Tranche Warfare, CDOs in Default

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1 2008 ANNUAL MEETING AND EDUCATION CONFERENCE American College of Investment Counsel New York, NY Tranche Warfare, CDOs in Default 9:30 a.m. - 10:30 a.m. October 24, 2008 MODERATOR: Cynthia J. Williams Dechert LLP PANELISTS: Richard F. Buckley, Jr. Massachusetts Mutual Life Insurance Company Amelia M. Charamba Nixon Peabody LLP Eric Saari TIAA-CREF

2 I. Introduction of Panelists 2008 ACIC Annual Meeting October 24 9:30 10:30 a.m. Tranche Warfare, CDOs in Default Presentation Outline II. III. Overview of recent history of the CDO/CLO market by size, sector and recent issuance Overview on the CDO market and the credit crunch A. Reliance on subprime RMBS and synthetic ABS/RMBS in many CDOs B. How subprime RMBS underperformed rating agency worst case scenarios 1. Incentives of major market participants: a. Mortgage bankers: front end compensation incentivized the origination of high yield RMBS and no skin in the game after origination. b. Warehouse loans provided by investment banks and commercial banks who earned fees and interest on the warehouse loans and, to the extent they took the risk of loss, also earned the excess spread above related warehouse loan interest/any gain on portfolio during the warehouse period. Sponsors, servicers, Collateral Managers and hedge funds sometimes took all or a portion of the risk of loss and related excess spread/gain. c. Investment banks earned investment banking fees at term securitization of the mortgage loans into RMBS and also upon repackaging of RMBS and ABS into CDOs. The investment banks and their affiliates could retain that portion of the transaction they wanted to retain (frequently retaining the super senior AAA rated tranche with its low regulatory capital requirements) and, as administrator to affiliated commercial paper conduits and SIVs, could invest in any commercial paper issued at the senior level of the transaction. d. For balance sheet transactions, loan originators achieved inexpensive long term financing for their portfolios while retaining management control. e. Rating agencies reviewed RMBS, synthetic and CDO structures, requiring revisions if needed to meet rating requirements, and earned up front fees and frequently ongoing fees for rating the rated securities issued in the transaction, as well as initial and ongoing fees for providing ratings or credit estimate for individual assets in certain of the transactions (such as loans in CLOs). f. Servicers/Collateral Managers earned senior, subordinate and sometimes incentive management fees and increased assets under management BUSINESS DRAFT

3 g. Trustees and their affiliates earned trustee fees, collateral administrator fees and back-up servicing fees. origination. 2. Relaxation (failure) of both underwriting and diligence standards at a. No documentation loans; no downpayment required; reach for yield/origination fees. b. Appraisals, some of them fraudulent, in an era which believed property values could only go up and employment/economy strong. appraisers. c. Residential speculation/fraud and abuse by mortgagors and 3. Relaxation (failure) of underwriting and diligence standards at securitization, particularly in transactions involving second lien loans and lower grade structured finance CDOs. a. Reliance by sponsors, investment banks, rating agencies and investors on models dependent on historical inputs during a real estate market spiraling upward in a good economy for residential mortgage loans whose underwriting and diligence standards were ever looser. b. Very limited diligence on underlying residential mortgage loans beyond review of tape data; no real auditing of the portfolio by going back to the mortgage borrower and confirming information provided. heavily on ratings. c. Limited or no investor diligence with some investors relying too 4. By mid 2007, actual delinquency and payment default experience on subprime mortgage loans in recently issued RMBS transactions was in excess of rating agency assumptions used to establish RMBS ratings in stress test models and residential real estate values were falling so that rating assumptions regarding historical realization on foreclosure also would not be met. Result: continuing downgrades of RMBS securities. 5. The downgrade of monoline insurers providing financial guarantees to the most senior tranches of RMBS securities which were underwritten by the rating agencies one notch below the monoline insurer s credit rating also resulted in downgrades. C. Many CDOs and SIVs were negatively impacted including: holdings. 1. Cash flow and market value CDOs/SIVs with substantial subprime RMBS 2

