Today, in the Huffington Post, I posted a document that shows an earlier incarnation of the ABACUS trade (although, not that different from the one that has got the SEC up in arms). I also explained it as well as I could. Head on over and let me know what you think.
Posted tagged ‘CDO’
Well, Citi reported earnings this past week. And, as many of you know, there are a few reasons you’ve heard to be skeptical that this was any sort of good news. However, there are a few reasons you probably haven’t heard… (oh, and my past issues on poor disclosure are just as annoying here)
These numbers should bother Citi shareholders. Ignoring the 1Q08 numbers, Citi–whose global business is much larger and much more diverse than it’s rivals–generates no more, if not slightly less, revenue than the domestically focused JP Morgan and much, much less than Goldman. But it gets worse. Goldman’s balance sheet was $925 billion vs. Citi’s $1.06 trillion in assets within it’s investment banking businesses, roughly 10% larger. I’d compare JP Morgan, but they provide a shamefully small amount of information. As an entire franchise, however, Citi was able to generate their headline number: $24.8 billion in revenue, on assets of $1.822 trillion. JP Morgan, as a whole, was able to generate $26.9 billion, on assets of $2.079 trillion. JP Morgan, then is 14% larger, by assets, and generstes 8% higher revenue.
These numbers should be disconcerting to Citi, it’s no better at revenue generation than it’s rivals, despite having a larger business in higher growth, higher margin markets. Further, in an environment rife with opportunity (Goldman’s results support this view, and anecdotal support is strong), Citi was totally unable to leverage any aspect of it’s business to get standout results… and we’re only talking about revenue! Forget it’s cost issues, impairments and other charges as it disposes assets, etc.
On The Magical Disappearing Writedowns: Even more amazing is the lack of writedowns. However, this isn’t because there aren’t any. JP Morgan had writedowns of, approximately, $900 million (hard to tell, because they disclose little in the way of details). Goldman had approximately $2 billion in writedowns (half from mortgages). Citi topped these with $3.5 billion in writedowns on sub-prime alone (although they claim only $2.2 billion in writedowns, which seems inconsistent). But, that isn’t close to the whole story. Last quarter, in what I could find almost no commentary on during the last conference call and almost nothing written about in filings or press releases, Citi moved $64 billion in assets from the “Available-for-sale and non-marketable equity securities” line item to the “Held-to-maturity” line item. In fact, $10.6 billion of the $12.5 billion in Alt-A mortgage exposure is in these, non–mark-to-market accounts. There was only $500 million in writedowns on this entire portfolio, surprise! Oh, and the non–mark-to-market accounts carry prices that are 11 points higher (58% of face versus 47% of face). What other crap is hiding from the light? $16.1 billion out of $16.2 billion total in S.I.V. exposure, $5.6 billion out of $8.5 billion total in Auction Rate Securities exposure, $8.4 billion out of $9.5 billion total in “Highly Leveraged Finance Commitments,” and, seemingly, $25.8 billion out of $36.1 billion in commercial real estate (hard to tell because their numbers aren’t clear), are all sitting in accounts that are no longer subject to writedowns based on fluctuations in market value, unlike their competitors. These are mostly assets managed off the trading desk, but marked according to different rules than traded assets. If one doesn’t have to mark their assets, then having no writedowns makes sense.
On The Not-so-friendly Trend: This is a situation where, I believe, the graphs speak for themselves.
Do any of these graphs look like things have turned the corner? Honestly, these numbers don’t even look like they are decelerating! Compare this with the (relatively few) graphs provided by JP Morgan.
These aren’t directly comparable, as the categories don’t correspond to one another, and JP Morgan uses the more conservative 30-day delinquent instead of Citi’s 90+-day delinquent numbers. However, JP Morgan’s portfolio’s performance seems to be leveling out and even improving (with the possible exception of “Prime Mortgages”). Clearly, the pictures being painted of the future are very different for these institutions.
