Investigating the Eligible Investments

In many ways connected to our earlier piece on "Investigating the GIC," Moody's downgraded various LCDO tranches underwritten by Lehman Brothers. As their name suggests, these CDOs are backed by loan credit default swaps (LCDS). With the underlying being by nature synthetic, funded issuance can be invested in "Eligible Investments," such as a GIC.

For these deals, proceeds of funded issuance was invested (either substantially or completely) in the Lehman Brothers ABS Enhanced LIBOR Fund, which according to Moody's, consists of -- or invested in -- a portfolio of highly-rated asset-backed securities. Moody's remarks confirm the suspicions we describe in our earlier piece on GICs: that the proceeds of liquidation may not be sufficient to repay in full the principal amount of the funded note tranches.

Those notes were downgraded by 3 to 6 rating subcategories across the board. We're admittedly surprised by the mildness of these downgrades, but they remain on watch for further downgrade, so stay tuned.

Structured Research Ratings

Institutional Investor published its survey results for top structured securities research firms of 2008,
with JPMorgan again taking the cake. Lehman Brothers and UBS follow closely in 2nd and 3rd respectively, with Citi a distant fourth. Credit Suisse and Merrill tied for fifth.

In the product-specific rankings, JPM held firm or improved in all of CMBS, CDOs, ARM and prepayment MBS research categories. On the CDO front, UBS's research, led by Doug Lucas, moved up into 2nd place from 3rd in 2007. JPMorgan's Chris Flanagan, Kedran Garrison and team retain top spot. For the rest of the breakdowns, see Institutional Investor.

Investigating the GIC

Came across this article on Creditflux this morning. Think you’ll find it (and our comments below) interesting:

Single-name spread widening biggest factor in CSO valuation declines, says Lehman Brothers
News Digest, 3 September 2008

In a recent research report, Dissecting the losses in synthetic CDO investments and their implications for the credit markets, Lehman Brothers researchers point out that marks on corporate synthetic CDOs continue to deteriorate. They say a valuation below 50% of par is quite possible even if the reference credit portfolio is relatively high in quality.

They take the hypothetical example of an August 2006 10-year double A rated CSO issued at par paying 100bp over Libor at issuance and with collateral invested in a monoline GIC. The deal is linked to a 4-5% tranche of a 100-name portfolio with an average rating of strong triple B and an average spread of 42bp.

They estimate the current value of that deal as 42 cents in the dollar. Most of that fall in value comes from the general widening in credit spreads, which are on average 2.5 times wider than they were when the transaction was issued. The researchers calculate that this has contributed a 34% decrease in the value of the deal after taking account of the gain from convexity and moves in correlation. The decline in the value of the cash collateral has added a 20% loss in value with the balance from transaction costs.

The paper concludes that unwinds or restructurings of CSOs have the potential to send spreads wider and curves steeper and to cause credits which are popular in synthetic CDOs to underperform. But Lehman says that significant unwinds are unlikely in the near term unless there are unforeseen accounting or regulatory changes or large-scale changes of rating methodology.

Let’s just agree upfront that we’re not too surprised by these valuation numbers, but we’ll focus on the carefully hidden sentence: The decline in the value of the cash collateral has added a 20% loss in value with the balance from transaction costs.

We’re assuming this “cash collateral” is the GIC. Essentially, the AA tranche they’re describing suffers -- in addition to the pains of this liquidity crisis -- from the depletion of the eligible investments (i.e., the GIC), which has lost 20%. GICs are typically comprised of assets of the highest credit quality, usually with an emphasis on their being short-term assets, typically at least P-1 rated (short-term rating) and/or Aa3-rated or higher (long-term rating).

The GIC’s loss -- especially in a fully-funded transaction -- may itself be enough to wipe out the AA tranche, which detaches at 5%, even if the synthetic portfolio suffers no losses.

Perhaps it’s not too surprising that the AA CDO tranche is down 50 plus percent in mark-to-market losses, given the GIC – the supposedly most reliable portion of its investments is itself down 20%, and the circular relationship entailed. (Let’s only hope this 20% is a recoverable MTM loss, and hasn’t been realized.)

Side Pockets - Keeping Hedge Fund Capital in Their Pockets

In the light of increased regulation, we’re seeing a fair share of interest in side pockets. Without further ado, here’s the low-down:

Side pockets are essentially segregated sub-accounts used by some funds (think hedge funds) to allow them flexibilities in dealing with, and accounting for, illiquid and non-marketable instruments (think CDOs), and potentially other assets.

How, Why?
The fund’s offering and organizational documents should disclose pro forma the extent to which it may transfer fund investments to side pockets.

Side pockets provide a structural mechanism for transferring certain (typically illiquid or hard-to-value) investments into a separate class of the fund. The fund investors’ participation interests are separated in tandem with the assets: only those investors having ownership interests at the time the side pocket is created for a specific investment are exposed to the performance of that “side-pocketed” investment.

This accounting arrangement allows the fund to defer valuation of side-pocketed securities until a valuation or liquidation event occurs, such as the disposal of the security, the bankruptcy of the issuer, or the manager’s transfer of the side-pocketed security back into the fund’s main pool of (liquid) securities.

Caveats…

Importantly, an investor’s liquidity is limited while any investment to which she is exposed is side pocketed.
In other words, an investor cannot fully withdraw from the fund until all side-pocketed investments to which she is exposed are removed from the side pockets. She retains her proportionate share in these side-pocketed investments -- even after completely withdrawing from the fund’s primary investment portfolio -- and is subject to an unlimited lock-up period on this portion, during which she will generally not receive any distribution proceeds.

Management Fees, Accounting Repercussions…

Side pocket investments have typically been valued at cost (as opposed to being marked-to-market) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When side-pocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket.

UPDATE - November 7, 2008: Public announcement that GLG Partners ringfenced illiquid investments from its European equities hedge fund