The TARP Has Blown Away, Build Your Own

Be ahead of the curve. Be ready to cut loose assets with losses looming, and take active control of assets that should be kept to preserve principal. We explore these concepts in the following article.

 

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After much haggling, posturing, and speculation, the TARP (Troubled Asset Recovery Plan) has blown away. Holders of ABS, RMBS, CMBS, and CDO paper , ie. "Structured Finance Assets” are left dealing with continued asset deterioration and a frozen market.  While many corporate credit unions held a skeptical view of participation in TARP, the absence of a liquid market remains a blow for all. Now, many purchasers of SF securities are left scratching their heads, asking ‘what now?’ 

Although the future seems bleak, investors do have options.  It may take more time and energy, but the net result will be a cleaner balance sheet and a better understanding of one’s investments.  At this time, the focus should be on surveillance and distribution.

  1. Prioritize credit. Some SF purchases were outright mistakes, while others may be performing and well enhanced. 
  2. Employ a strict surveillance regime and understanding of deal documents, swap counterparty, rating agency action, control triggers, and changes in control triggers.
  3. Establish a buy-sell-hold strategy for each position.
  4. Develop a marketing and sales strategy.
  5. Privately Distribute.

With these five steps, you’ll be ahead of the curve. Be ready to cut loose assets with losses looming, and take active control of assets that should be kept to preserve principal.

Step 1: Vigorously Review Recent Vintage Collateral
In general, pre 2005 vintage structured finance transactions (RMBS, CMBS, ABS, CDOs) possess less leveraged collateral, superior structural features, and boast higher subordination providing additional cushion for senior classes.

Recent vintage structured finance transactions (2006-2008) are substantially inferior, in part because of looser underwriting standards and the erosion of structural features. In order to feed the liquidity machine, many credit concessions were made:  CMBS saw increases in interest-only and partial interest-only loans (most 2007 transactions have north of 90% interest-only and partial interest-only collateral), CDOs saw more “barbelling” of collateral, which was done to game valuation models and RMBS saw an increase in subprime and Alt-A collateral transactions. The first step in triaging  your structured finance balance sheet is to separate all transactions by vintage by designating 2006 to 2008 transactions for more rigorous review.  

 Step 2: Get a Clear Handle on Make-up of Collateral
An understanding of the collateral in SF transactions is critical in making the right judgment call.  Although the concept of ‘pooling of assets’ is the same for all SF deals, that is where the similarities end.  For example, although RMBS and CMBS seem very similar (both products are backed by mortgages), they are NOT.  For one thing, RMBS loans are made to ‘consumer’ borrowers who’s loan performance is based on FICO scores and general credit.  CMBS loans are made to ‘commercial’ borrowers who not only have deeper pockets, but can rely on underlying property cash flows to help make debt service payments.  This is a big fundamental difference.

A basic, high level understanding should be made for all SF bonds.  Are they backed by ‘consumer’ or ‘commercial’ borrowers?  How correlated is the performance of one asset to another (ie, do all the assets generally perform the same or is there specific individual risks for the assets)?  How dependant is the asset on the general economy?

After a basic understanding is made, the next step is to understand the specific default and recovery drivers for each collateral type.  Does the collateral generate cash flow, or is the asset type linked to ‘credit’?  Are recoveries dependant on ‘market price’ or is there another metric?

Finally, the performance of the assets underlying the transactions needs to be monitored.  Observing the ongoing performance of a deal is critical in making timely decisions.

Step 3: Closely Vet your Deal Documentation and Structure
Only attorneys and masochists like to re-read deal documentation. However, many losses recently experienced by structured finance investors at the most senior tranches occur not only because the collateral has deteriorated, but because structural triggers outlined in deal documents were not clearly drafted and followed.  Who are the controlling classes in your deals and what are their rights? Are you the controlling party? What are the rules with respect to changing those in control? Who is the swap counterparty and what is the existing value of the swap?  Are the rules and triggers structured to protect your class going unnoticed, thereby causing you undue losses? Answers to these questions change daily as credit ratings of counterparties once deemed invincible are downgraded, and collateral level defaults mount and set-off triggers. In some cases, the party controlling the decisions in the transaction is out of business, or, in business with a substantially reduced workforce.

Step 4: Collateral Managers Must Nurture Mutual Relationships with the Wizards
Many investors play a passive role in managing their bond investments.  It is important to be involved by asking questions and forming relationships with the different transaction parties.  Do you know the special servicers, trustees, rating agency analysts and asset managers on a first name basis? Are they telling you the status of the underlying collateral and payment history of the obligors? Do you have the most recent watch lists, and opinions of those monitoring those watch lists? Do those that service the collateral have an alignment of interest with you, the senior investor?

Generally, modelers do not speak or build relationships with those closest to the deal. Anyone can create a cash flow default and loss simulation to determine the ‘value’ of a structured finance security.  While accurate models have a very important place in making the right decision, obtaining information from the transaction parties is equally, if not more important, especially if a timely decision makes a big difference.

Step 5: Get in Control by Understanding What You Hold
“Vultures” are circling to fill their coffers with distressed debt. However not many trades have happened because of the massive disparity between mark to model and mark to market pricing. Other than Lone Star’s purchase of $6.7bb of ABS CDOs from Merrill Lynch for $0.22 on the dollar and $5bb of seller financing, and a select few others, public activity has been dim. The government has tried a variety of initiatives to spark liquidity, most recently the TALF (Term Asset-Backed Securities Loan Facility) program aimed at the acquisition of recently issued consumer ABS (credit cards, auto loans, student loans etc.). Quietly, however, the market is moving and assets are being traded while the masses seem to be lying in wait. 

It is imperative that you understand what you hold, what will or will not have value in the future, and that you are ready to sell. Have a ‘sell book’ prepared that outlines your positions so that you can maintain optionality. Although $0.80 on the dollar may seem too low for some holdings, $0.22 may be a great price for others, and $0.70 for others. You won’t want to be the one that misses the right bid. Furthermore, as an investor, you may be in a controlling position to make decisions on transactions as subordination has eroded. Remember, a fast amortization or liquidation of collateral creates inherent disagreements among owners within the same structured finance vehicle. There may be a decision hanging in the balance that allows your position to be repaid, and you just don’t know it yet.

Though not widely reported, there are paths for distribution out there. We will help you prepare for, and find them.  Please contact us or visit our website.  We have the models, we know the people, the tricks, and the rules. This is our business.

 
 

Dec. 1, 2008


Comments

 
 
 
  • Very thoughtful article!
    Paul
     
     
     
  • Great article!
    Seth