Friday, November 13, 2009

Goldman Pays Junior CDOs Before ‘Junk’ Senior Classes

Posted on Bloomberg by Jody Shenn:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

The moves are unusual in that the most senior creditors are typically the first in line to get paid. Fitch analyst Karen Trebach said the use of reserve funds may help cause or add to losses for holders of the CDO’s remaining classes.

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Michael Duvally, a spokesman for New York-based Goldman Sachs, declined to comment.

Goldman Sachs packaged $1.4 billion of credit-default swaps into the CDOs when they were created in September 2006 and December 2006, Fitch said. The derivatives were intended to pay off a Goldman Sachs unit if commercial-mortgage bonds defaulted.

CDOs, which repackage assets such as mortgage bonds and buyout loans into new securities of varying risk, were among the biggest contributors to $1.7 trillion of writedowns and credit losses reported by the world’s largest financial firms since the start of 2007, according to data compiled by Bloomberg.

TPG Credit

The disclosure of Goldman Sachs’s move adds to signs that some firms are compounding investor losses by exploiting wrinkles in CDO agreements that can run hundreds of pages.

TPG Credit Management LP, a fund associated with buyout firm TPG, has attempted to purchase $355.8 million of trust preferred securities for 5 cents on the dollar from six CDOs. The fund is offering holders of lowest-ranking classes, including JPMorgan Chase & Co., an additional 5 cents on the dollar to allow the sales.

Wells Fargo & Co., the trustee, has asked a federal court for guidance because senior investors are concerned they will be hurt as the CDO collateral gets removed without sufficient compensation.

Ratings Cuts

In July, KKR Financial Holdings LLC, an affiliate of buyout firm KKR & Co., canceled portions of junior notes it held from three high-yield, high-risk corporate-loan CDOs, allowing cash to continue being paid on the rest instead of being diverted to senior classes, according to Moody’s Investors Service.

Moody’s downgraded the senior slices of one of the CDOs as a result, saying it previously had projected a “low likelihood” of such a maneuver.

Fitch, citing a deterioration of securities still in the reserve account and swaps in the CDOs’ holdings, downgraded the classes of Abacus 2006-13 that weren’t redeemed to CCC, or seven steps below investment grade. Classes of Abacus 2006-17 that weren’t paid down were lowered an additional step to CC. Some of the debt in each portion was originally AAA rated.

The repaid classes had face values of $66 million and the rest totaled $553 million, according to data complied by Bloomberg.

The transactions also contained separate credit-default swap classes that were even more senior-ranking and weren’t rated by Fitch, Trebach said. Such so-called unfunded senior- senior swaps and other classes are in some cases retained by issuers.

Credit-default swaps on asset-backed debt offer payments if securities aren’t repaid as scheduled, in return for regular insurance-like premiums.

Investment Account

Goldman Sachs bet against $1.4 billion in commercial-backed securities and other CDOs through default swaps that were inserted into the Abacus issues, and it then sold notes from the CDOs equal to part of that amount, Fitch said. The cash raised was put in an “eligible investment account.” As with similar “synthetic” deals, securities bought for that account could be used to repay the CDOs, make payouts on the underlying swaps or both partially.

Goldman Sachs also had the ability to use “principal proceeds from the eligible investment account” to redeem Abacus classes “without regard to sequential order,” which it chose to do to retire junior classes, Fitch said.

Motivations for such action could include ownership of the notes or separate bets against higher classes, according to Howard Hill, a former Babson Capital Management LLC portfolio manager who founded securitization-related departments at four of the primary dealers that trade with the Federal Reserve, among them Deutsche Bank AG and UBS AG.

Positions Unknown

“You just don’t know without seeing who owns all the positions related to the deal,” Hill, who now runs a blog from New Milford, Connecticut, said in a telephone interview.

The reserve account may also be depleted because, while a Goldman Sachs unit entered into an agreement to buy securities in it at par to enable payouts if needed, that’s not true in all situations, according to Fitch.

The “put option” can be voided if any of those securities default, which is now likely as 38 percent of Abacus 2006-17’s investments are rated CC, Fitch said. Investments, which had to be AAA rated, may have included notes such as mortgage securities or other CDOs, Trebach said.

The “probable” default of account investments may also trigger the unwinding of the Abacus CDOs, and the amount garnered in sales may not be enough to terminate the underlying default swaps as would also be required, Fitch said. About 98 percent of swaps held by Abacus 2006-17 are tied to bonds with “junk” ratings or near that level and under review, the firm said.

If Goldman Sachs hadn’t used some of the cash in the accounts to redeem notes, the senior securities would be “less exposed to losses,” Trebach said. If what’s left is insufficient, even the Abacus CDOs’ super-senior swap classes may be called upon to make up the difference, she said.

1 comment:

Cormick Grimshaw said...

From FT Alphaville (How did Goldman `get away’ with it?):

By carefully constructing the deal to allow it the opportunity, of course. Here’s what Fitch says:

"Classes marked paid in full (PIF) have been fully redeemed under the Optional Redemption provision. The provision allows the issuer to redeem the notes using principal proceeds from the eligible investment account. The notes may be redeemed without regard to sequential order. Principal proceeds may also be used to reinvest under the eligible investment criteria. Use of the proceeds are under the sole discretion of the issuer (Goldman Sachs)."

A quick synthetic CDO explainer here. Unlike `normal’ CDOs, the underlying credit exposure of a synthetic CDO is based on credit default swaps rather than tangible assets (CMBS, RMBS and the like). In the Abacus cases the cash raised from selling the synthetic CDO tranches was put into an “eligble investment account” — and it’s from that account that the bank took cash to repay those junior noteholders. Before senior ones.