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Tuesday, March 31, 2009

"Moody's, we have a problem!"

Last week Moody's announced that it has downgraded and left under review for possible further downgrade its ratings of all classes of notes issued by SVG Diamond Private Equity I and SVG Diamond Private Equity II - deals they should never have rated and should stop rating immediately. (But that's just my opinion.)

Why?

The two deals comprise approximately $717 mm in total. They are CDO transactions, each "referencing a portfolio of shares of private equity funds."

Herein we have problem numero uno: the inherent, obvious lack of diversification by industry. Unlike other CDOs where the rating agencies thought there was diversification, here there never was any such supposition - the underlying are [all or primarily] private equity fund shares (at least according to Moody's press release).

It was diversification and subordination that allowed one to take junk -- it's a technical term, not scathing -- and create investment-grade, or even a AAA. Well, since there's limited diversification here, the junk all acts in tandem, and so the resulting necessity, as we saw above, to downgrade all tranches.

(To be entirely transparent, certain other CDOs, called trust-preferred CDOs or TruPS CDOs, were issued backed wholly by bank or insurance-issued trust preferred securities. These are similarly desirous of diversification, but were rated equipped with the knowledge that banks and insurance companies are heavily regulated and so a lesser default risk. Private equity firms, to say the least, are not heavily regulated.)

From Moody's press release:



SVG Diamond Private Equity is a bankruptcy remote special purpose company incorporated with limited liability in Ireland for the sole purpose of acquiring its interest in the portfolio and certain other assets securing the notes, and issuing the notes.

...

Today's rating actions are primarily a result of the deterioration of the performance of the private equity asset class and the amount of unfunded commitments. The presence of a liquidity facility renders the risk of a default on an interest payment remote.

And now for the juicy stuff:



In reaching its rating decisions, Moody's considered the following important factors:

(1) Cash
The current amount of cash in the structure has been compared to the initial projections. Distributions and drawn-downs have been projected until maturity.

(2) NAV
The Net Asset Value (NAV) of the portfolio as reported by the manager has been compared to the initial projections. Based on the fair value accounting (FASB 157), the NAV presents an aggregated performance metrics.

(3) Public Information Regarding Private Equity
Private-equity funds typically disclose a limited amount of information to the parties involved. Moody's examined the recent disclosure of large publicly quoted buy-out funds with regards to the mark-downs of outstanding Leveraged Buy Outs (LBOs) and Venture Capital (VC) portfolios and used them as guidelines to understand the state of the private equity industry.

(4) Public Equity
Unlike Private Equity, for which historical performance data is available only for the latest 25 years, Public Equity indices provide performance information over a much longer period. As an example, the LPX 50, an index of 50 major publicly traded Private Equity companies, is approximately 67% down since September 2004 (deal inception) and 82% down from its peak in May 2007. In the absence of transparent Private Equity performance data over this time period we can look to Public Equity as a proxy.

(5) Manager's View
The transaction manager has been asked to provide the projected levels of distribution, draw-downs and NAV. Moody's believes that the manager is in a unique position to time the various material elements that impact the cash flow. Moody's applied stressed to the projected levels from managers.

(6) Liquidity Position
By nature, private-equity investors commit capital that will be drawn in the future. Historically, the full amount of committed capital has not been drawn by the Private Equity funds. Moody's believes that the likelihood of a commitment to be drawn during a systemic credit crisis is high.

Moody's has developed a monitoring model for this type of transaction. The model first estimates the cash available over the life of the deal. It also models the liquidity facility dynamically. Based on the factors listed above, Moody's defined three states of future portfolio performance: optimistic, baseline and pessimistic and assessed the probability of losses for each tranche in each of the three states. Haircuts on the projected distributions are in the range between 0% and 40%, depending on the state of the portfolio.


Now we introduce Problems 2 through n:

(2) We're certainly NOT seeing any measure above that takes into account Moody's INDEPENDENT opinion. All we see is "Moody's applied stresse[s] to the projected levels from managers." Sadly, that doesn't take much insight. Nor much investigative research.

