Posts Tagged ‘Tranche’

The Education of a Mortgage Bond Manager, Part II

Saturday, July 21st, 2012

 

by David Merkel, Aleph Blog

In much of my life, I have been thrust into situations for which I was not ready, and ended up rebuilding the wheel, or came up with an unorthodox approach that worked.  But a lot of the problem came down to the question of time horizon.  How long can you buy and hold, even if temporary market conditions make you squeamish?

I remember the first CMBS bond that I bought in 1998: it was the longest AAA tranche of a Nomura deal, which was out of favor at the time.  I did a lot of work analyzing the deal, and concluded that the bond was a lot safer than many competing bonds and offered more yield.  In early 1999, when I described this purchase to the investment committee of a charitable board the I was on, one said, “Only 7%, and you are locked in for 14 years?”  I said that stock valuations were high, and that 7% was a great return.  It was a great return, and far better than the stock market over the same time period, though I could not have known that at the time.

I became an advocate for CMBS in my firm as I realized that the hot product being offered would have the majority of its cash flows come at the 10-year maturity, but there would still be some level of withdrawals.  After some modeling, I realized that the best strategy was investing 80-85% of the money 10 years out, while leaving 15-20% of the money as pseudo-cash: 2 years out or shorter.  Of all of the mortgage bond categories, only CMBS offered assets with a ten-years or more duration, with minimal credit risk.

I used Charter/Conquest as my software.  It enabled me to set a consistent set of macroeconomic principles to evaluate a large number of properties in different economic areas.  The software would project the cash flows  of each property, given the assumptions that you fed it.

I spent time analyzing geography and property types.  I had a decent idea as to what areas of the country were doing badly, and with what property types.

I created what I called the black bucket.  Property types and geographic areas that I did not like were assigned to the black bucket, and if the  black bucket got big enough, we did not play in the deal.  It was a good method, and one CMBS expert at a bulge-bracket bank said to me that it was the most rigorous means of testing CMBS that he had run into.  Most buyers were far more trusting, and tended to buy quality issuers that were taking advantage of their reputation.

By having an independent standard of value where I worked, I did better than competitors.  I did not follow fads; I followed value to the greatest extent that I knew.

Brokers would be puzzled on why I turned down deals from good dealers, or why I bought deals from originators that were subpar.  My lesson was dig into the details, and ignore names.  Analyze the data, avoid the marketing.

Doing your own analysis is a lot of investing.  Ignore the puzzled expressions of your brokers, and buy what you have determined is valuable.  More in part 3.

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Synthetic CDO’s – When Risky Isn’t Risky – Or Free Equity

Wednesday, April 4th, 2012

 

by Peter Tchir, TF Market Advisors

Synthetic CDO ‘First Loss’ tranche safer than ‘Second Loss’ Tranche

In the past few weeks there has been some more noise from regulators and the rumor mill related to synthetic CDO’s.  It hasn’t hit the frenzy surrounding the Abacus deal last year, but the questions are starting to pop up again.  Who was long what?  Who was short what?  Who picked the portfolio?  Etc.

While all that is important, I figured now is a good time to trot out one of my favorite pieces.  In many cases the ‘first loss’ or ‘equity’ or ‘unrated’ tranche was actually safer than the ‘second loss’ or ‘mezz’ or ‘rated’ tranche above it.  Does this make any sense?  On the surface, NO!  An investor would expect the more senior tranche to underperform the ‘equity’ in good scenarios and outperform in bad scenarios.  That makes sense, yet many of the synthetic CDO’s were created in such a way that there was almost no scenario where the second loss tranche outperformed the equity tranche.  Bizarre, but true.

It’s important to understand this phenomenon as it helps explain a lot of the strategies that were employed and also why the defense of ‘I owned the equity’ is not a very strong defense.  I will now try and walk you through how this paradox is possible.

Cash CDO vs Synthetic CDO

The best way to demonstrate ‘safe’ or ‘free’ equity is to show how we got there and why its unique to the synthetic CDO’s.  Free equity does not exist in the cash CDO world (maybe that’s why that market was a fraction of the synthetic one?).

