Moody’s Better CLO Cosmetics

Earlier this week, Moody’s Investor Services announced their intention to remove a significantly severe default probability assumption from its rating model.  The net and immediate effect will be to lift Moody’s ratings of Collateralized Loan Obligation (“CLO”) programs by one notch in the most senior classes of most transactions and by as many as three notches for many junior CLO tranches.

The decision by Moody’s to eliminate the “crisis era” default probability factor of 30% from its methodology should be a tremendous boost for the CLO market, as the relatively strong performance of many existing programs will appear to be rewarded by this upgrade. 

While some bankers argue that the ratings lift will do more harm than good to new CLO issuance activity, we find that a little hard to believe.

While many have recently argued for investors to abandon their traditional over reliance on ratings when making investment decisions, we are on the record suggesting that over time, many investors will revert back to the rating agency evaluation for, at minimum, a significant portion of their decsion-making, if not the majority.  We believe that simply highlighting CLO’s by pulling some classes up into “investment grade” territory will only further illuminate the improved performance and the relative high return that these securities generate.

We can’t see how that will be anything but good for both existing  and new CLO programs.

Interesting that both Fitch and Standard & Poors have decided to take a “wait and see” approach to Moody’s acknowledgement of vastly improved market conditions.  Our guess is that they will not be far behind in recalibrating their own models.  Before anyone cries that “the sky will fall again” if the rating agencies go back to their old ways, just keep in mind that all those that said that the agencies went much too far in their reaction to their ratings of CLO’s two and three years ago (when they were under tremendous pressure to pay for past mistakes) have recently been proved to have been correct.  Many, if not most, CLO’s have performed exceedingly well through the Credit Crisis; a credit to their structuring and the performance of the asset managers involved.

Covered Bond Wars: US vs. Canada

There’s an interesting dichotomy playing out in the markets over the past couple of weeks over the support that the US and Canadian governments are prepared to provide to the future development of Covered Bonds  in each of their respective markets.

In the US, the FDIC is throwing a fit over recently proposed legislation that would seemingly align US covered bond structures with the same types of investor protections that covered bond investors have come to expect in Europe and other active covered bond markets.  The FDIC’s central bone of contention seems to be that any sniff of preference for covered bond investors when it comes to issuer bankruptcy or liquidation is bad legislation.

This reaction by the FDIC is perhaps the best evidence about what their “real position” is in connection with the “Orderly Liquidation Authority” recently granted to the Corporation under Dodd-Frank.  While the FDIC has recently indicated that it would not be their intention to void claims made by holders of securitized bonds of an issuer in receivership, certainly this reaction to the covered bond legislation would seem to indicate that they at least want to keep their options open, if not worse.

The Canadian government, on the other hand, seems to be fast tracking legislation that will make it even more clear that covered bond holders should be able to expect that their lien against certain pledged cash flows from mortgages or other pledged assets, will be protected under Canadian law.

We have always felt that the covered bond market was mostly a novelty, attractive to certain types of issuers and we don’t really feel that the purported issuer benefits associated with the structure when applied under a Basel III regimen are that meaningful.  The real issue here is the viability of the tested concepts of “non-recourse” and “true sale treatment”.  Without one or probably both, you can’t have a securitization marketplace.

You can argue that Covered Bonds aren’t really a securitization and we would be the first to agree.  However, the fact that they are being pitched to structured finance investors as a replacement for securitized instruments, is telling in its own right.  What covered bonds have really become is a more “politically correct” alternative to traditional securitizations; nothing more and nothing less.

As they say….. It is what it is!  If this is what we have to look forward to then it seems pretty clear that the Canadians get it, while US regulators continue to lag behind.

US Treasury Announces Wind Down of $142B MBS Portfolio…. No Surprise as to Who the Buyers Will Be

Earlier today, the US Treasury announced it intentions to begin the long anticipated unwinding of its US$142 Billion Mortgage-Backed Securities Portfolio that was accumulated through the Government’s Financial Stabilization Programs, beginning in 2008, at the lowest points of the financial crisis.