On the Stuff You Know About: I’ll be honest, this business about Citi benefiting from it’s own credit deterioration was confusing. Specifically, there is more going on when Citi refers to “credit value adjustments” than just profiting from it’s own Cittieness. However, Heidi Moore, of Deal Journal fame helped set me straight on this–the other things going on are dwarfed by the benefit I just mentioned. Here’s the relevant graphic from the earnings presentation:
And, via Seeking Alpha’s Transcript, the comments from Ned Kelly that accompanied this slide:
Slide five is a chart similar to one that we showed last quarter which shows the movement in corporate credit spreads since the end of 2007. During the quarter our bond spreads widened and we recorded $180 million net gain on the value of our own debt for which we’ve elected the fair value option. On our non-monoline derivative positions counterparty CDS spreads actually narrowed slightly which created a small gain on a derivative asset positions.
Our own CDS spreads widened significantly which created substantial gain on our derivative liability positions. This resulted in a $2.7 billion net mark to market gain. We’ve shown on the slide the five-year bond spreads for illustrative purposes. CVA on our own fair value debt is calculated by weighting the spread movements of the various bond tenors corresponding to the average tenors of debt maturities in our debt portfolio. The debt portfolio for which we’ve elected the fair value options is more heavily weighted towards shorter tenures.
Notice that Citi’s debt showed a small gain, but it’s derivatives saw a large gain (the additional $166 million in gains related to derivatives was due to the credit of it’s counterparties improving). Why is this? Well, notice the huge jump in Citi’s CDS spread over this time period versus cash bonds, which were relatively unchanged. Now, from Citi’s 2008 10-K:
SFAS 157 requires that Citi’s own credit risk be considered in determining the market value of any Citi liability carried at fair value. These liabilities include derivative instruments as well as debt and other liabilities for which the fair-value option was elected. The credit valuation adjustment (CVA) is recognized on the balance sheet as a reduction in the associated liability to arrive at the fair value (carrying value) of the liability.
Citi has historically used its credit spreads observed in the credit default swap (CDS) market to estimate the market value of these liabilities. Beginning in September 2008, Citi’s CDS spread and credit spreads observed in the bond market (cash spreads) diverged from each other and from their historical relationship. For example, the three-year CDS spread narrowed from 315 basis points (bps) on September 30, 2008, to 202 bps on December 31, 2008, while the three-year cash spread widened from 430 bps to 490 bps over the same time period. Due to the persistence and significance of this divergence during the fourth quarter, management determined that such a pattern may not be temporary and that using cash spreads would be more relevant to the valuation of debt instruments (whether issued as liabilities or purchased as assets). Therefore, Citi changed its method of estimating the market value of liabilities for which the fair-value option was elected to incorporate Citi’s cash spreads. (CDS spreads continue to be used to calculate the CVA for derivative positions, as described on page 92.) This change in estimation methodology resulted in a $2.5 billion pretax gain recognized in earnings in the fourth quarter of 2008.
The CVA recognized on fair-value option debt instruments was $5,446 million and $888 million as of December 31, 2008 and 2007, respectively. The pretax gain recognized due to changes in the CVA balance was $4,558 million and $888 million for 2008 and 2007, respectively.
The table below summarizes the CVA for fair-value option debt instruments, determined under each methodology as of December 31, 2008 and 2007, and the pretax gain that would have been recognized in the year then ended had each methodology been used consistently during 2008 and 2007 (in millions of dollars).
Got all that? So, Citi, in it’s infinite wisdom, decided to change methodologies and monetize, immediately, an additional 290 bps in widening on it’s own debt. This change saw an increase in earnings of $2.5 billion prior to this quarter. In fact, Citi saw a total of $4.5 billion in earnings from this trick in 2008. However, this widening in debt spreads was a calendar year 2008 phenomenon, and CDS lagged, hence the out-sized gain this quarter in derivatives due to FAS 157 versus debt. Amazing.
And, while we’re here, I want to dispel a myth. This accounting trick has nothing to do with reality. The claim has always been that a firm could purchase it’s debt securities at a discount and profit from that under the accounting rules, so this was a form of mark-to-market. Well, unfortunately, rating agencies view that as a technical default–S&P even has a credit rating (“SD” for selective default) for this situation. This raises your cost of borrowing (what’s to say I’ll get paid in full on future debt?) and has large credit implications. I’m very, very sure that lots of legal documents refer to collateral posting, and other negative effects if Citi is deemed in “default” by a rating agency, and this would be a form of default. This is a trick, plain and simple–in reality, distressed tender offers would cost a firm money.
