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Robert Sainato, Managing Director, Structured Credit & Mortgage Group, ADVISORS ASSET MANAGEMENT

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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Malay Bansal, Managing Director, CAPITALFUSION PARTNERS

Three Misconceptions about Issuer-Paid Ratings
Friday, May 27 2011 | 10:34 AM
Malay Bansal

By Malay Bansal & John Joshi

The issuer-paid model for ratings is widely seen as one of the most significant aspects of the process that needs to be reformed. Yet, no good solution to reform this process has emerged. Part of the reason for that are three widely held misconceptions.

Issuers select which NRSROs will rate their deal, and they pay the rating agencies rating their deals. Many blame this dynamic for causing a conflict for the agencies, and enabling ratings-shopping by issuers. This is perhaps seen as the biggest problem in the current ratings system. Dodd-Frank and other rules in the US and Europe are trying to reform the process. Some proposals suggest removing references to rating agencies from rules, while others suggest regulating them more heavily. The former leaves a hole; the latter increases the perception that the ratings have official approval. No good solutions have emerged.

A previous article in this blog and in Structured Credit Investor (The Unrecognised and Unaddressed Ratings Issue, Malay Bansal, 7 July 2010) made the point that the ratings reform is proving to be intractable because the real issue is not being recognized or addressed in any of the reform proposals. The real problem is that the rating agencies are combining two roles into one. The first role is to provide a rating based on statistical analysis of historical performance of the assets (remember that the ‘SR’ in NRSROs stands for Statistical Ratings). The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. The official NRSRO status gives their subjective opinions extraordinary power and can actually have an impact on the outcome, making the ratings more pro-cyclical.

The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as ‘Informational Ratings’, without any legal or official role impacting investor charters, debt covenants, and so on, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The conflict of issuer-paid ratings could be avoided if issuers paid the fee for NRSRO ratings, which will be freely available to everyone, but investors paid the fee for research and informational rating available to subscribers only. Availability of the second will serve as the important function of checks and balances on the NRSRO ratings paid for by the issuers. However, neither issuers, nor the rating agencies seem to find that suggestion appealing. This is partly because of three widely held misconceptions about issuer-paid ratings.

Misconception 1: Issuers Pay for Ratings

Investors, naturally, don’t like the idea of having to pay for ratings, especially since they get it for free in the current system. However, the reality is that they are really the ones paying for it even now. The bankers for the issuer select, engage, and pay the rating agencies, but the payment comes from the money paid by investors for purchasing the bonds. By letting the bankers pick the agencies, investors tilt the balance of power to the issuer. Since they are paying for it anyway, investors should be open to paying for ratings more directly. This will reduce their concerns about the conflict of interest.

Some have criticized the high fees charged by the raters. However, there is another factor investors need to consider in this regard. If they want good quality output from the agencies, they need to be paid sufficiently to be able to attract and retain talented people. Lowering the fee is not the solution. Any scheme which involves investors selecting and paying for research from the agencies that provide better information and analysis will increase competition and provide the right incentives.

Another point in this regard is that only investors who purchase the bonds at initial issuance pay for ratings at present. Cost for investors will be lower if it was spread over all the investors. Subscription fees could be partly based on AUM, making it easier for smaller investors to subscribe.

Misconception 2: Investor-Paid Rating System will be Bad for Rating Agencies

Many, though not all, on the rating agency side, do not like the idea of having to rely on investors for their earnings. It is much better to get all the fees upfront, which sometimes includes the fee for surveillance of the deal throughout its life. However, the preference for upfront payment misses some important considerations.

First, there are a lot more investors than issuers. Even smaller payments from investors could provide the same or more revenue. Also, a smaller charge will cause more investors to sign on for the service.

Second, if the revenue is coming from investors, it is not dependent on the volume of deals, and will not fluctuate dramatically based on volume of issuance. This will provide more stability to those organizations, and allow them to focus on the quality of their work.

Third, more stable revenue would mean a higher multiple for the valuation of their businesses, which will be a positive for their owners and investors.

Fourth, if payment for rating is at the time of issuance, the agencies have to be picked to rate it. This does not align the interests of rating agencies with those of investors, creates a credibility problem, and leaves them open to criticism. By reducing the incentive to be picked to rate the deals at issuance, agencies will be better off, as will be the overall financial system, including the issuers.

Misconception 3: Ratings have to be either Issuer-Paid or Investor-Paid

Almost everyone seems to think that ratings have to be either paid by issuers or investors. However, it does not have to be one or the other. Just a sufficient portion of fee has to come from investors to provide the right incentives. Especially in structured finance transactions, where it is expensive to perform the right amount of due diligence to rate the deal, some amount of upfront payment may be necessary. However, if payment from investors is a significant portion of total revenue of rating agencies, investors and the financial system will benefit from the proper alignment of incentives that would create.

Clearly, splitting the rating agency role into two is a significant change. However, if done thoughtfully, it can be a significant improvement to the current system, and work for the benefit of everyone.

Notes: Views expressed are personal views only, and not of any affiliated organization or group. This article was originally published in Structured Credit Investor.

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