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Tuesday, June 07 2011 | 11:40 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
|TruPS CDOs: Positive Convexity for Seniors, Mezz Tranche Optionality?
The TruPS CDO Market continues to underperform all other CDO markets to date, but this could change as soon as this year. We believe that certain TruPS CDO tranches could start to outperform due to substantially shortening WALs. At present, the market is assuming 0% CPR, translating to very long WALs. The market may be significantly overestimating the WALs of certain 1st priority tranches, especially if prepayments increase due to increased M&A activity, refis, and the Collins Amendment (see below). This effect could be even more pronounced in deals that have older bank TruPS paper in it.
For certain mezz tranches that are currently PiKing (those with only 1-5% negative OC cushion), we are bullish on certain cuspy tranches that may turn on in the future. The catalyst driving this is the new trend of deferring TruPS paper starting to pay again (see below). A careful fundamental analysis of the underlying deferrals could reveal significant upside in these cuspy TruPS CDO mezz tranches, as only a small number of deferral cures can greatly affect your return on these tranches.
Bank TruPS CDO Quotes (Assume 2005 or later)
Potential Increase in Prepays on the Horizon: M&A, Basel III/Collins Amendment, and Refis
Over the past six months, a new positive trend emerging is a pick up in M&A activity among small banks. Recently Iberia Bank took over ailing Omni Bank. Omni TruP debt, although paying at the time, was effectively prepaid.
Last year the Collins Amendment and Basel III passed, resulting in the loss of bank trust preferred debt TIER I status. This could result in many TruPS getting called beginning in 2013. Under the Collins Amendment, phase out of trust preferred Tier 1 credit begins in 2013 and ending in 2016. Although few banks have called their paper yet, this is likely to pick up in the near future.
Many older TruPS CDOs (pre-2006) hold bank TruP debt, strong with a high coupon. Some of these banks can easily refinance some of their paper. As defaults and deferrals continue to bottom and the new issue market picking up, we could see a significant number of banks prepaying.
Deferrals Beginning to Pay Again
Between M&A, new equity capital from third parties, and improvement in banks' asset quality and liquidity needs, we are seeing a number of issuers that were formerly deferring curing to pay again (see example list below). Corporate activity and equity injection have been major reasons for cured deferrals. In these cases, the new equity capital is received either through acquisition or injections from third parties. When this occurs, the deferred TruPS interest must be repaid before the new investors/holding company can be paid. Still, other banks are paying again due to better performance. For example, Inland Bancorp Illinois and Lawson Financial Corp (deferring TruPS) cured due to better performance (not M&A).
Some examples of banks that were deferring and have been since cured can be found below.
Tender Offers: A New Trend
Last year there were several requests for noteholder consent from distressed banks to tender their securities. All requests until this January have been denied. According to Fitch, they have received notification of the first tender offer ($20 bid) that was accepted. This is the first successful tender offer we have heard of and may be the start of a new trend. These types of transactions need to be analyzed carefully as it may or may not be beneficial to noteholders.
Optionality Down the Cap Structure
Some original AA-A rated PiKing paper has been underwater (negative OC Cushion) due to deferrals and defaults. Many of these tranches are underwater between 1%-10%. For those tranches that are "at the money" where they are only underwater by between 1-5%, there could be significant opportunity here. Given the trend in some bank deferrals curing, potential refis (especially on older deals), M&A activity, and slowdown in new deferrals/defaults (see default/deferral index below) there may be some tranches that get turned on in the coming months or years. If these tranches start paying again, returns could be extremely significant.
Swap Drag--Significant Drag on Deals but Should Improve Over Time
Hedge drag has been a significant factor hurting interest cash flow to date. Significant asset deferral/defaults combined with the low level of LIBOR have impaired many tranches. These imperfect hedges to date have been problematic, but it is important to note that as time goes by hedges "roll off" and as LIBOR rises (eventually), this mismatch may even help the deal (if LIBOR rises enough). Under the right circumstances, this problem now could reverse itself!
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ABS CDO Commentary
Tuesday, May 10 2011 | 07:31 AM
Robert S. Sainato CFA, CFP, CIC, CAIA
Managing Director, Structured Credit & Mortgage Group,
ADVISORS ASSET MANAGEMENT
Relying on NAV from outside sources (IDC/Mgr Marks etc.) can be a dangerous game as this can mislead investors. We strongly believe that Marks cannot be relied on. Spending additional time to independently mark the portfolio can help avoid potential pitfalls and can help investors spot significant misvaluation. This part of the analysis is especially important for cuspy and longer-WAL tranches. It is imperative that NAV is correct before asset-level assumptions can be used for deal-level cash flow analysis.
ABS/Multi-Sector CDO Opportunity: Buy Credit I/O ABS CDO's with Non-Agency Mezz. & Sub. Paper Underlying
The suspension of the foreclosure process has profound effects on non-agency credit I/O paper. By slowing down liquidations, cash flows to sub. and mezz. non-agency RMBS can continue for at least another 6 months which can have a profound effect on valuations of this underlying. Over the past few months, sub. and mezz. have been rallying (reflecting) longer timeline, but ABS CDO Credit I/O's (1st-pay '05-'07) ABS CDO's and 2nd-pay '04 and earlier paper haven't moved enough to reflect this improvement in cash flow.
