Issuer vs. Investor-pay Model

In CDO land, it’s long been considered a conflict of interest for issuers to pay rating agencies to have their own bonds rated (i.e., the “issuer-pay” model).

Indeed, both parties have the same initial goal: to close the deal and get paid. If the deal doesn’t close, neither party gets paid. (If the deal closes, but you’re not the rating agency used due to too stringent criteria, you similarly won’t get paid.)

This “mis-alignment” of interest is thought to encourage rating agencies towards leniency on certain rating considerations that may otherwise hinder deals from being done.

Excerpt from (now Chief Credit Officer at S&P) Mark Adelson’s Sept. 2007 speech before the House’s Committee on Financial Services, on the role of credit rating agencies in the structured finance market:

…rating agencies that had tougher standards become invisible, and, once more, they don’t make any money, because the way you make money rating a deal is you rate the deal and charge the issuer. So it puts pressure on the rating agencies to loosen their standards…

The “quick fix” solution - an “investor-pay” model - proposes that rating agencies are compensated by the investor and hence align their compensation structure with the party whose interests they’re trying to serve: after all, they are an “investor’s service.”

Firstly, we’re not convinced that an investor pay model removes this conflict-of-interest. Secondly, importantly, we show that investors may already be paying these rating agency fees.

Example:
A CDO’s flow-of-funds details how funded note issuance proceeds are used to purchase collateral and account for the deal’s closing expenses. When issuance proceeds prove insufficient, one solution is to issue a loan that covers the remaining expenses. Payments to this loan will be made through the deal’s priority of payments “waterfall” senior to any noteholder’s.

Under the issuer-pay model, some investors pay rating agency fees over time.

Click to enlarge

In the above table, the loan covers the $800K owed to rating agencies. On each distribution date, this loan will be partially amortized though a payment of both interest and principal. This payment represents proceeds that would have otherwise made their way to investors. In low default scenarios, this effects equity noteholder’s excess spread. In higher default scenarios, this effects rated noteholder’s ultimate receipt of interest and/or principal.

Under the investor-pay model, all investors pay rating agency fees upfront.

Click to enlarge

In the above table, investors purchase the deal’s notes at an additional 20 bps. This additional cost covers rating agency fees. The loan will be smaller and will therefore represent less of a burden to investors on each future distribution date.

At the end of the day, issuer-pay vs. investor-pay may just be the difference between having some investors pay fees over a few years and having all investors paying agency fees right now.

Keep watching this page for updates on where we’re going with this…

Behavioral Psychology, and the Regulation of Systemic Risk

It seems every day or two either the House or Senate is passing another bill to regulate the rating agencies or the banks or the hedge funds or this or that (see for example Hedge Fund Symposium: the regulation question, which covers this daily).

From an economic perspective, regulation takes time, money, and effort. And frustration. Sarbanes Oxley was only one of many regulatory requirements that imposed an insufferable burden and resource drain on smaller companies. Not that regulation might not be good; but rather that it needs to be carefully considered before implementation. There's (unfortunately) a rush, now, to propose the latest regulation.

But it's much more fascinating to consider this from a behavioral perspective. If you were unfairly nasty to Jimmy yesterday, you feel guilty, and so today you're overly nice. In other words, you overcompensate.

Let's think of regulation, too, as being on a continuum. It's not black and white, but perhaps the sweet spot is somewhere in the grey area: between a complete lack of regulation (closer to where we were) and a totalitarian, 1984, government.

Here's an example: earlier this month Senate Banking Committee Chairman Christopher Dodd suggested that congress will consider creating regulators to monitor systemic risk. And House Financial Services Committee Chairman Barney Frank suggested that he plans to start the regulatory overhaul with legislation that makes the Federal Reserve the regulator for systemic risk.

Now you have to appreciate that systemic risk is quite something to monitor. Academics -- most notably MIT's Andrew Lo -- have been successful at describing systemic risk in research papers but gloriously unsuccessful in implementing strategies (within their own hedge funds) to mitigate against it or profit from it. And so the natural question: imposing the new regulation may be fine and dandy, but how exactly is the Federal Reserve going to monitor and buffer against systemic risk? Are we wasting money, creating jobs to merely collect superfluous data? My comment is that the Fed may do this perfectly well, but that the careful consideration of how they'll approach the task need necessarily come before the imposition of the new regulation.

Nassim Taleb goes further in his recent interview with Bloomberg Surveillance:

"You know, people claim that we didn't have enough regulation. No. We had regulation. It was just bad regulation and bad regulators.

... the system is becoming very fragile because of interlocking relationships ... you even lose the national aspect of things ... the whole world is becoming a large bank ... banks are incompetent at risk management, have always been incompetent at risk management."