The Bottom Line: Citi isn’t out of the woods. In this recent earnings report I see a lot of reasons to both worry and remain pessimistic about Citi in the near- and medium-term. If you disagree, drop me a line… I’m curious to hear from Citi defenders.
In another installment of the series called “In The Year 2010″ I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000″). This is a thought experiment, nothing more.
This edition, as the title would seem to suggest, is about C.D.O.’s. Please sit down, because I’m about to argue something very counter-intuitive. C.D.O.’s will be alive and well in the year 2010. Now, I’m willing to claim this victory on a technicality–corporate C.D.O.’s are still being issued. Now, safe in my assured technical victory, I’ll go farther out on the limb
It’s somewhat instructive to understand what have been the various motivations behind the C.D.O. market, historically (some of these obviously no longer exist)…
- There was the reach for yield. If one could get AAA C.D.O.’s for a higher yield than other AAA bonds, it was a no brainer. Both were AAA, obviously! No extra risk.
- A highly customized risk profile. If I looked at a pool and thought 6% of the balance was going to written off, but no more, I could buy the 7%-10% tranche and get a higher return. Obviously this higher return would need to match whatever threshhold I established, but that was most likely related to the market anyway. Some people referred to this as taking a position in the collateral with leverage. C.D.O.’s are, in essence, leverage on leverage, but this is a complicated, technical, and largely semantic argument. The surface intuition is that taking a levered position increases your return if nothing defaults, but less has to default for the buyer to lose money.
- C.D.O.’s were used to finance bonds or other debt positions. “How?” is what I heard you say, in the back? Well, think about it this way: an investment bank requires 50% of the purchase price of a set of bonds and charges LIBOR+100bps on the other 50%. We say that you’ve financed the purchase of the bonds two to one at a rate of one hundred basis points over LIBOR. Now, using our example, let’s say one could issue a C.D.O. and sell enough bonds to get 50% of the purchase price of the underlying bonds up front. Let’s also assume that the liabilities have a weighted average interest rate of LIBOR+10bps. Using the C.D.O. instead of a traditional loan, especially since the C.D.O. can’t be cancelled like a loan can and, most likely, contains much more lax terms than a loan, is much more cost effective. Taking this a step further, it was even possible for C.D.O.’s to be issued that allowed more bonds to be put into the C.D.O. or allow bonds that were sold to be replaced. This effecive made the C.D.O. a credit line with an extremely cheap interest rate. Keep in mind the “equity” or “most levered tranche” or “bottom” of the C.D.O. generally was structured to have a very high return, somewhere in the 15-25% range.
Also, the backdrop of the boom in C.D.O.’s, don’t forget, was a very low rate environment. If one could get LIBOR+10-15bps on AAA bonds when rates were, in 2004 for example, 1% (for USD LIBOR and the Fed Funds), that was a major out performance for a AAA security (AAA, how much risk could there be?!).
Now that the historical context is out of the way, it seems pretty clear that some of these reasons for isssuing C.D.O.’s will not diminish in importance. Funds and money managers will always need more yield. Investors that are smart about credit analysis will always want to take the risks they understand and get paid for taking said risks. Funds and other “levered players” will always need financing. So, let’s examine how the landscape changes rather than disappears.
- Complexity will die. There are a number of reasons for this. Part of the reason is that buyers of C.D.O.’s will begin to realize that structure adds a layer of complexity that no one really can grasp fully. Why have dozens of triggers and tests at every stage of the waterfall (the way cash is distributed in order of seniority)? In some deals, I’m sure, this complexity helped some tranches of the C.D.O. In some other deals, I’m sure, this complexity hurt some tranches of the C.D.O. The one constant is that it’s nearly impossible to tell the right levels and specific mechanics beforehand. Hence the complexity will die and structures will simplify. Likely this also means less tranches. Why have a $4 million tranche size in a $400+ million deal when you can’t even predict losses within an order of magnitude (1%, 9%. or 20%? Who knows?!)? This is hardly a new concept, I introduced it already when discussing residential mortgages.