(3) These ratings are based on limited historical data: as opposed to the original collateralized bond obligations (CBOs) which were at least supported by corporate bond default rates since at least the early eighties, here Moody's isn't falling back on any substantial historical data.

(4) The limited data they are falling back on isn't even necessarily private equity data: it's public equity and venture capital-type data.

(5) Moody's is relying heavily on the manager's view (!) and projections. Need we say more? This is not entirely dissimilar to a hedge fund investor running in blind despite access to data! Sherlock Holmes would turn in his grave.

(6) Moody's is relying heavily on the manager's NAV. Okay. But how are they combatting potential mismarkings, especially for NAV-lites? I understand if they can't be expected to spot Ponzi schemes, but some cushion on the NAV interpretation would be swell. "The Net Asset Value (NAV) of the portfolio as reported by the manager has been compared to the initial projections." This unfortunately doesn't seem too useful. More useful would be to analyze the NAVs, especially as we're in an economic environment marked by its unwillingness and inability to evaluate illiquid assets (private equity investments are an ideal, typicaly, problematic example). In a market swamped with scandal, including accounting and valuation scandal, solely trusting the key "interested" party simply does not, can not suffice. Especially as an NRSRO - a nationally recogized statistical rating agency. With power comes responsibility.

(7) "The current amount of cash in the structure has been compared to the initial projections. Distributions and drawn-downs have been projected until maturity." Again, I have no confidence that this approach is worthwhile. Firstly, given the market changes, one can't possibly expect anything to be similar to initial projections. Secondly, projecting drawn-downs through maturity -- out in 2024 -- seems a gargantuan, purely academic task.

(8) We still have no knowledge as to what changed that suddenly demanded all tranches be simultaneously downgraded. These deals were rated 3 and 5 years ago. Isn't there a steady realization -- as with all other CDOs they rate -- that the lower tranches have become a credit concern, followed by the mezzanine, and then the senior-most tranches? Was Moody's simply asleep at the wheel?

We have no reason to believe, based on this announcement, that Moody's has any competitive edge over Joe the Plumber in evaluating the quality of this CDO. Aside, perhaps, for the knowledge that "Moody's has developed a monitoring model for this type of transaction." Given these deals were rated in 2004 and 2006, this seems an odd, retrospective remark. From a psychological perspective, this comment appeals to me as a demonstration of innocence by one not accused of anything. The assumption is naturally that they have a (hopefully accurate)model, given the complexity of the transaction and that they have imposed ratings on the issued tranches. The confession therefore, that they have a model, has the opposite affect of being reassuring: it seems Moody's recognizes that they're walking an unnatural, uncomfortable path here, tip-toeing like a cat on a hot tin roof.

It's sad that they ever chose to rate these transactions in the first place. (Why not simply turn it down until you have sufficient data to support such an analysis?)

It's sad that despite the scarceness of data supporting their ratings, and their ratings' heavy reliance on unreliable data, they continue to rate them.

It's sad that each deal's investors continue to pay monitoring fees to Moody's for its scarce, unreliable, spontaneous monitoring.

Thursday, March 26, 2009

TARP-to-Market?

The New York Post reported that Citigroup and Bank of America went on a TARP-sponsored “toxic asset” buying spree (mostly AAA-rated Option ARMs/Alt-A-backed MBS).

BofA explains that "[these] purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market."

Note: Thanks BofA, but isn't the TALF working on that? Weren't the government’s TARP injections meant to be used by you for commercial lending?

As the Post says, what's most troubling about this is “how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay."

Note: Obviously, winning bids should be higher than competing bids but it sounds like the winning bids were significantly higher in these cases.

It may be that both banks are hoping to recoup some of their losses by doubling-down on the same toxic assets, but why go out of your way to pay more than the market?

Well, with the PIPP around the corner, overpaying now may actually allow for profits later.