Taleb seems to maneuver towards the same question, and the creation of systemic risk via globalization. But he would likely want to know:Will the Fed be better positioned to manage systemic risk for the entire system than banks' risk management divisions were able to manage their own risk?

Are we overdoing the regulation, now, as we had perhaps underdone it under Greenspan? Does overcompensating not simply create the opposite problem? (When companies are having to apply significant resources to compliance and regulatory controls, they are to an extent hindered from growing: ultimately the aim of any economy.)

Looking at this another way, regulation here runs counter to utility theory. Has the severe economic downturn been so powerful as to return our Senators and Congressman to their biologically-engendered loss aversion roots? Or is this purely a short-term solution, with loss aversion making way for greed and utility as soon as resources become less scarce?

Note: see Phil Pearlman's piece on the deeper nature of loss aversion, evolution and risk complacency, and how the resulting cognitive dissonance may affect one's trading tendencies.

UPDATE - Feb. 24, 2009: The American Enterprise Institute for Public Policy Research, in their piece "Risky Business: Casting the Fed as a Systemic Risk Regulator," had some harsh criticism for the Fed's ability to monitor systemic risk:

This Outlook examines the notion that the Fed should be the systemic regulator, pointing out that the agency has for many years had all the powers of a systemic regulator for banks and has failed to use them effectively; that supervising industries other than banking requires skills and knowledge that the Fed does not have and probably could not acquire in any reasonable amount of time; and that a role as systemic regulator would impair the Fed's independence and create conflicts with its more important function as the nation's monetary authority. Finally, this Outlook questions whether systemic risk itself can be defined--and whether the commonly accepted notion of systemic risk supports the creation of a systemic risk regulator.

The Harry Markowitz Approach

One outcome many of us (practitioners) walk away with from the financial mess we helped create is that, perhaps, simplicity is king.

Yes, cash is king for you and your fund and its survival. But when the world is out of control, unless you're John Paulson, you're probably going to suffer by way of your retirement investments, personal investments, or hedge fund investments (for the high-net-worth individuals out there).

One way or another, we almost all suffer from a credit freeze. We all suffer from complexity.

Modeling complexity, itself, leads to an additional premium be charged on the product (you would want more "spread" for owning it due to the difficulty analyzing it). Additionally, the more complex the financial instrument, the more prone it is to different "risks" and typically the more illiquid the instrument -- and, hence, an additional "illiquidity premium" that decreases the value of the asset.

On the structured finance side, the different risks mentioned above may include default and default timing risks, prepayment speed "risk," recovery rate risk, interest rate risk, extension risk, covenant risks &c.

Now these are not all bad, always. As we know, with risk comes return and, for example, prepayment speeds may work in your favor as a certain tranche holder in the structure, and in another holder's disfavor. But this is fixed income, primarily -- typically less than 10% of each structure is equity-like -- and so you know your upside: par. Risks that may affect your note's ability to get said "par" are suboptimal. And it's not a zero sum game: when the deal performs poorly, almost everyone suffers.

Back now to simplicity. The easier it is to understand and model the variables that may affect your note's future cashflows, the easier it is to predict future income to your note; the easier it is to "value" the note ... to sell the note, &c.

And we think Harry Markowitz "gets it." Indeed we may bedgrudge him some or many aspects of his "modern" portfolio theory. (We have, for example, expressed our skepticism that the "diversification" offered by multi-strategy hedge funds actually mitigates against the sharper downs, no pun intended, in "Jack of All Trades?")

But his piece "Proposals Concerning the Current Financial Crisis" for the Financial Analysts Journal is simple and to the point: we need transparency. His approach to obtaining the necessary data is perhaps optimistic and debatable, but the message is clear. Information, no clarity, no simplicity is king.

The key takeaway: the more we know about what the assets are, and who holds them, the better able we will be to allocate sufficient funds to buffer against the pending problems, and to choose how and where best to apply such funds.

Blackstone, or Bruce Lee

Bruce Lee's Game of Death was more than just an action flick.

On a macro level, it showed Hollywood's ability to cast something as something else: with Lee's life having come to a tragic end before the movie was finished the director managed to finish the film using a look-alike and archived footage from Lee's other films, and only 15 minutes of actual footage.

On a more micro level, it showed Lee, in the now-famous yellow track suit (remember Uma Thurman in Kill Bill?) first mimicking the other factory motorcyclists (in uniform), and then distinguishing himself against a rigid, conservative praying-mantis-kung-fu-artist in the "Palace of the Dragon."

In a climactic final scene, he regularly changes style until he's able to out-maneuver the lanky, awkward-seeming 7'2" Lakers basketball player, Kareem Abdul-Jabbar. Flexibility. Artistic differentiation.