ABS/Multi-Sector CDO Market Overview
The ABS CDO secondary market continues to trade up due to lack of supply and significant relative value. At this point, we are now seeing 1st-pay CDO risk-adjusted returns range from 7% (well-supported deals) to very low double digits (weaker deals). Investor interest for most of last year was mainly in older pre-2003 multi-sector deals, but we have seen this appetite change as of late. The lack of supply, rising forward rates, and foreclosure timeline extension have pushed many investors into "credit I/O" type investments. In terms of credit I/O bonds, these risk-adjusted returns did range from high teens to mid-20's but have now rallied to mid-teens returns (in general). Given the rising forward curve and lack of supply, we believe ABS CDO's will continue to outperform, especially at the credit I/O level.
Potential Supply & Basel III
Supply to date (secondary--no new issuance) has been relatively muted but this could change. On our trip to Europe, we spoke with several clients that have been beginning to talk about lightening up and having reluctance to buy ABS CDO's that are rated CCC. Basel III (although not in effect yet) is driving this decision-making. As most know, the big change in Basel III is treatment of CCC's for banks. Specifically, capital charges for banks will be a function of leverage. For example, if a bank is twelve times levered, the bank will have to hold 12 x 100%. Specifically, if the risk-adjusted return on the CCC ABS CDO is 12% and the bank has twelve times leverage, their effective return is negligible. This would make it prohibitively expensive to hold these types of assets. We need to monitor this trend very carefully since many European banks hold Legacy ABS CDO's and many European US banks have been a buyer of this paper.ABS/Multi-Sector CDO Opportunity: Buy 1st-Pay Seasoned Multi-Sector CDO's with Seasoned CMBS that are Cuspy
We mentioned this strategy in our last commentary, and it has performed significantly better than expected. At current levels, we still believe that the trade has more room.
The trade we mentioned in our last commentary involves the idiosyncratic loss surface/return profile of each one of these deals (ABS CDO's). To us, deals can fall into several camps. We have looked at deals that are very digital in nature (i.e. 25% return or 100% loss) and also deals that have a risk-adjusted yield of high single digits to low double digits with 5% to 0% downsides. However, there are deals that have a significant number of assets (ex. Seasoned CMBS) in them that are very option-like combined with other very solid assets. This mixture of assets is extremely hard to duplicate as most of these assets are difficult to find. The risk-adjusted return of this type of portfolio could be base case low double digits with a downside of 5%. The upside to this trade is in its optionality. On an optimistic scenario, potential upside could be over 20%.
We continue to encourage all investors to look for these types of deals. The way we uncover this is by running various scenarios and not just "base & stress" scenarios. This type of scenario analysis will help reveal "The Potential Optionality" of a trade.
0 Comment | Add Comment(s) | Securities, CDOs, NAV, CDO_Secondary_Market, Basel_III, Investors, Potential_Optionalit, |
Monday, April 11 2011 | 03:46 PM
Chief Executive Officer & Co-Founder,
|There are several forces that might govern a bank’s behavior and keep it from taking reckless risks in lending and investing, possibly endangering the safety of its depositors and investors. First, there is the market: investors who don’t like lending policies can sell the bank’s stock and bonds, causing their prices to fall. Second, there is the oversight of the bank’s management. Third, there is the oversight of the bank’s Board of Directors. Fourth, bank regulators act as watchdogs, seeking to protect the interests of the depositors; this oversight is sometimes called “prudential supervision.”
In the wake of the recent worldwide financial crisis, it appears that the controls exerted on many banks by the market, by management, and by the board, were not enough to prevent gross excesses in bank lending, particularly in the real estate markets.
These problems quickly became those of the government and taxpayers, because of national systems of deposit insurance and the perception that some banks and financial institutions were “too big to fail.”
Consider our own country, where the federal government bailed out commercial banks such as Citibank, Wachovia, JP Morgan/Chase and Bank of America, as well as investment banks and other financial institutions, notably AIG. Similar dilemmas have faced the European Union, including Greece, Italy, Spain, Portugal and Ireland (and others, such as Iceland, which are seeking membership).
These shortcomings have led to calls for more stringent prudential supervision. In the United States, one aspect of the new environment is the far-reaching Dodd-Frank legislation. Internationally, the Basel Accords, promulgated by the Bank for International Settlements, are now entering a proposed third stage (Basel III).
The Dodd-Frank legislation is so far-reaching that banks are still scurrying around trying to understand how to comply. One striking aspect, as emerging in regulations under the 2010 Interagency Guidance Appraisal and Evaluation Guidelines, is that affected financial institutions will need to establish more objectively the value of their illiquid collateral, such as whole loans, real estate owned and derivatives, preferably by third party (arm’s length) evaluators ( disclosure: this is one area where my own firm consults). There has been militant talk by Republican Party spokesmen to roll back key provisions of the legislation, so the legal situation will remain in flux. Tea Party representatives particularly deplore the emerging Consumer Protection Agency.
As to Basel III, the proposed revisions are intended to increase the quantity of quality of banks’ required regulatory capital. More specifically, there will be greater clarity about eligible Tier I and Tier II capital, and the lowest quality category, Tier III, will be eliminated from eligibility. There will be required stress tests, which are hypothetical projections assuming adverse conditions such as economic recession and declines in real estate markets.
Of course, there are real questions about the ability of regulators to anticipate problematic lending, any more than stock investors, managers or boards. At the least, though, such regulators experience different economic incentives from the other players and may be more fearful of the inexpensive borrowing power that is available to depository institutions, multiplying the profit or loss from lending and investing activity.
Ron D'Vari CFA, CEO of NewOak Capital, and Andrew Szabo CFA, Managing Director of NewOak Solutions
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