- Arbitrage C.D.O.’s will reign supreme. This one is controversial, and the term “Arbitrage C.D.O.” almost takes on a different meaning each time it’s defined. The intuition, though, is that a hedge fund taking advantage of a market dislocation by issuing a C.D.O. is an “Arbitrage C.D.O.” Why will these be popular? Well, C.D.O. shops, or firms that are serial issuers of C.D.O.’s, have mostly blown up and are done. Traditional money managers will be shying away from C.D.O.’s for a long time. So, in order to sell the C.D.O. equity, the most levered risky piece, the firm issuing the C.D.O. will need to also be willing to take on the equity–this leaves only hedge funds. Arbitrage C.D.O.’s also come together more quickly and generally are backed by corporate bonds. Funds and other accounts that, as a core competency, already analyze corporate credit won’t have to go “outside the comfort zone” to buy into arbitrage C.D.O.’s.
- C.D.O.’s or C.D.O. technology will become part of the M&A world more and more. Aha! Maybe too clever for my own good, but while all these specialty finance companies used to be able to issue a C.D.O. for funding purposes on their own, now they will need an investment bank to connect them with hedge funds or take on the debt, and thus the risk, themselves. These C.D.O.’s will likely be simple too (see #1), but will be an efficient way for these companies to finance assets or move them off the balance sheet. Here’s an example: a diversified finance firm, with a large lending presence, for example (most likely with a R.E.I.T. subsidiary, a popular structure of the past eight years) will be looking to sell itself. However, because the assets on it’s balance sheet look risky the leveraged finance groups will need to arrange some financing against those assets. The structure? Most likely a C.D.O. with hedge funds providing the cash and getting a “juiced” return on their money. This is essentially the covered bond product, but with an extra layer of complexity (tranching) on top.
Okay… that’s enough prognosticating for now. Still deciding which product is next. Drop me a line if you have a favorite!
This comes from a comment I left on Barry Ritholtz’s “Bailout Plan Open Thread” the other evening. The basic premise is that the “Bailout Bill” as we know it basically says we need to go out and “lift” the street out of toxic crap. Then, the world will be better. It’s at least a bit less like the Underpants Gnomes in the sense that the toxic crap and the freezing up of the credit markets are linked… However, here’s the plan we should see if we, as taxpayers, really want our money going to help us.
1. Purchase only loans or securities that have the right to control loans directly or modify loans. The magic of the C.D.O. is that it’s backed by things that are backed by other things. So, if I buy some sub-prime–backed bonds and C.D.O.’s backed by those same bonds, I’m buying two securities being affected by the same loans. Just buy the loans. With the loans being controlled by the government, they are now free to…
2. Recast all delinquent loans to be much longer, have lower interest rates, and be much harder to abuse. Guess what interest rate you get on a forty year mortgage? A lower one! Why? Because the duration is much higher. Why? If I make five basis points per year over the life of a forty year loan I’m making more money than if I earn five basis points over the life of a thirty year loan. Thus, the interest rate where I make the same amount of money should be lower on the forty year loan. The government doesn’t even need to smash any potential profits to make loans more affordable.
3. Offer financial institutions two options: sell the government’s bailout fund loans or securities at the price the government offers to purchase them at, or sell them at their mark and give the government equity. Why? Because if the bank isn’t willing to sell at a reasonable bid, furnished by the government, then their mark is over-inflated and they are trying to avoid an adverse hit to earnings–the government should receive more compensation for bailing out the bank. This should be applied to each position one at a time–no securities should be purchased in aggregate, that’s too easy to game. As a matter of fact, that’s how sub-prime worked to begin with: pools of loans got more and more barbelled and the bottom loans defaulted. On average they were normal, in reality they were crappy enough to break the securities. Oh, and the equity should have voting rights. Of course, there are questions to be answered.
4. Lend directly to people and small businesses. If the economic fears are all about the seizing up of the credit markets, we should be able to fix these problems by lending to those that live and die by financing. Create very strict standards for qualifying for these loans. FICO and income requirements, unlike sub-prime loans had. For businesses, underwrite loans to actual income and asset levels and only lend very conservative amounts of leverage.