Blackstone's announcement today -- regarding their proposed change of investment objective and policy of their Carador plc vehicle -- is similarly impressive.

Recognizing that senior (AAA) CLO tranches are trading at distressed levels ($70 range, or spreads around 550 bps), they may feel that these tranches have a similar risk profile -- in terms of expected loss, volatility -- to the assets described in their policy: equity and mezz CDO tranches.

From their circular to Carador shareholders:

Change to the investment objective and investment policy

It is proposed to amend the investment objective and the investment policy of the Company to permit investment in the Senior Notes of CDOs which are collaterised by senior secured bank loans, namely CLOs.

The current investment objective of the Company is "to produce attractive and stable returns with low volatility compared to equity markets by investing in a diversified portfolio of equity and mezzanine tranches of CDOs". The investment Manager believes that in the current market environment Senior Notes, as more senior tranches in the CDO structure, may provide an attractive return with a lower risk profile.

While sometimes you're forced to play the same game, at least for a while, Blackstone's nimbleness (think Bruce Lee's flexibility) in this instance differentiates them.

And best of all we may have a new CLO AAA buyer at the end of this. Ah, the "economy of motion."

Maiden Lane Series "Underperforms"

Bloomberg News covered the bleak future of the Fed's investment in Maiden Lane I. We're adding this graph to their article to give you an idea of what's been happening with the rest of the family: Maiden Lane II (created to purchase AIG's RMBS) and Maiden Lane III (created to purchase AIG's CDS exposure to CDO tranches).

The Elephant in the Room

From Bloomberg News: Moody's updates key assumptions for rating CLOs

From Expect[ed] Loss:

Update (02.23.09): Fitch Releases Loss Severity Scale

Update 2 (08.12.09): S&P announces it "may offer a new type of rating on U.S. home-loan bonds reflecting its expectations for how much might be recovered after the securities default." The “stressed recovery ratings” would apply to prime, Alt-A and subprime mortgage bonds with credit ratings of BB+ or below that had originally been granted AAA ratings.

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).


RELATED ARTICLES:
Regional bank writes down trups CDOs by 99%

Trups CDOs collateral has deteriorated sharply, according to PF2 Securities Evaluations

The Corporate Loan Conundrum

Here's our two cents worth on the year-end state of the leveraged loan market, and a little insight into the challenges that lie ahead.

First off, 2008 was a tough year for corporate loans. Among leveraged loans, we saw roughly 4.5% to 5% defaults for the year, heavy pricing declines (the S&P/LSTA U.S. Leveraged Loan 100 Index was down roughly 30% in '08) and with them low recoveries, due, among other things, to the supply/demand problem and pessimistic perceptions for the economy.

(Worth pointing out was a slight uptick in the second half of December. Was this a bottoming out? A false bottom perhaps? Some high-level executives and managers are vocal about current spread levels being at or near their highs, and that we're due for some tightening in 2009. See for example Creditflux's Viewpoint: Looking for the bottom; but are they talking their book, and do we really have a good feeling for the duration of loans in this low, slow prepayment environment?)

An Issue of SUPPLY (and demand)

Demand is so small is deserves only a side mention; supply is the elephant. Why?

1. Fund (incl. hedge fund) liquidations and forced selling, to meet both investor redemption requests and (particularly variation) margin calls
2. Selling by banks to decrease leverage
3. Overhang of unsold loans (incl. bridge loans) on syndication desks' balance sheets that the banks were no longer able to securitize due to the severely diminished CLO juggernaut, a previously major source of demand for broadly syndicated loans
4. Demand by existing CLO managers has decreased too:

• low prepayments on current loans in the portfolio mean less available principal to reinvest
• loan downgrades have resulted in many CLOs maxing out on their CCC-rated buckets (which in turn limits managerial flexibility in trading new loans)
• historically low loan prices mean that investments in these loans are reflected as "deep discount" purchases for overcollateralization test purposes

What the future holds for loans and CLOs

Corporate loans weren't highly traded, relative to bonds, say, prior to the onslaught of CLOs (which steadily gained steam from 2001 to early 2007). S&P/Markit/Reuters' move towards a CUSIP identifier (from LoanX, LN numbers) may prove of minor assistance to the liquidity situation, but this will take a while.

The prospects are dim for 2009: large supply and high defaults are typically accompanied by low recoveries, a dual burden (see for example Longstaff, Schwarz's "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt").

As this relates to CLOs: as defaults continue to plague corporations and deals continue to fill their CCC buckets -- and then have excess CCC assets haircut at market value (not recovery rate) for overcollateralization test purposes -- more CLOs naturally begin to trip overcollateralization triggers on a weekly basis, causing cashflows to be directed from the junior tranches and residual pieces towards paying down senior note holders (reducing the duration of the latter).

