payments (and, besides, close to 10% of the portfolio's already a goner).


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