5. Immediately raise capital requirements across the board. As Steve Davidoff notes (Lesson #4 when one follows that link), when you need to raise capital the most, you can’t. He concludes, as I have before, that this is a wonderful argument for raising capital requirements. Also, less levered institutions are more sound in general–there is more room for error. And, as one could guess, the competitive “flavor of the day” businesses, like C.D.O.’s and sub-prime, are much more levered because financing these products is viewed as a way to win business. This is why the institutions with cheap balance sheet are experiencing huge writedowns due to counterparty exposure with financing arrangements. Citi disclosed writedowns of billions in warehouse lines where C.D.O. issuers were holding bonds with nearly no equity, on Citi’s balance sheet.
6. Required compensation reform. It’s well documented, conjectured, and even assumed that Wall St.’s compensation scheme is to blame for a lot of the mess we’re in. Swing for the fences and jump ship to another bank if it doesn’t work. That’s what it seems the most recent round of large bonuses for executives and traders that caused this problem were following. It’s simple, if you need money from the American people, you sign on to these reforms. Otherwise one might encounter a moral hazard due to government subsidized capital. Honestly, it shouldn’t be that hard to come up with an onerous set of restrictions and requirements for paying people exorbitant sums of money.
7. Immediate and broad consumer protections and consumer financial product reform. Rather than have banks start to do whatever they want to reduce their risk (I’ve heard reports of people with home equity lines in good standing paying their bill one day late and having the entire line canceled) require they treat their consumers fairly. Completely restrict the ability for banks to raise rates on things like credit card debt–to retroactively increase rates on existing debt is ridiculous in the first place. In an economy driven by spending and credit, for better or worse, putting consumers further at risk of defaulting on their obligations is stupid. Eliminate binding arbitration of consumer debt–just invalidate it completely, retroactively. I would prefer this practice be eliminated altogether, but if we’re keeping to the topic at hand I’ll only put forth that proposal. Lastly, put strong disclosure requirements in place for all consumer debt products, including new loans or recast loans. Require institutions to show the annualized rate, over the life of the loan, if interest rates rise 2%, 4%, 5%, and if the forwards are realized. Require large print, plain English disclosures. Some people will say Im trying to babysit people, but, honestly, how can one argue against requiring banks tell their customers basic information about their loans? Right, one can’t.
This is what we should have gotten to both get the economy and markets moving in the right direction and ensuring the confidence in institutions and consumers are both restored. Just my opinion..
Isn’t this just like politicians… Now that they are bailing out some “too big to fail” firms and starting up a mass-produced bailout, why are they buying securities? Shouldn’t they be bailing out homeowners? They vote. If a bank is carrying loans, or securities, on their books at seventy cents on the dollar then why not give the borrower enough to pay the loan off (assuming it’s mark is it’s current principal value)? Anyway, by forgiving the loan, the potential exists for a C.D.O. to be paid down too–don’t forget they are securitizations of securitizations.
Maybe using taxpayer money to have the newly taxpayer-owned G.S.E.’s (more than sponsored, I suppose) make a loan to them at a much lower rate )obviously for the lower amount)? Honestly, seems illogical to go around bailing out financial institutions when those benefits are perceived to be more concentrated … More benficial to people who caused the problems rather than those who stand to lose the most from them.
Anyway, just my thought on this “bailout” …
Disclosure and financial filings seem to be topical today with the S.E.C. announcing the Investment Banking Analyst Mercy Initiative. So, I’ll play ball. I have read a bunch of things recently making claims about the ability of a diligent investor to know what they are “getting into” and what the risks are for investing in a public company that has disclosure requirements. Actually, I haven’t been doing this for decades, so let’s quote someone that has… Tom Brown:
No one, inside or outside the company, could accurately predict what … ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general–is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.
I emailed Tom to clarify a few thing, but never heard back. So, as I am prone to do, I’ll assume I’m correct in my interpretation and move on. I’m assuming that this was also the case in the past–how else would people be able to buy into a financial institution in the past if Tom didn’t think his words were just as true two to three years ago? (Nothing has really changed in disclosure requirements, right?) Surely, in the past, the issue would have been taking a view on the performance of the various financial institutions’ assets as well.