Similarly detrimental is the fact that most CLOs ramped up their loan portfolios during a credit cycle marked by the particularly high levels of liquidity it generated and the low defaults exhibited. The resulting strong demand created the opportunity for debt issuers to obtain low coupons on their debt despite weak covenant packages. Strong covenant packages typically reduce a company's cost of debt and, importantly, protect debt investors from wide negative swings in the value of their investment. (In sum, relative to a company's overall investors, weak debt covenants are arguably equity-friendly for the company, and debt-unfriendly.) See also The Luxuries of a Covenant Light Lifestyle.

The optimistic view is that this can all change quickly if we begin to see sufficient buyer power at these distressed levels. If some of the distressed funds decide that the opportunities lie in loans, and the bigger loan/asset managers (PIMCO, Babson, TCW, Blackrock) start putting their money to work, loan prices could rebound even on thin volumes and the deals which have benefitted from decent excess spread generation over the last 4 to 5 years during the low default environment may survive some of the pending difficulties. Certainly we're optimistic that many, if not most, of the AAA tranches will come out whole in this scenario, but whether the AA or single A tranches survive or suffer principal losses may differ from deal to deal, and may depend on the remaining length of each deal's reinvestment period, among other things.

While we fear the worst, we're long optimism.

Another Day, Another "Plug"

Ditto our prior article Static Measures for a Dynamic Environment:

Moody's is revising its assumptions to reflect the expected stress of the global recession and tightened credit conditions on corporate default rates, which are likely to be more variable and extreme than those in other recent historical downturns. Specifically, the changes announced today include: (1) a 30% increase in the assumed likelihood of default for all corporate credits in synthetic CDOs, and (2) an increase in the degree to which ratings are adjusted according to other credit indicators such as rating Reviews and Outlooks. Moody's also announced an increase in the default correlation it applies to corporate portfolios as generated through a combination of higher default rates and an increase in investment grade and financial sector asset correlations.

Static Measures for a Dynamic Environment

It is with a touch of disappointment that we read S&P's announcement yesterday that they're downgrading certain leveraged super senior (LSS) notes based on a change to their model.

What's particularly disappointing is that they're applying a (new) static measure for volatility -- a variable which we all know is certainly not static -- to long-term transactions. We call this a model "plug." Essentially, each time volatility changes, S&P could legitimately recalibrate its model and either upgrade or downgrade tranches (typically downgrade) on the basis of this change. From their release...

Today's rating actions reflect a recalibration of the model we use to rate these transactions. Specifically, we have increased the volatility parameter we use when simulating spread paths.

In future, we will use CDO Evaluator v4.1 and a volatility parameter of 60% to model all LSS transactions that have spread triggers. Before this recalibration we used a volatility parameter between 35% and 40%.

Given the rating agencies typically hide behind the mantra that their ratings are long-term "opinions" (expected loss or default probability measures, as the case may be) it's odd that they would adapt their model to incorporate short term "plugs." Each time volatility changes going forward, can we expect a reciprocal adjustment to be made to rating levels?

The ratings are being given based on a static volatility measure, and updated at S&P's whim to recognize the inherent flaw with the model... and that's not to mention the elephant in the room, the static correlation assumptions for all environments.

Let's look at this from another viewpoint: when trading stock options using Black-Scholes, one could legitimately argue that you're trading volatility. The price is out there in the market - it's a given. The Black-Scholes formula allows you to solve for volatility, and you could then buy or sell the option based on your assessment of the current and future volatility of the stock's price. Thus volatility is assumed to change over time, and if it were assumed to be constant (such as S&P is assuming), options wouldn't trade. Black Scholes suffers from having a static volatility measure (sigma), but if you're going to have a model where price is not known (from the market) and volatility is a huge unknown, it can't suffice to apply a static measure which then gets updated with time, at the agency's discretion, potentially adversely affecting your supposedly long-term ratings.

What do we recommend?
If rating consistency is important (which we believe it is, especially when pension funds and other endowment funds are substantial investors and when institutions place regulatory capital -- and hedge funds post margin -- against assets based on their ratings), then it's suboptimal to apply static, long-term measurements for both correlation and volatility, as these are key inputs to the model. We're not suggesting it's easy to model each variable as path-dependent, or time-dependent, but if you can't accurately estimate the key parameters in your model the only solution is to stop rating the instrument until you feel you can accurately estimate those variables.

Summary
Volatility, like correlation, is best understood as a measure that's dependent on time. Having said that, if S&P legitimately believes that the new (60%) measure is forever good, we would like to see them admit that the original measure was flawed (and show us how and why they reached the incorrect level), and reimburse all note issuers who paid and continue to pay for these flawed ratings. Ah, the responsibilities that come with collecting fees for your assumptions and modeling capabilities!