Posted tagged ‘CDOs’

In The Year 2010: C.D.O. Edition

October 21, 2008

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)…

  1. 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.
  2. 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.
  3. 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.

  1. 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.
  2. 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.
  3. 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!

The Financial Markets Stabilization Act We Should Have Seen

October 14, 2008

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..

On Recent Stories: Something for Everyone

August 27, 2008

I haven’t had the opportunity, in a long time, to cobble together some real thoughts. However, here are a few quick takes on what is going on recently…

1. Citi continues to shuffle deck chairs. Now, I don’t know what they could be doing right now to fix their situation. The problem they are facing is that they need to control costs in an environment rife with morale problems. As one commenter on Dealbook pointed out, I don’t know who believes that Jamie Forese is asking a subordinate to become his equal–indeed that’s probably not even within his power to do. I also don’t know why there is such a massive use of management consultants–in a large bank with an everything-needs-signoff-from-the-C.E.O. culture it’s hard to imagine someone who runs a department of 200 people can go out and hire McKinsey … Those managers can’t even upgrade their own travel arrangements to first or business class! Anyway, the real issue with these measures is that the worst abusers are powerful and find their way around these policies and senior management’s time is better spent doing other things than approving new computers and offsite meetings.

IRONY ALERT: As I was writing this post, I saw this item from Research Recap:

McKinsey sees considerable scope for investment banks to cut their noncompensation costs – possibly up to $2 billion in recurring savings.

McKinsey said its experience indicates that data, printing, supplies, delivery and professional services usually yield the fastest results; restructuring real estate and IT spending may take longer but generate much larger savings.

McKinsey said its analysis suggests that “executives can embark on this additional belt tightening without harming a bank’s culture and morale.”

Of course, morale at most investment banks is already so low that a further whack at expenses is unlikely to make it any worse.

(emphasis mine.)

Honestly, you can’t make this stuff up…

2. Lehman is approaching a deal to sell a stake in it’s asset management unit,  Neuberger Berman, to a private equity firm. This is a good start for a relationship, of the kind I have already opined on, between Lehman and a business that should be looking for disintermediation. I would, if I were Mr. Fuld, look to sell a stake in the asset management unit, get an equity investment in Lehman itself, and form a permanent J.V. with whatever top-shelf private equity firm will be winning the auction. Maybe Lehman can try cross-selling … “Mr. Kravis, I see you own a part of our asset management division, can I interest you in some cheap real estate debt? With gas prices so high who couldn’t use some hard assets?” Feel free to fo read my prior post–I go into a lot more detail there about the nuances of what the structure, in an ideal world, should look like.

3. Fannie and Freddie are falling … in slow motion! I have no idea, none at all, why the failing and bailout of Fannie and Freddie are both taking so long. Guess what? If Fannie and Freddie are woefully undercapitalized now then what’s the catalyst for things to get better? There is none. This whole situation doesn’t make sense. Are they waiting for the G.S.E.’s to be insolvent? We already know they are leveraged instutions completely concentrated in markets that are dead, dying, or woefully sick. I guess I don’t understand the rationale for waiting to take action… From the WSJ:

The Treasury probably doesn’t need to make a decision imminently unless the companies lose their ability to tap debt markets at reasonable costs, said Joshua Rosner, a managing director at research firm Graham Fisher & Co.

If the Treasury is forced to inject capital into Fannie and Freddie, though, that is likely to be part of a restructuring that would likely wipe out the value of previously issued common and preferred shares and lower the value of subordinated debt.

[Obligatory paragraph about what the stock did today.] …

Fannie increased its holdings of “liquid” investments, cash and short-term securities that can easily be sold, to $103.6 billion, up 43% from June. The move gives the company more flexibility to reduce its future borrowings if market conditions worsen, company officials said.

(emphasis mine.)

In what world is $100+ billion of anything easily sold? Simply stupid. Especially with the Fed pressuring the Treasury Department to ease up on wiping out certain equity holder because of the destruction wiping out parts of the G.S.E.’s capital structure would cause. Have any of these people ever seen markets function in the face of uncertainty? Oh, right … the last year or so. Well, at least that’s going well…

4. The next big problem is here: distressed companies. People expect that this will be the next set of losses and economic distress. Corporates have been fairly resilient, as a sector, to this economic downturn. Part of this is the lag that corporates have from the time consumers start tightening the purse strings to the time that effect is seen on the bottom line. Nothing else to say, really, the numbers are all moving in the same direction.

5. Random Assortment of other things…

A. Remember the rating agencies? Well, now one is going to sell you something that will tell you how much you’re going to lose on the C.D.O. paper you bought because they said was safer than it actually was after using their flawed ratings methodology… Apparently the part of their suite that worked was the part that picked out the downgrade candidates.

B. In a slight nod to my political views, there is finally hard data that we, as a society, have a vested interest in investing in those amongst us that have the least.


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