Choose Your Own Adventure

In good times anything is possible. Second class managers can raise capital for new funds; corporate debt managers suddenly become experts in structured finance; and trust proliferates.

In good times risk-averse pension funds invest in ABS CDO equity and traditional managers go for the exotics, be they weather derivatives, airline securitizations or bonds secured by the future royalties from David Bowie’s music. In good times small managers win bids to manage multi-layered complex CDO-squared portfolios supported by actively-managed leveraged loan funds, ABS CDOs, CDOs supported by commercial real estate, bond funds, trust preferred CDOs and other CDO-squareds, collectively; and structurers can sell anything, everything. Oh, in good times

… anything is possible. And if it shouldn’t be possible, it can be hidden away behind all the growth that we are seeing -- and we can be easily distracted by, and forgiving due to, all the peripheral positives.

STYLE DRIFT

In bad times everything is illiquid. Those same managers no longer have the experts around who made them believe their forays into alternative exotics would pay off. Those exotics lie in side pockets, either unanalyzed or constantly scrutinized -- but no longer ignored.

Oh in bad times the too-big-to-fail become too-big-to-succeed and have to be trimmed to take advantage of overlaps and economies of scales.


... in good times we overcome our animalistic instincts to preserve. Utility theory trumps our innate loss aversion and for a short while the concept of risk leaves the dictionary.

Then we blink, take a good look around and troubled times have come
to My Hometown.

Counterparty Risk

In 2009 we discussed in great depth many of the risks relating to both CDO structures and to their underlying securities. We'll continue to explore these nuances in 2010, but first we'll kick off with one of the risks we only covered lightly in '09 - counterparty risk.

Stepping back for a second here: the key concept is that in the complex, opaque and illiquid world of CDOs, at each credit rating level you were being paid more -- higher coupon or spread -- to assume additional risks, other than credit risks. These include but are not limited to illiquidity risks, model risk, operational, legal and counterparty risk.

We commented in a NYSSA article that: "We desperately need to move away from a culture in which investors, sophisticated or not, would buy the highest-yielding asset at each rating level, irrespective of its other-than-credit risks and without having performed an adequate analysis (or even possessing the tools or skills to perform such an analysis)."

The recent U.S. Bankruptcy Court ruling in the Dante CDO lawsuit captures several of these key risks: complexity, model risk, counterparty risk and legal risk. For an immature product (synthetic CDOs) supported by an imperfectly defined-or-tested bankruptcy process, the several layers of risks and dependencies inevitably give way when the unexpected occurs: in this case, the default of Lehman Brothers. (Lehman was single-A rated, not AAA, and so it raises an additional eyebrow that its default should impinge upon the performance of a tranche whose AAA ratings were designed to have been removed from any such dependencies.)

Debtors: LEHMAN BROTHERS HOLDINGS INC., et al.
Plaintiff: LEHMAN BROTHERS SPECIAL FINANCING INC.
Defendant: BNY CORPORATE TRUSTEE SERVICES LIMITED

Here follow some choice extracts from the ruling:

"This is a matter arising out of a complex financial structure that includes an added layer of complexity due to the pendency of parallel and potentially conflicting legal proceedings in this Court and the United Kingdom. The litigation in England (the “English Litigation”) was first commenced in the High Court of Justice, Chancery Division (the “High Court”) followed by an appeal to the Court of Appeal, Civil Division (the “Court of Appeal” and, together with the High Court, the “English Courts”). At issue both here and in the English Courts is the priority of payment to beneficiaries (one a noteholder and the other a swap counterparty) that hold competing interests in collateral securing certain credit-linked synthetic portfolio notes. The swap counterparty is Lehman Brothers Special Financing Inc. (“LBSF”), one of the Lehman entities whose chapter 11 case is before this Court.

... After a trial, the High Court issued a judgment in which it held, inter alia, that LBSF’s interest in the collateral securing the Swap Agreements (the “Collateral”) was “always limited and conditional,” and, therefore, payment pursuant to Noteholder Priority did not violate the so-called “anti-deprivation principle” under English law.