By buying large volumes at inflated prices, Citigroup and BofA are inflating market levels for these toxic assets. This strategy will allow these banks to temporarily mark-up and sell their own toxic positions to investors participating in the PIPP.

Example:


(Click to enlarge)

I'd keep an eye out for subsequent (inevitable) mark-to-market retractions.

Tuesday, March 24, 2009

Hedge Funds and Rabid Regulation

With Obama urging Congress to empower regulatory units and quicken regulation, one is encouraged to ponder on philosophically.

Are we simply overcompensating for having been under-regulated or poorly regulated? Are we ready to impose and adopt new regulation? Is regulation even a cure?

As one can imagine, poor regulation in its abundance may have a similarly negative effect to poor regulation in its absence. Perhaps there's a covenient middle ground. But the speedy (raging) imposition of new regulation simply cannot be the answer: it hinders growth and poses significant operational burden at a time when the U.S. -- no, world -- economy simply cannot support it. And it's expensive.

Now we don't contend that all regulation is bad. Some of it, for example the rating agency debate, is healthy. But when the political maneuvering becomes extreme it can undo much of the good work that came before it. Hedge funds, for example, are appealing due to the leverage and return they can achieve. But they become infeasible under certain regulatory and disclosure regimes. We are, in effect, ensuring that very few hedge funds can and would want to continue existing. The move towads being an asset manager, consulting firm, or bank would be much more appealing: if you're going to be heavily regulated anyway, why not take the upside?

The hedge fund industry certainly has a few items worthy of an additional eye (i.e., some form of supervision). We've spoken a little about sidepockets and challenges in consistently presenting fair value. Side letters, as an aside, and redemption gates are also obviously problematic and requiring attention.

And so too are fund documents: not only the restrictions they impose, but more importantly the capabilities and flexibilities their language allows. As Risk Without Reward (RWR) points out, the idea of "buyer beware" is only useful if the documents have not been drafted in such a way that allows just about anything "in the sole discretion of the investment manager."

For example, CDO indentures for managed deals have various sections describing what are acceptable Substitute Collateral Debt Securities. Fund documents, less so.(Even today we saw -- and it's not necessarily a bad thing -- two of Eaton Vance's funds approving investment in alternative new asset classes, with one fund allowing investments in commercial mortgage-backed securities (CMBS) and the short-selling of sovereign bonds subject to certain limits. For another way managers get around regulation see Regulatory Capital Arbitrage.)

Aside from investment criteria investors should look at operating expenses for the fund. Does the hedge fund pass legal and formation fees onto the fund owners? Okay. Are investors alone paying for data and vendor tools that are used for the manager's other (possibly prop capital) funds? Is that sharing pro-rata? And is the fund paying for the marketing of its shares? (Hat tip to RWR for this catch). Data and analytical tools are expensive, as can be the fund marketer's traveling expenses. Frustrating indeed. But time to ask those tough questions. While we still have hedge funds.

Tuesday, March 17, 2009

Regulatory Capital Arbitrage

Yesterday's repackaging of G Square Finance 2007-1 Ltd.'s A1 tranche is interesting for a handful of reasons.

The process itself is indicative of the market's thought process in general, and the origin of securitization in the first place: to take something lowly-rated and, via the application of leverage (or subordination), to create something with a higher rating.

In this instance, out of a CDO tranche rated in the CCC region by Moody's and S&P, they've created some portion of investment grade debt, as per the rating methodology of Dominion Bond Rating Services (DBRS).

What Happened? - Why Interesting?

Essentially we have what looks to be a vanilla new-issue CDO-squared (CDO^2). Based purely on the future proceeds of the existing A1 tranche, two new tranches were issued: one being the subordinated piece, comprising 77% of the new capital, and the other 23% being rated BBB(low) by DBRS.

DBRS has never really been a player in the CDO market: investors in CDOs would typically demand at least one of the "Big Two" (Moody's, S&P) or two of the "Big Three" (Big Two plus Fitch) before purchasing a tranche.