In yet another “I told you so” moment, the Treasury indicated that they expect to make a profit on these purchases made from banks during those dark days.  Despite the loud drum beat of naysayers and arm-chair experts who indicated that the program would be a disaster and cost US taxpayers billions, it turns out that all those bankers, who were reluctant to sell into the program but were compelled by artificially low market prices (at least in terms of historic trends in valuations) and a need to meet capital requirements or to sustain general liquidity in their mortgage businesses  to do so, were probably right after all.

Immediately, speculation centers on these same banks as the most likely candidates to bid on these Treasury sales.  Why not, they have known all along that the long-term value of these securities is excellent and who knows the underlying fundamentals of the underlying collateral better than the bankers that created the securities to begin with.

Maybe it’s just us but we see these predicted results as one of those few times when the end result looks exactly like what the authors intended.  The program provided a vital link to liquidity for the banks during a time of crisis and the banks will now re-purchase the securities at an overall cost to those banks (and a profit to the Government) which is in line with historically fair market valuations.

We suspect that such a good news story will get much less attention than it probably deserves.  Bravo to Treasury on this one.  God knows they get beat up enough when they make a mistake.

FDIC Proposed Rule for Orderly Liquidation Underwhelming for Securitization

Earlier today, the FDIC issued a press release announcing that their Board of Directors had approved a Notice of Proposed Rulemaking (“NPR”) which is intended to further clarify the FDIC’s role and policies in connection with the Orderly Liquidation Authority granted to the FDIC under Title II of the Dodd-Frank Act.

Perhaps the clue provided by the emphasis placed in the press release on the liability of senior executives of a failed firm at the expense of possible good news for the structured finance industry should have been a clue.  Perhaps the FDIC would like issuers and investors to simply rely on the Corporation’s “good intentions” because we come away from our first read of the proposed rule, which is essentially an addendum to an interim rule which was adopted by the FDIC in January 2011 in connection with Title II of Dodd-Frank, with a continued lack of confidence that the FDIC intends to provide clarity to investors in mortgage-backed and other securitized structures.

Today’s NPR, in the FDIC’s own words……..

“This proposed rule (“Proposed Rule”) builds on the interim final rule published by the FDIC on January 25, 2011 (“Interim Final Rule”) to address additional provisions of Title II. The Proposed Rule addresses the following issues: (i) the definition of a “financial company” subject to resolution under Title II by establishing criteria for determining whether a company is “predominantly engaged in activities that are financial in nature or incidental thereto;” (ii) recoupment of compensation from senior executives and directors, in limited circumstances, as provided in section 210(s) of the Dodd-Frank Act; (iii) application of the power to avoid fraudulent or preferential transfers; (iv) the priorities of expenses and unsecured claims; and (v) the administrative process for initial determination of claims and the process for judicial determination of claims disallowed by the receiver.”

It is this last section where we have spent most of our time, considering alternative interpretations for how the FDIC is suggesting they will handle the claims of secured creditors.  If we are correct that this section is intended to include holders of securitized debt of a failed financial institution placed under the FDIC’s stewardship then we see problems.

The proposed rule notes that the receiver must approve all claims and that the value of all pledged collateral “above fair market value” becomes the property of the receiver (we assume to be utilized to settle other claims of the estate).  Other sections define a covered “financial company” to include both on-balance sheet and off-balance sheet transactions.  The rule also seems to make it clear that all claims must go through an administrative claims process and that it will be the FDIC that determines if critical criteria, including the “perfection of security interest” in the related collateral meets all legal criteria.

