Monday, November 16, 2009

Weird waterfalls and the synthetic CDO stumper, part deux

Posted on FT's Alphaville by Tracy Alloway:

Last week, the machinations of two Goldman Sachs synthetic CDOs made waves across the internet and structured finance industry.

In short, Goldman Sachs paid off (at face value) some junior tranches of two CDOs — Abacus 2006-13 and Abacus 2006-17 — at the expense of senior tranches.

That’s a practice virtually unheard of in CDO circles — and is extremely surprising given that one of the basic ideas of structured finance is to have clear and legally-binding payment waterfall structures. Holders of the A tranche get paid first out of available CDO cashflows, followed by the B tranche and then the equity tranche, etc. But the documentation for the two Abacus deals seems to have allowed the issuer (Goldman) to use its “sole discretion” to redeem the notes without regard to seniority.

The Abacus events came to light thanks to a ratings action from Fitch, covered by Bloomberg journalist Jody Shenn, and then migrated to the blogosphere, where there was speculation that bailed-out insurer AIG may have been the counterparty to the two deals. That wasn’t a stretch of the imagination given that a number of other Abacus deals (these are the CDO deals Goldman supposedly used to short subprime) reportedly had AIG-bought CDS.

On Monday, we have a bit more detail, courtesy of Janet Tavakoli, president of Tavakoli Structured Finance:

In my November 10, 2009 commentary I mention that among the “bailout” credit default swaps that AIG was required to mark-to-market, Goldman bought credit default protection from AIG on seven Abacus deals apparently underwritten by Goldman Sachs. (Goldman also bought credit default protection on CDOs underwritten by others for a total of around $20 billion).

To the best of my knowledge, the deal that Bloomberg’s Jody Shenn mentioned in his article is not among them. It is interesting that Goldman bought credit default protection on the higher rated tranches from AIG, and was made whole by a U.S. government engineered bailout. Now Goldman is reportedly paying off the junior tranches of separate Abacus CDO first, presumably because it is allowed in the documentation.

I warned in my CDO books that this sort of cash flow game changer (among other unpleasant clauses) can blind-side unwary investors (or credit default protection providers) in senior tranches. One wonders about the identity of the senior investors (or senior protection sellers) and what they think about this.

In the secondary trading market, structures like this are called WTF deals.

WTF indeed.

Yves Smith over at Naked Capitalism has some comment from a source claiming to have seen the documentation for the Abacus deals. The incredulity is patent:

I have read hundreds of securtization [sic] disclosure documents (and drafted quite a few) and dozens of cdo dox. I have never seen any sort of “sub bond cross over date” that would apply for a deal that was taking losses. This would be such an unusual feature it would need to be highlighted in red and underlined, if I am understanding the facts in this article.

I have seen structures that deliberately fast paid sub bonds via excess spread (ie not locked out from principal for the first 3 years). But this was permitted because it did not harm the senior notes - ie sub bond was replaced by overcollateralization via excess spread (it also lowered the coat of the liability structure… And allowed bbb holders to get out ahead of senior holders). And it was always clearly disclosed and well discussed and understood.

This is happened on a 3 year old, under performing deal, so excess spread is not likely available.

I can’t think of a situation where a manager would get this type of discretion - most deals are written to protect against this type of “discretion” because it creates uncertainty about what a bond is likely to get. Changes in priority or cashflow ia always set up as something that happens by operation of triggers or events clearly labeled in the dox.

Mbs historically permitted a limited amount of discretion to manage defaulted loans (modify, short sale, pursue deficiency) which had some opportunity for conflict between them and the bond holders. As a result, there would be many checks in the dox to limit conflicts, such as requiring that the servicer not be a holder of the senior bonds…

I can’t figure this issue out. I know the abacus deals (and deutsche’s Start deals) - i reviewed them briefly before turning them down (the sales men were relentless on these deals). I saw enough to know they were different from normal transactions. All of the normal rules were off on the sales process, structuring, review etc.

Despite that, in reviewing the offering term sheets, I didn’t see broad cash flow priority discretion left to the manager. I would have been very surprised if I had.

As you might have gathered by now — what’s at stake here is the de rigueur waterfall structure of CDOs.

Goldman’s two Abacus deals may have had “sole discretion” built into the deal documentation — but it seems that many in the industry were caught unaware. Given that CDO documents can run into the thousands of pages, we wonder whether senior Abacus noteholders would have noticed the clause.

Weird waterfall structures of course do nothing for the (already suffering) CDO industry as a whole.

Related links:
CDO guide: tranching - Incisive Media (from the ABC of CDO)
Goldman and AIG, redux - FT Alphaville

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