... the Court has learned that the Debtors are perhaps the most complex and multi-faceted business ventures ever to seek the protection of chapter 11. Their various corporate entities comprise an “integrated enterprise” and, as a general matter, “the financial condition of one affiliate affects the others.”

... The issues presented in this litigation are, as far as the Court can tell, unique to the Lehman bankruptcy cases and unprecedented. The Court is not aware of any other case that has construed the ipso facto provisions of the Bankruptcy Code under circumstances comparable to those presented here. No case has ever declared that the operative bankruptcy filing is not limited to the commencement of a bankruptcy case by the debtor-counterparty itself but may be a case filed by a related entity -- in this instance the counterparty's parent corporation as credit support provider. Because this is the first such interpretation of the ipso facto language, the Court anticipates that the current ruling may be a controversial one, especially due to the resulting conflict with the decisions of the English Courts.

One of the distinguishing characteristics of the Lehman bankruptcy cases is the complexity of the underlying financial structures many of which are being analyzed for the first time from a real world bankruptcy perspective. It is to be expected, as a result, that the cases of LBHI and LBSF on occasion would break new ground as to unsettled subject matter. This is one such occasion.

This decision places BNY in a difficult position in light of the contrary determination of the English Courts confirming that Noteholder Priority applies to claims made against it in England by Perpetual. This is a situation that calls for the parties, this Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting
judgments.

For more on counterparty risk in CDOs, see: Hedged Trades: Lessons from the Crisis (slide 9)

If you haven't already joined us at our Ratings Reform website, please visit http://ratingsreform.wordpress.com/. We look forward to your comments and suggestions throughout 2010, and beyond!

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):

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

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.

Too Big Too Frail, or a King’s Gambit

Looking back at the years from the late 1990s to, really, 2006, the escalation of securitization acted as a vehicle for tremendous growth in the United States. It provided an additional source of demand for receivables from student loans and credit cards to residential mortgages; and it allowed investors the ability to gain exposure to certain of these asset classes in accordance with their desired risk level.

If rapid economic growth was the advantageous result of securitization, what was the cause? The usual suspects: to avoid certain taxes and regulatory capital charges, taking assets off banks’ balance sheets in such a way as to allow or promote almost unlimited lending.

Having grown together and having fallen apart together, it’s difficult not to see securitization and our economy in a similar light, or at least to see the art form of securitization as a microcosm for the U.S. financial economy as a whole.

The parallels are uncanny

While European and Asian investors, post the Asian crisis, had an insatiable desire from the supposedly safe and reliable U.S. market, structured finance investors’ appetites were similarly indefatigable. Foreign investors moved steadily from U.S. Treasuries to agency mortgages to corporate bonds, non-agency mortgages and on as their confidence increased; structured finance investors transitioned from CMOs to CBOs, CLOs, trust preferred CDOs and then on to CDOs of CMOs, CDOs of CDOs of CMOs, and even collateralized fund obligations (CFOs).

Both foreign investors and structured finance investors were burnt. Both the U.S. economy and the securitization market are trying to struggling new ways to grow, to reinvent themselves. Both are recovering from severe criticism pertaining to their regulation (e.g., the SEC has been faulted for its failures to investigate certain Ponzi schemes like that of Madoff, and to monitor the credit rating agencies (CRAs); while the CRAs are heavily criticized for their ratings on residential mortgage-backed securities, among other products).

And both are realizing that the interconnectedness of their risks pose “systemic” risk issues: while “too-big-to-fail” banks are purportedly being supported by the U.S. government to mitigate against further widespread turmoil, the effects of single mortgage and corporate credit failures are rolling through the structured finance products network, from direct securitizations to resecuritized products like RMBS CDOs, CDO-squareds and even CFOs, backed by hedge funds that have often invested in structured finance securities.