If we are reading this correctly AND this is exactly the intent of the FDIC, how in the world can a broad investor base take any comfort in their abilities to rely on the market fundamentals of the securitized structure in which they invest?  It seems that the credit analysis moves decidedly away from the collateral and squarely onto the financial condition of the issuer.   We would point out the simple truth that investors, in very many cases, make investment decisions not on the likelihood that they will be paid under the best conditions but that they will likely be paid under poor or even the worst conditions.  We see the continued “lack of clarity” from the FDIC between what they sometimes say and what they put down on paper as a continuing source of frustration for the structured finance industry.

The FDIC Chairman’s pronouncements that this latest rule brings greater certainty to the objective that shareholders and creditors (not US taxpayers) will pay for the failure of  financial institutions makes for good political theater but they continue to avoid the questions that investors, who believe they have purchased assets in the open market from a financial institution and had believed they now own those assets, have about the legitimacy of their rights to those assets.

We await further clarification from the FDIC.

The FDIC release, in its entirety, can be viewed at……

Proposed Rule On Priority Claims Under The Orderly Liquidation Authority of Dodd-Frank Act – PDF

FDIC Position on Safe Harbor Clarified? Maybe not.

In late February, FitchResearch published a report detailing their recent analysis of the impact of Dodd-Frank, including its Orderly Liquidation Authority  (“OLA”) provision and the FDIC’s interpretation of the act as it relates to Safe Harbor protections for securitizations.

It’s obvious that Fitch spent some quality time both researching the FDIC’s deliberations about the effects of Dodd-Frank on Safe Harbor and the Agency’s most recent policy statements about how they would intend to use their new powers .  The report provides some great background about the history of Safe Harbor and the related concept of  “true sale” as they have been utilized to provide protection and instill confidence in securitization structures for investors for more than three decades.

However, we remain unconvinced of Fitch’s conclusions about the FDIC’s official position on Safe Harbor.  Too many times in the article, Fitch refers to their “impressions” and their “interpretations” of comments made by the FDIC during a series of interviews Fitch recently conducted with the Agency.

We are left with a less than comfortable feeling that Fitch’s conclusions, as genuine as they may be, may reflect too much wishful thinking.  When we read answers to questions about how the FDIC would interpret their rights in its role as receiver for a failing financial organization that include phrases like “the FDIC will not seek to exercise its authority under Dodd-Frank”, we really don’t get that warm and fuzzy feeling.  We’ll accept that the general counsel’s office at the FDIC may believe this today and it seems to be that comments like this are what Fitch has based their conclusions upon.

We’re not as sure that current FDIC staff interpretations about how the FDIC may or may not act, when a bank falls into receivership down the path, is really something that should be broadly relied upon by investors.  The Fitch Report is excellent in the background and analysis that it provides but, perhaps, it comes up a little short in its conclusions.

Of course, you should draw your own conclusions.  The report can be accessed at:

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=605045

Don’t Beat Up the Trustee

Are MBS trustees really afraid of their own shadows?  An article in this week’s Wall Street Journal might lead you to believe so.

The article described a recent decision by a group of investors holding a position in a bad 2006 Bank of America securitization to bypass their bond trustee, The Bank of New York Mellon, and to pursue litigation against BoA on their own.  The article seems to infer that the group, known as “Walnut Place”, had become frustrated by the trustee dragging its feet in pursuit of the investors’ claims against the issuer.

While we are already on the record for prodding bond trustees to become more proactive in the pursuit of their fiduciary responsibilities, we feel compelled to point out that it is more than likely that there is more to this story than may meet the eye; certainly more than a casual reader might take away from the WSJ article.

First, we would point out that the bond trustee represents ALL the bondholders of a particular issue.  As such, the trustee must carefully weigh the claims of any holder or group of holders against the rights and best interests of all other holders of that security.  We have no information about the actual percentage of the outstanding bonds that the Walnut Place group holds of the BoA 2006 series but if it less than a majority of the bonds outstanding, then it is not hard to understand that Walnut’s “strategy” may not be consistent with the best interests or even with direction provided to the trustee by other bondholders.  One possible clue as to how much of the issue is held by Walnut Place could simply be The Bank of New York Mellon’s refusal to file suit against BoA.  If Walnut held a majority of the bonds (51% or more), under normal circumstances, the trustee would be hard pressed to say no. 