This tells us one of two things is happening: either (1) the market no longer needs a rating from either Moody's or S&P, or (2) there is no intention or need to sell the tranche.

More likely (2) than (1), but a mixture is probably most likely.

Firstly, given the tarnished reputations of the Big Three, one can legitimately excuse using an alternative rating agency.

Secondly, the holder may not want or need to sell the tranche, but may simply seek regulatory capital relief: once the item is rated in the CCC region, you're essentially having to cover it one-to-one from a regulatory capital perspective. If able to re-invent this same tranche in such a way as to have any of it (in this case 23%) rated higher, that portion will achieve certain capital requirement relief. Thus, instead of having 100% requiring one-to-one reg. capital, you now have 77% requiring heavy capital reservation, with the other 23% requiring less - possibly significantly less.

Thirdly, it is possible that the holder's reg. capital requirements do not require the rating be from one of the Big Two or Big Three, but any nationally recognized statistical rating organization (NRSRO). In that case, the holder could essentially pick (or "shop" for) whichever of the ten NRSROs appeals most to him or her, in terms of (a) cost of using such NRSRO and/or (b) amount of leverage such NRSRO will allow at the rating level(s) he or she wishes to achieve. In summary, the lower the fees, and the lesser the required level of subordination, the more appealing the NRSRO.

Hello competition. (Not that we approve of it, but simply comment on its existence.)

(As an aside, according to Asset-Backed Alert data, Moody's was asked to rate only 39.8% of MBS deals issued in 2008, down from 74.2% in 2007. Keep in mind that often more than one rating agency will rate the same deal. DBRS was on 17.6% of 2008 deals, versus 2.9% in 2007.)

Monday, March 16, 2009

Rating Agency Model Debate

As it pertains to a previous piece of ours, entitled: Issuer vs. Investor-pay Model, New York State's Insurance Superintendent Eric Dinallo wrote an op-ed piece for the Wall Street Journal proposing the investor-pay model.

Michel Madelain's (COO of Moody's Corp.) response was displayed in the letters to the editor section. Here is our response:


Dear Editor,

New York State Insurance Superintendent Eric Dinallo’s March 3 piece (“Buyers Should Pay for Bond Ratings” ) argues against the rating agencies’ issuer-pay model and their “powerful incentives to bias ratings to keep debt securities’ sellers satisfied and the rating fees flowing.”

While supporting Mr. Dinallo’s initiative, we suggest that his proposed investor-pay model is similarly flawed.

Here’s why. Particularly in structured finance ratings – the area of increased scrutiny today – the issuer has little or no “skin in the game”: Only investors holding securitized bonds are affected by the actions of the rating agencies. Therefore, under Mr. Dinallo's proposal, the only party that has skin in the game would be responsible for paying the rating agencies’ fees. We believe the resulting pressures imposed by investors on rating decisions would be at least as intense as those imposed by issuers or structuring banks.

To combat the inherent conflict of interest, one could align the rating agencies' fees with the performance of each bond, as benchmarked against its rating. Thus, if a AAA behaves like a CCC, it won’t be compensated for as a AAA would.

More importantly, as Mr. Dinallo mentions, “ratings will never be flawless.” The Holy Grail is, thus, to de-link the world’s financial stability from ratings performance. We concur with the essence of Sean Mathis’ September 27, 2007 testimony before the U.S. House of Representatives’ Committee on Financial Services:

“…I believe, however, that the true culprit [is] the system that allowed NRSRO ratings to become critical and an embedded part of the protections built into our capital markets, financial institutions, and pension funds without sufficient or appropriate thought given to accompanying supervision or accountability.”

Sincerely,

Gene Phillips and Guillaume Fillebeen
Directors, PF2 Securities Evaluations, Inc.

Thursday, March 12, 2009

Some CDO Equity for You, Sir?