I will walk through 2 hypothetical examples that illustrate the point.  The example is more similar to a corporate CDO than a mortgage backed one, but the principals remain the same, and in reality, the trade first appeared in the credit referenced world and then moved to the mortgage world as that market developed.

For a cash CDO, let’s assume we have 100 bonds each paying T+150, each with a maturity of 5 years.  Let’s assume that the 5 year treasury yields 4.5% (reasonable at the time most of these deals were created).  So we have a portfolio of 100 bonds paying 6% each.

For a comparable synthetic CDO, let’s assume we have 5 year CDS on the same 100 bonds (issuers) and each CDS pays 100 bps.  That’s a reasonable ‘basis’ where the 5 year bond pays T+150 and the CDS to the same maturity is 100 bps.  Its simplified for our purposes, but realistic.

If each position is $10 million, then the $1 billion bond portfolio generates annual income of $60 million.  The $1 billion CDS portfolio generates $10 million of annual income.

Now let’s assume a simple capital structure.  A 3% ‘first loss’ tranche, a 10% ‘mezz’ tranche and a 87% ‘super senior’ tranche.  Again, this is simplified, but not out of line on a 5 year corporate structure to have the mezz as BBB and the Super Senior as AAA.

Let’s assume that the senior tranche of the cash deal gets T+60 or 5.1%.  They get less than the average since there is so much subordination.  Assuming a ‘basis’ of 50 bps, the synthetic deal would pay 10 bps on this tranche.  Lets assume the mezz tranche earns T+300 or 7.5%.  They are receiving a premium to the average because although they have second loss, they do have leverage once losses start hitting that tranche.  That mezz tranche for the synthetic would pay 2.5% keeping the 50 bps basis.

So here is what we have:

So in a no default case, the returns look reasonable for the risk.  The funded returns are higher, but that does reflect the use of cash.

The key element here, the driver of the free equity, is the income versus cost of the senior tranches.  In a cash deal, 86% of the income is used pay the interest due on senior tranches.  For a synthetic deal, only 34% of the income is needed to pay the senior tranches.  This excess income, and how little of an impact any individual default has on the income stream of a synthetic deal, is what creates free equity.

Now let’s take what might be an extreme case, but is great at illustrating the difference between the cash deals and synthetic deals.  Let’s assume 20 defaults occur, all with 0 recovery.  This would generate $200 million of losses.  It should wipe out the equity, the mezz, and eat into the super senior.  Where it gets interesting, is when you look at the residual income.

With $200 million of assets gone, the cash deal would only generate $48 million of income.  This would be enough to pay the full interest due on the senior tranche, but not enough to cover the ‘mezz’ tranche and nothing left for the equity.  That makes sense to me.  It’s on the synthetic side that you get a very interesting dynamic.  The residual income would be $8 million.  Not only is that enough to continue to paying the interest on the senior and mezz tranches, but it leaves $4.6 million for the ‘first loss’ tranche which is 15% per annum on the notional!

It all comes down to the ‘waterfall’ of how the interest is distributed.  On the cash deal, its easy to see that with 20% default, on day 1, with 0 recovery, that the equity would be wiped out, the mezz would be wiped out, and even if there were no waterfall/cashflow restrictions, there would be no distributions to the first loss holder.

On the synthetic side, the story is very different.  The equity would be wiped out, but receive $23 million over the 5 year deal in residual interest flows if there were no more defaults.  The mezz tranche would be wiped out but receive $7.5 million in interest over 5 years.  So the mezz loss would be 92.5/100, or 92.5%.  The first loss piece would lose 6.9/30 or only 23%.  It seems amazing, but the first loss loses less than the second loss in a synthetic cdo with a straight waterfall.

To make matters worse, the mezz tranches were often structured so that they stopped receiving their interest payments on any portion of their tranche that had been used to cover a default.  In the above example, that $2.5 million per annum would have then gone straight to the first loss holder.  The second loss would have received 0 in income and had to pay for the $100 they lost.  The so-called first loss piece would actually receive 7.1 millon per annum (24%) and over the life receive 35.7, so even after paying away $30 in losses, they would have received a positive return, while the tranche above them, the more senior tranche, the IG rated tranche, would have lost 100% and even the super senior would have had a negative return!