On the other hand, Walnut Place may hold a majority of the issue but that might only illuminate another very good reason why BNYM did not file suit.  It could very well be that Walnut Place was not willing to indemnify the trustee for taking up the chase.  Standard provisions in nearly all trust agreements allow the trustee to ask for appropriate indemnities from the holders that they represent in these types of situations, particularly when asked to take legal action against an issuer or arranger.

If, in fact, Walnut Place does hold a majority of the BoA 2006 bonds, we would guess that they refused to provide the trustee with an appropriate indemnity.  We have been the first to recommend that the trustees become more proactive in the pursuit of the interests of their bondholders, by becoming more engaged in their pursuit of remedies in cases of bond defaults, bankruptcy, etc.  We have witnessed the trustee community be a little too guilty of touting their “fiduciary role” and then running for the hills when the going gets tough.

However, we agree wholeheartedly that pre-default compensation levels for trustees of mortgage-backs, asset-backs and other structured debt programs are, in no way, enough to support the work and the liability that goes along with the pursuit of these litigations.  We would also point out that bondholders, particularly sophisticated holders of complex instruments, know this fact very well.

We suspect that the facts that may not have been included in the WSJ article could be that either Walnut Place is a minority holder or they were not willing to stand behind BNYM with a proper indemnity. 

Holders are always free to pursue their own interests.  In  this case, perhaps that is the best course and that might make this a little less of a story then it might appear to be at first glance.

MERS Must be Saved

The fallout from the recent ruling by the US Bankruptcy Court that the MERS “system” does not comply with current law is fast making its way through the bank and mortgage markets, potentially threatening the business models of lenders and servicers, as well as the overall operating efficiency of the market.

Judge Robert Grossman recent ruled that system by which the automated MERS program for assignments and the related positioning of MERS as a “principal” in the chain of ownership is not consistent with current law.  Judge Grossman did acknowledge the significantly negative impact that his ruling will have on the markets, as banks and servicers will now be faced with a major “redo” in the execution and recordation of mortgage documents.  To his credit, the judge seems to grasp the weight of this decision but was reluctant to attempt to legislate from the bench and has instead suggested that the appropriate legislative bodies take up the cause for fixing the system.

Apparently, MERS has already started to notify its clients to reconsider their reliance on the 15-year-old process for automating the arcane “physical” recording processes that have been on the books since the invention of the wheel!

Not only does this ruling affect the hotly debated foreclosure process that so many banks and servicers are currently trying to navigate, it could negate the validity of billions and billions of dollars in mortgage-backed securities which are collateralized by MERS mortgages.  MERS estimates that it maintains more than 50 million mortgages in its system.

Before anyone jumps out the window, clearly these mortgages have substantial value so, even if some, many or all are “thrown-out” as a result of a related litigation, we think that you have to assume that the issuer of an MBS security will eventually sort out the chain of ownership, thereby exchanging the value of those mortgages for any restitution it may be obligated to pay to its bondholders.

The “real cost” of this ruling is the loss in efficiency that the MERS system has provided to the residential mortgage market in the US for more than 15 years.  Critics argue that the MERS system was a scam from the very beginning, providing Wall Street with a slick way to get around local law and speed the path to getting MBS deals into the market.   We think such a view is totally ridiculous.

Anyone who has been through the local UCC and county filing processes can tell you how arcane and outdated these rules and regulations are.  This is about as clear a case as you will find of a situation where logic should ultimately prevail.  The MERS program is logical, safe and efficient and, despite Judge Grossman’s ruling, there remain many good legal minds that believe the MERS system is legal and does meet the law.

Nevertheless, as the Judge seems to have suggested, it is time for the legislative end of government to step in and fix the law.  The US Congress seems to be the most appropriate place to start.  We hope they are listening.