The “holes” that exist in certain CDOs and have been exploited recently by, among others, TPG, Marathon, Goldman Sachs, Cohen and KKR, remind us of the vulnerabilities in our financial system, where Marxist (or Michael Moore-like) capitalistic short-term measures continue to be the order of the day, be it in the form of bonuses or aggressive trading strategies. It’s not your money, and hey if it doesn’t work out, there’s always another firm looking for an aggressive trader. Reputation and responsibility to the client or customer seem to be a thing of the past. (Think of Billy Joel's Allentown or Bruce Springsteen's -- ironically called the "Boss" -- My Hometown.) The U.S. work culture is moving further and further away from the “permanent employment” environment, such as that of Japan.

Financial product regulation needs to be mindful of, and consistent with, the changing working environment and investment tendencies.

The King’s Gambit opening in chess is just that – a gambit. White offers a free pawn and weakens his king’s safety in exchange for a gamble on speedy development. The quick expansion leaves “holes” that can only be ignored for so long. If the speedy development doesn’t prove successful (i.e. meaningful and lasting) white is in danger of having a weakened, exposed king, and must quickly consolidate if he wishes to survive.

Relative to the economy, the problem is not how big the banks are, but how exposed they are to poor investments, how well their risks are managed and how liquid their capital. Do we have the transparency to regulate them, and can they adequately manage themselves? (State Street and US Bancorp are examples of “big” institutions that have not failed, being service rather than investment-heavy: the key differences being strategy, focus and management.) It’s not, therefore, a question of “too-big-to-fail” as Mortimer Zuckerman suggests. Nor is it a problem of too-big-to-succeed. (BlackRock has shown us that.) It is a problem of too-complex-to-regulate.

Consolidation, thus, ought to comprise a slew of objectives, including: ensuring all players in the game are more responsible and perform the necessary due diligence; ensuring that regulators understand and are able to accurately gauge the marginal and cumulative risks involved before approving the usage or purchase certain financial products; and requiring that regulators be granted the necessary authority and be incentivized to apply it, responsibly, to enable their efforts to have a lasting effect.

And so we end off with our financial reform motto: the key challenges at hand are to better align regulatory interests and to create an environment that encourages market transparency, consistency, and responsibility. Liquidity will inevitably follow.

Introducing RatingsReform Blog

Expect[ed] Loss Readers,

We'll be moving our future blogs on rating agency reform and regulation to a new site: http://ratingsreform.wordpress.com.

Please visit us there to follow our commentary on credit ratings reform and to share your opinions with us. Oh, and don't be shy to sign up!

- ExL

Marathon, or Just a Quickie?

Friday’s Asset-Backed Alert describes the (mildly fascinating) behind-the-scenes activities of Marathon CLO I, a 2005-vintage CLO managed by Marathon Asset Management.

According to the article, Marathon itself recently purchased most or all of its deal’s senior-most tranche from Bank of America, at prices purported to be in the 85 cents on the dollar range. To turn a quick profit on their senior note investment, Marathon swiftly sold off roughly two-thirds of the collateral underlying the CDOs, with the proceeds being diverted towards substantially paying down their senior tranche, at par. By our back of the envelope calculations, if Marathon purchased the entire tranche, they would have made a profit on this trade of roughly $26.75mm already, with potentially more to follow.

As far as we’re aware all of the deal’s par coverage tests (“OC tests”) declined between mid-September and mid-October, despite continued improvement in the market for leveraged loans, which support these CLOs.

Why is this Interesting?

(1) While Marathon may have benefited greatly from its extensive trading activity, all other noteholders are, at least in our opinion, worse-positioned for it: in a month in which most CLOs’ OC test ratios improved, all OC ratios of Marathon CLO I suffered, arguably purely as a result of their aggressive trading during this period.

(2) The substantial paydown of the Class A1 notes (CUSIP 565763AA7) might encourage Moody’s to upgrade the tranche from its current rating of A1, with a possible Aaa rating in sight.

(3) Managers are typically disincentivized from any earlier-than-necessary unwinding of their deals: the longer their deals run, the longer they continue to collect management fees for managing the collateral; however, in this situation, the upfront profit of say $26mm would vastly outweigh the potential additional revenue stream of less than $2mm per year that a manager may hope to earn in fee from managing a deal such as this. (Managers earn fees based on the size of the portfolio, so a paydown decreases future fee generation.)