I looked at three firms’ disclosure, from 2006, related to C.D.O.’s … what I could find. Now, in the interest of full disclosure, I’m not trained to do this. I’m just a person, with some financial experience, looking at some S.E.C. filings. I knew i was looking for C.D.O. exposure, especially in the context of figuring out what banks would need to be responsible for if the market had a severe dislocation. Let me explain what I mean by this. Remember all the liquidity put chatter? While mostly related to S.I.V.’s, this is still a relevant concept for C.D.O.’s. As in any syndicated deal, most common for selling bond or stock offerings related to corporations but also relevant for securitized products, when an investment bank agrees to do a securitization they have most likely (call it 80+% of the time) agreed to “take down” or purchase the securities they are unable to sell to investors. Easy enough, right? Those assets are what has generated a huge amount of writedowns. It’s very easy to see the relationship between market share in the C.D.O. and securitized products space and magnitude of writedowns.
These relationships, however, are very complex. Multiple investment banks could be selling an individual deal and each could be responsible for purchasing different parts or different percentages of leftover securitizations. These are individually negotiated for each transaction. As a firm is building up assets (for example, sub-prime mortgage-backed securities), before they have enough to actually securitize and create a C.D.O., the bank/investment bank could have all the risk of those assets losing value or defaulting–if the C.D.O. doesn’t get done then it becomes a big problem. It’s also a big difference what types of assets or structures make up the C.D.O. securities. One sees the problem growing. There is a lot of information that needs to be processed to come up with a reasonable estimation of losses. I would claim that it is completely insufficient for a bank, as they have been, to disclose exposures once they start to become a problem.
So, what did I find? Terrible disclosure. I was able to find almost no information. Certainly no information that would have helped come up with an estimate for losses from these firms based in any sort of logic or fact. Now, I’m not saying one should be suspect of current disclosure–I don’t know what is next to blow up or cause big problems and none of these firms are run by the same regime that decided the previous level of disclosure. What I am saying is that I wouldn’t have been able, even if I had known exactly what was going to happen, to know the magnitude of the losses.
First, I looked at Citi. Citi had a notion of participating or structuring. Those numbers were combined and reported together. This helps to determine market share, perhaps. This does nothing to disclose the risk on the balance sheet. This number ($110 billion) could be made up entirely of bonds were Citi is at risk. It could also be entirely made up of bonds where Citi has no risk and is taking fees. There is nothing I found in the 10-K’s to say anything more helpful. So we know losses, if these C.D.O.’s (named V.I.E. or Variable Interest Entities in the disclosure) were sold at 22 cents on the dollar, as Merrill reportedly did, the losses would have been between zero and $86 billion. Whew! Nailed it down… Now, knowing that, do you buy or sell Citi’s stock?
Second, I looked at Merrill. They state some numbers and then footnote saying they might, potentially, hold a financial interest in some of the securitizations. Same situation as Citi. No disclosure as to what kinds of bonds these are. How much was retained? How much in financing obligations exist related to these? What percentage would have had to be retained by Merrill if unsold?
Last I looked at Bear’s filing. Bear was a slight improvement. They actually stated some of what they retained and have some exposure numbers which one could back out some other information from. Still, if I was modeling the losses I would be asking for a lot more information–while an improvement, in my opinion, it wasn’t enough.
Below are the tables from the various filings. Also, if one was looking for C.D.O.’s, I put the number of instances the term of interest appeared.
Now, since the S.E.C. is mandating and revamping filings and disclosure, perhaps they can do something about this. Maybe financial firms should be forced to disclose risk numbers and sensitivities. I certainly don’t have all the answers, but I think it’s pretty clear that no one had the answers, nor did they have the specific questions, before this crisis occurred.
From the Citi 10-K (2006):
Mentions of the word C.D.O. : Thirteen (lucky!)
From Merrill’s 10-K (2006):
Mentions of the word C.D.O. : Zero
From Bear’s 10-K (2006):
Mentions of the word C.D.O. : Eight
One thing that came up often as Merrill’s recent C.D.O. sale and capital raise were discussed is how one could really say the following two statements, from the Merrill press release, are not conflicting with my statement. Let’s examine the Merrill statements first…
- Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser.