Much in line with the instruments Frank Partnoy described in his 1997 Wall Street thriller F.I.A.S.C.O, principal protected notes (PPNs) provided the structuring banks with an additional outlet for selling CDO equity.

Among others, pension funds and private clients -- often unknowingly -- became the eventual holders of CDO equity, blessed with an investment grade rating, usually AAA.

What is a Principal Protected Note (PPN)?

PPNs typically comprise of two components: a principal component (not CDO equity) and an interest component (often CDO equity).

Principal Component:
  • typically AAA-rated, zero-coupon US Treasury strip (non-cashflowing)
  • accretes to a specified principal amount at maturity
Interest Component:
  • typically lowly rated or unrated "first loss" piece of a CDO (CDO Equity)
  • earns residual (excess) interest to CDO
How Does This Work?

The AAA rating awarded by the rating agencies to the PPN is what we call a "pass through" rating. It is based solely upon the rating of the abovementioned principal component.

Thus, because the AAA-rated Treasury strip accretes over time (since it pays no interest coupon), on maturity it will have achieved the promise on the PPN, by design. In other words, the rating of the PPN addresses the return of ultimate principal by maturity (not principal plus interest).

How may this instrument be sold (to you, by your financial advisor)?: Well, you have upside if the CDO equity performs well, while losing nothing in the alternative scenario (assuming the US government does not default on its debt). And thus a PPN makes sense.

Or does it?

Time will tell how well those investments will turn out. Right now, they're not looking too good. In other words, we hope you don't own any.

To end off with a quote:
"I have trouble understanding public pension funds' delving into [CDO] equity tranches, unless they know something the market doesn't know.'' - Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions.

Tuesday, March 10, 2009

Supplying Credit Where Credit is Due

The liquidity, or rather illiquidity, crisis manifests in various forms: notably, corporations (large and small) struggle to raise capital and consumers struggle to finance their purchases.

With home prices sharply down -- as opposed to consistently up -- homeowners can no longer resort to the mortgages for speedy cash-out refinancing (mortgage equity withdrawal, or "MEW"). As the downturn continues, and with banks freezing their consumer lending practices, our consumer base moves toward student loans and credit cards as an ultimate, non-recourse, source of funds.

The availability of funding in these two markets, often the final source for troubled consumers, may help certain borrowers avoid bankruptcy (see The Bankruptcy Burden). But these markets, too, are troubled.

Credit Cards
Meredith Whitney writes in "Credit Cards Are the Next Credit Crunch" that credit card lines are being reduced with increasing velocity, with an overall contraction likely in the order of 57%, in her estimation. Indeed, "overly optimistic underwriting standards made more borrowers appear creditworthy. As we return to more realistic underwriting standards, certain borrowers will no longer appear worth the risk, and therefore lines will continue to be pulled from those borrowers."

On the flip-side, with credit card write-offs steadily increasing, credit card companies' profitably will likely suffer, as the charge-offs outpace the increase in yield they're able to generate on performing cards. The three largest programs Chase(CHAIT), Citi(CCCIT) and Bank of America (BACCT) already have below average excess-spread generation, according to a Moody's report I'm looking at from mid-January.

What will happen to Discover (DFS), currently on the brink of sub-investment grade status at BBB-/Baa3, is a worthwile consideration. Absent further government intervention, will they be able to finance their securitized portfolio if it hits an early amortization event?

Student Loans
The student loan situation is no less compelling: students cut off from student loans may be forced to drop out of school, which in turn decreases their earning capacity and ability to settle their loans.

With the FFELP Stafford Loan program having a four-year limit of $27K, any reduced student loan availability may particularly impinge upon students attending schools with low graduation and/or poor job placement percentages.

In a market notorious for its absence of job growth, studying -- expensive as it already is -- is increasingly in demand. This demand may prove good for certain coffee shops, but if we don't approach this situation from the bottom up, we're going to find ourselves with a large population of frustrated, defaulting "student-borrowers" devoid of the access to funding required to set their record straight.