(4) The spirit of the deal is that managers are supposed to manage “across the capital structure.” In other words, though very difficult, they’re supposed to make managerial decisions that are in the best interests of all investors of the deal, certainly not only the senior-most tranche holders. At the same time, the dynamic is that rating agencies are trying to protect their rated noteholders, but not only the senior-most holders. Though it’s an imperfect system, the collateral manager is often required to purchase some of the equity of its own deal, to ensure that it manages across the structure, thereby sending proceeds down the waterfall as far as the equity notes (see here for examples of how this structural nuance can be manipulated).

(5) In this scenario, largely as a result of the early liquidation of assets, most if not all of the other rated noteholders will suffer, which could bring the rating agencies’ ratings on these notes into question, and the equity holders likely lose any potential upside they might otherwise have hoped to gain on their investment.

(6) Aside from allowing “Credit Risk” sales, rating agencies try to protect against aggressive management by limiting the amount of trading activity permissible by a manager (see example language below). With Marathon posturing such a large proportion of these sales as “Credit Risk Sales” it really calls into question the definition of a “Credit Risk Sale” and the question of a manager’s ability to arbitrarily designate a sale as a Credit Risk Sale simply to allow for its effectuation. Given that they were able to sell these assets at, on average, over 90 cents on the dollar, can they really have been Credit Risky? Does Marathon know something about all of these loans that the rest of the market does not? Did they all just suddenly become Credit Risks, encouraging Marathon to liquidate them in the best interests of all holders, or is Marathon acting in its own capitalistic interests?

Example Indenture Language

ARTICLE XII

SALE OF UNDERLYING ASSETS; SUBSTITUTION

Section 12.1. Sale of Underlying Assets and Eligible Investments.

(a) Except as otherwise expressly permitted or required by this Indenture, the Issuer shall not sell or otherwise dispose of any Underlying Asset. Subject to satisfaction of all applicable conditions in Section 10.8, and so long as (A) no Event of Default has occurred and is continuing and (B) each of the conditions applicable to such sale set forth in this Article XII has been satisfied, the Asset Manager (acting pursuant to the Asset Management Agreement) may direct the Trustee in writing to sell, and the Trustee shall sell in the manner directed by the Asset Manager (acting as agent on behalf of the Issuer) in writing:

(i) any Defaulted Obligation, Credit Improved Obligation or Credit Risk Obligation at any time; provided that during the Reinvestment Period and, with respect to Defaulted Obligations and Credit Risk Obligations, at any time, the Asset Manager (acting as agent on behalf of the Issuer) shall use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount (A) with respect to Defaulted Obligations and Credit Risk Obligations, at least equal to the Disposition Proceeds received from the sale of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon), and (B) with respect to Credit Improved Obligations, at least equal to the Aggregate Principal Amount of the Underlying Asset that was sold; and provided further, that the Downgrade Condition is satisfied;

(ii) an Equity Security at any time (unless earlier required herein); provided that during the Reinvestment Period, the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets with a purchase price at least equal to the Disposition Proceeds of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon) received from such sale;

(iii) any Underlying Asset which becomes subject to withholding or any other tax at any time; and

(iv) in addition, during the Reinvestment Period, any Underlying Asset not described in clauses (i), (ii) or (iii) above, if (x) no Downgrade Event has occurred and (y) with respect to any sale after the Payment Date occurring in September 2012, the Aggregate Principal Amount of all such sales for any calendar year does not exceed 25% of the Portfolio Investment Amount; provided that the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount at least equal to the Aggregate Principal Amount of the Underlying Asset sold (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon).

UPDATE, November 20, 2009: This morning's Asset-Backed Alert edition suggests, quite disturbingly, that Fortress and TCW may be considering similar moves to that of Marathon, in their Fortress Credit Funding CLO and Pro Rata Funding Ltd. deals, respectively.

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."

"and yes I said yes I will Yes."

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”

OUR OPINION

Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.

Liquidity

Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.


Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Anatomy of a Recovery

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.