- The purchaser will not own any assets other than those sold pursuant to this transaction.
Seems obvious, then, that a decline in value will mean they take the assets back. Well, then why did I make the following statement (in the comments)?
- [There] can be provisions that allow Merrill to extract assets from other Lone Star entities or require the SPV to get more money from the Lone Star funds
Simply put, there are a lot of different ways one can structure a trade like this. First, there are the moving parts of the economic terms: the interest rate, the margin amount (think of this exactly the same as buying a stock on margin: essentially a loan) required upfront, the level of margin required to be maintained, etc. The interest rate is easy, I would think the interest rate would be somewhere around L+100bps or so. The terms for margin could be tricky, though. For example, the financing could be structured such that it requires 25% of the market value up front and requires that any time the equity decreases by 5% it is paid back in to ensure the fund always owns 75% of the risk.
Now, regardless of whether these terms are correct or not, we have hit a snag. The second statement, cited above, from the release seems to indicate that this isn’t really possible. Lone Star’s vehicle will only own these mortgage assets, so where does the rest come from? There are a number of ways Merrill can enforce this margin be kept up. First, as is common, they give themselves the power to do so by putting in “cross default” provisions. This allows Merrill to seize assets and other monetizable interests that are in its possession or control through financing arrangements with Lone Star. An example would be if a private equity fund owned a company and also purchased some securities with a repo agreement to finance them. If the private equity fund defaulted and the company had collateral with the firm providing the repo financing, the collateral could be seized. It’s also possible that there is a requirement for Lone Star to fund the margin, although not necessarily keep it in the vehicle.
Let’s see that, immediately, something interesting falls out from these terms. First, Lone Star has to be willing to fund some margin in the short run. If the assets drop in value to drive their equity down by some threshold amount (5% in the above example), they would need to fund that or potentially suffer elsewhere (cross default) or, potentially, face the assets being taken back altogether. This last option is clearly in Merrill’s best interest since it could seize the 25% equity already in the trade and have the upside of the assets as well–assuming Lone Star would never have put in more than the 25% upfront. This seems to defy logic, especially with assets being volatile in the short run and the clear implication that 22% of face value would become the valuation benchmark. One must also admit that Lone Star will be willing to put more money into this trade when the most mundane part of the transaction is considered, namely the interest owed on the 75% being borrowed. Consider this: if there was truly no way for Lone Star to put money into these assets then Merill would own them again ~30 days after the transaction closed. Why? Monthly interest payments on the financing. Lone Star will owe around 1/12th of 1 month L.I.B.O.R. + 100bps every month. That isn’t coming out of the margin, I would bet.
So what have I shown? There are enough degrees of freedom that one can cast scenarios where John Thain is either kicking his feet up and relaxing or where he’s calling down to the C.D.O. trading desk every ten minutes asking for marks on the assets to see if they are coming back to “Mother Merrill.” I will caveat the above by saying that I don’t know what is required to be disclosed in these sorts of arrangements, but it seems like Merrill would have the higher burden to disclose anything adversely affecting their financial status, and the lack of further bad news in the financing should be taken as an indicator.
It is for these reasons that some of the speculation surrounding the C.D.O. portion of the sale were a bit simplistic and probably not accurate in the way they stated what the true economics of the trade were. For example, saying they sold for five and change cents on the dollar is not true. We also cannot say that Merrill has sold it’s upside but retained it’s downside. Nor can we say both at once. All of these gloss over a level of nuance necessary to fully understand the transaction or require a number of assumptions.
Now that you know more than you ever wanted to know about financing, what was the point? Well, let’s examine these two statements from a NYT piece on Thain and the recent Merrill activity:
“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.
Mr. Thain has been accused of misleading investors because as recently as mid-July he said that he felt comfortable with Merrill’s capital levels. He said his statements like the one on the second-quarter earnings call were true when he made them. “We would not have needed to raise more capital unless we completed the C.D.O. sale,” he said.