Scary but true.  And yes you could argue over the time value of money, and you can argue over capital structure, and you can argue that individual spreads were be different and in all likelihood higher spread names would default first, all of which make the ‘free’ equity less free, but its almost impossible to argue that the equity is as risky as you would think.  The risk/reward that exists does not match what you would expect.

If there are no defaults, it’s clear that the first loss portion will outperform the mezz tranche.  Its now also clear that under extremely adverse conditions, the first loss outperforms the tranche above it, which is truly bizarre.  At least, maybe, there is something in the middle ground, that salvages the mezz tranche?

How about there are 10 defaults on day 1, each with a 70% recovery.  This is fairly unrealistic, but should be an example skewed against the first loss tranche.  The 10 defaults each losing 30% means a total loss on the portfolio of 3% so the first loss would have to pay out that amount.  The mezz tranche would have no losses.  The mezz tranche would receive the $2.5 million a year its entitled to.  Even with 10 defaults, the residual income to the first loss tranche would be 5.63 million.  A total of 28.2 million over 5 years.  So a slight net loss of $1.8 million or an annualized loss of just over 1%, compared to a gain of 2.5% for the mezz tranche.  Yes, in this case the mezz moderately outperformed, but any additional defaults would primarily impact the mezz so the outperformance would disappear quickly.  And this is the most harmful case I can think of where mezz receives all that it is entitled to and the equity receives the bare minimum.

There were deals where the equity was getting large ‘guaranteed’ interest payments, sometimes in excess of 20%, so more than the amount at risk over the life of the trade.  Guaranteed coupons this high were a sign of how unrisky the risky tranche was.

One European dealer created a structure, where, by using a reserve account to build up excess cash flow, they got the rating agencies to rate the ‘first loss’ tranche HIHGER than the tranche above it!  Boggles the mind that the rating agencies did it, but more proof that the concept is real.

How could this happen?

One of Wall Street’s biggest flaws seems to be complacency when something is working.  The CDO structure had worked with bonds and loans and other cash instruments as the underlying.  The flows made sense.  The first loss did very well in good times, but underperformed the more senior tranches in times of high default rates.  There really was no reason to suspect that the dynamics of a synthetic CDO changed all that.  On the surface it seemed the same.  Heck, it even got a similar ratings profile to the cash deals.  The relative value paid to senior investors in synthetics seemed in line with what investors demanded on the cash side.  People had Guassian Copula models attributing the spread to various tranches ‘fairly’.  Though I remain convinced that the quants just liked the word copula because it reminded them of copulation.

Another reason it happened, is because have you ever tried to explain to risk management that the first loss tranche is safer than the second loss tranche?  How the unrated tranche is less risky than the BBB rated tranche?  It’s so counterintuitive it’s not an easy argument.  The first time someone told me it existed, I shook my heading thinking they were missing something.  It just doesn’t seem right, but it is.

This happened primarily for the early deals.  As people became more aware of the issue, bells and whistles were added to protect the senior investors (at their request).  After defaults, cash flows to the first loss would stop, or at least some portion would stop, to build up a reserve or cushion against future defaults.  It helped and seemed fair.  Over time the product evolved and in the later credit deals, the risk/rewards had gone back to being more in line with expectations.

As a market developed for single name CDS on the mortgage side, synthetic CDO’s backed by them were also created.  For better or worse, mainly for worse, most Wall Street firms seemed to have a mortgage department that was in direct competition with their credit department.  In chasing P&L and accolades, the amount of communication between the desks was often minimal.  Investors, who probably understood the concept of ‘free’ equity less than the street, also tended to run their investments in credit cdo’s separately from their mortgage backed cdo investments.  I believe that this allowed many of the early mortgage deals to create the same sort of free or low risk equity that had existed in the early days.  There is nothing wrong with it, it just skews the risk reward and means that you have to be careful when making the claim that the equity holder was taking the real risk.

Have you ever wondered why so many bears were either long the ‘equity’ tranche or seemed willing to be long?

Well, wonder no more.  You now know that depending on structure, the first loss, or equity, was actually very well protected.  Deals could be structured in such a way that by owning the first loss and shorting more senior tranches, the base case was high teens returns, the best case were massive gains as big losses hit the super senior, and the scenarios that caused a loss were minimal (if not non-existent).  These are complex deals.  I have simplified the analysis to make a point, but the math works, and it does help explain why there are few stories about how hard it was to place the equity of synthetic cdo’s and why many of the people most bearish the underlying markets were long them and were short higher up the ‘capital’ structure.

So, if we get another round of discussion about the CDO market, like we did surrounding Abacus, at the very least I hope this makes you question what the parties are saying and spend more time figuring who had what risk, based on the documentation and the math, rather than just the name of the investment.

 

Copyright © TF Market Advisors

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John Taylor’s Open Letter To Greece: “Get Out Greece! Get Out Right Now!”

Thursday, February 2nd, 2012

From John Taylor, Chief Investment Officer Of FX Concepts

Open Letter To Greece

Get out Greece! Get out right now! You should have moved two years ago; you missed that chance, but now it is much better than later. Summer vacations are being planned while we speak, you must move fast to get the biggest advantage out of bolting from the euro. Don’t let the next global recession bare its teeth. Investors still have money and they are interested in buying your assets when the prices are knocked down – each day you wait their value is deteriorating and you are looking more desperate.

Most important: don’t listen to the naysayers in Brussels who are warning you of disaster outside of the ‘protective euro blanket.’ It’s much better outside, even the Turks know this. Do pay attention to Angela Merkel and Wolfgang Schäuble; they are telling you the truth – there is no hope within the euro. Even though the latest German plan to take away your financial freedom has been blocked, the PSI deal is almost as toxic. We read in the press that about 94% of your government debt is written under Greek law, which means you have control over it, but after the deal with the private creditors is signed all of this debt will be written under British law. Your parliament and your judges will be insignificant.

Right now you have control over the currency of your debt, like any real country, but after the PSI you will become no more than a province of the greater Eurozone, unable to modify your debt. Whether it is Brussels, Berlin, Washington or London that is calling the shots, you can be sure that after these negotiations and the next tranche from the Troika is in place, Athens will be powerless. Right now you have the power to lessen the debt burden by jumping the euro ship and valuing the new drachma at something like 50% of the current euro value. By doing this you have marked down the private sector and the public sector debt holders – this is a great advantage without even defaulting on those 94% written under Greek law. Don’t be shy, value the drachma aggressively lower, below where you think it should be, and then peg it. Euros will circulate together with the new drachma for a few days but Gresham’s Law guarantees that won’t last for long. When the euros are gone, drop the peg. The financial system will be a mess and the banks will be totally bankrupt. However, they are acting as if they already are, not making loans or assisting the economy in any way, so you won’t be losing too much, and you’re going to nationalize the banks anyway. It would be wonderful if the ECB helped out by supporting the new drachma for a year or so, but don’t count on it, as the Eurozone is in too much trouble to help. Remember, first one out is the winner and the pressure will shift to those remaining.

The self-serving cacophony from Euro-officials and Eurozone politicians arguing that you will be far worse outside the euro than in it are only promoting their own interests – not yours. For the last decade, Greece has been a great place to sell products, and Greece has been less and less a competitor in the marketplace as it was priced out of Europe. They’ve been making a fortune while Greek manufacturing has collapsed. Most important, Greece has been priced out of the vacation market. Aegean bound visitors now head to Turkey and on the Adriatic side they go to Croatia. With the new drachma dropping prices, TUI, Thomson Travel, and the other package vacation outfits will flock to your beaches setting off a boom. The negative side is that BMWs will be very expensive, as will all other imported items, so there will be some deprivation and inflation. Although there will be aggressive wage demands, you don’t have to give in. You will be free again to choose your course.

The standard of living will drop for everyone, but the offset is that tourism will come to life, manufacturing will be profitable again and the real estate market will be humming. All of a sudden, Greece will be a country where it is possible to make a living. Turkey has been locked out of Europe and has had a great time.

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