John Thain pretty much says the structure is well protected in the first statement. We’ve shown above that this transaction only makes sense for Lone Star if they are willing to let it run in the short term (and that makes sense if they truly think these assets are under-valued, otherwise why purchase them en masse). Couple this with all the criticism and negative P.R. John Thain and Merrill are taking for having to do the equity raise, and it’s pretty clear that that magnitude of attention is only worth is if this sale ended this chapter. Since he specifically states the contingency in the above quotation, I’m hard-pressed to think the sale has very little chance of ever being kicked back to Merrill.
In the end, I could be wrong and forced to eat my words. We’ll see, though, and I rather doubt it.
Well, there was an announcement from Merrill about some things:
- Selling CDO Assets
- Settling monoline issues
- Selling equity
Now, while all these are important, #2 is better covered elsewhere as I think reliance on insurers was stupid to begin with and #3 is what it is… best left for analyst reports for nuance, but very generally obvious. Let’s go to the release…
Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.
… [The] sale will reduce Merrill Lynch’s aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral – 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure…
Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.
Now, this is (via the WSJ via naked capitalism) 22 cents on the dollar. Wow! But, to be honest, this is sticker shock that comes from the massive liquidity being used here. The bid someone shows you on $30 billion versus $30 million is a very different proposition. This sounds like advice I gave before (see item #1 on that post). Now, what questions should the analysts be asking? Note the bold, italicized, underlined parts above. Seems as if the purchaser will be an entity, most likely formed for this transaction, that will only need 25% of the $6.7 billion, or $1.675 billion. Now, since the other 75% is financed, what happens if losses start flowing to these CDOs? The amount of equity decreases. From the Journal …
Many CDOs held by Merrill were viewed as highly likely to default and lose some or most of their principal value. Of around 30 CDOs totaling $32 billion that Merrill underwrote in 2007, 27 have seen their top triple-A ratings downgraded to “junk,” according to data compiled by Janet Tavakoli, a structured-finance consultant in Chicago. Their performance has been “dreadful,” she says.
So now Merrill is in a race. Up to 78% of notional value can be written down, now, with no one taking a loss. Then the next $1.675 billion falls to Lone Star’s equity, and then the rest come out of capital Merrill has put up for the benefit of Lone Star. With the above downgrade statistics such losses aren’t completely out of the question. With this in mind, I would want to know the financing terms. The devil is in the details. Such financings could require only some margin up front in addition to the 25% equity, or none at all. The financing terms could limit Merrill’s ability to claw back more capital as the assets see further writedowns. In general, these terms could mean the risk is only cushioned, not removed. I’m sure these questions will be asked, and that Merrill anticipated such questions. This makes me think that these issues lead to the depressed price–price was the one protection potentially preventing Lone Star from having to have to cough up more money (you can’t owe money if the assets are performing better than their price implies). However, if these terms aren’t very favorable (Merrill was trying to get rid of these assets, after all) one might not ever see the financing terms. It’s also possible that Merrill retains some equity upside in these assets. I guess we’ll wait and see…
Okay, I’m a huge fan of Research Recap, so don’t take this as “ragging” on them, but I was reading my feeds and came across this gem of a headline:
Wow! Really? Apparently CreditSights, whom I have heard good things about, put out a report saying this. The money quote? Here it is…
The Cash flow CDOs that are being launched increasingly appear to be designed to help banks clean up their balance sheets rather than attempts to arbitrage the agency ratings.
And then there was this other gem in the post, quoting the report…
“Any widening, it was claimed, would rapidly be exploited by a wave of CDO issuance. The most important driver of this stabilisation was synthetic CDOs – specifically the idea that bespoke single-tranche deals could be placed with investors without the need to fill the entire capital structure and this protection selling would push spreads lower.”“Such arguments have been demolished by the events in the past 12 months with both synthetic and cash flow CDO issuance falling like a rock owing to a slew of economic, ratings, and funding concerns.”
So why is CreditSights (CreditHindSights, in this instance) releasing such a report, detailing what everyone with a minimal attention span and the ability to read a newspaper would be able to figure out for themselves? Oh, right …
The full report is available for purchase.
I don’t think a firm needs to sell a report telling people interested in reading finance research that people aren’t buying CDOs like they used to, anymore.
Maybe their next report will analyze Bear Stearns most recent 10-K and detail some warning signs they see as troubling…