4 2. CDOs of CDOs and SIVs whose structures were modeled based on the ratings of their underlying assets (frequently AAA rated ABS and RMBS securities) so that as ratings were downgraded ( rating migration ), the assets were haircut for purposes of overcollateralization and interest coverage tests and, even before any payment default on the underlying assets, triggered (i) termination of reinvestment periods, (ii) redirection of waterfall cash flow to pay down the most senior securities first thus delevering the deal and reducing returns to the equity and/or (iii) events of default. IV. How CDOs are different than other bond private placements. A. Securities issued are dependent for payment primarily on the cash flow from the underlying assets. B. The securities are almost always sold in 144A transactions with a lengthy offering memorandum. 1. The offering memorandum describes the collateral in general, including eligibility criteria for permitted collateral and related risk factors, but typically does not include a description of the actual underlying securities in the CDO at closing since CDOs are trading vehicles (not static pool investment vehicles like U.S. CMBS/RMBS transactions) with 3 to 6 year reinvestment periods before amortization is required to commence, absent triggers built into the deal to start early amortization such as the overcollateralization and interest coverage tests. 2. The offering memorandum moves in tandem with the Indenture (i.e. as parties and rating agencies comment on the Indenture, corresponding changes are expected to be reflected in the final offering memorandum) and although the two documents should be consistent, they occasionally vary. In addition the offering memorandum includes other information not contained in the transaction documents including risk factors, conflicts of interest, descriptions of the issuer, the Collateral Manager and any monoline credit enhancer, a discussion of the tax treatment of the securities offered and the method of distribution of the securities. C. Most important structural features of a CDO: 1. Diversification of eligible assets; buckets. 2. Overcollateralization Test: the ratio of the aggregate value of the collateral (net of haircut amounts) compared to the outstanding principal balance of the rated classes of Notes. 3. Interest Coverage Test: the ratio of the aggregate amount of interest proceeds (including interest from the underlying assets and certain payments made by hedge counterparties to the issuer) and any interest reserves compared to interest due on the rated classes of Notes and certain administrative expenses and fees paid to service providers senior to the payment of such interest. 3

5 4. Haircuts which reduce the aggregate value of the collateral for purposes of the overcollateralization test and which may reduce interest for purposes of the interest coverage test: a. Definition of Defaulted Asset: Default is frequently defined to include (i) payment default, (ii) insolvency of the underlying obligor or (iii) any other event which, with notice or passage of time or both, could constitute an event of default under the underlying instrument whether or not called and whether or not the underlying instrument is accelerated and results in a haircut in value to the lower of fair market value or the lowest rating agency recovery rate for that type of asset or a 100% haircut if the asset has not been disposed of within a certain period of time. b. Market Value Haircuts: If an asset is acquired at less than a certain percentage of par (usually a high percentage determined by the rating agencies), the asset is valued at its fair market value, not par, even if performing and expected to pay par in full. c. Ratings Migration Haircuts: For certain transactions, increasing haircuts as the underlying asset is further downgraded. 5. If tests not met: compliance a. Senior most class of Notes is paid first until tests are back in b. If the overcollateralization test gets too far out of whack (typically less than 100%), an Event of Default occurs. 6. Waterfall: Underlying asset collections, proceeds and reserve amounts (if applicable) flow through a waterfall which varies depending on: a. whether the transaction is behaving normally with no problems: interest is typically paid on all classes of Notes and excess spread may be paid to the equity; principal collections may be used to invest and reinvest in additional eligible assets or held for such purpose or, under certain circumstances, may be paid either sequentially or pro rata for some period of time across multiple classes of Notes depending on the structure of the deal, b. whether the reinvestment period is over: during the reinvestment period, principal collections and principal proceeds may be used to invest and reinvest in additional eligible assets whereas after the reinvestment period principal collections and principal proceeds must be used to repay principal on the Notes either sequentially or pro rata for some period of time across multiple classes of Notes depending on the structure of the deal, c. whether an overcollateralization test trigger or interest coverage test trigger has been tripped in which case interest collections and proceeds and principal collections and proceeds or both are diverted to pay down the senior most class of Notes until the 4

6 tests are once again met, or if the overcollateralization ratio is less than 100%, an Event of Default occurs, and d. whether an Event of Default exists in which case all cash flow, after payment of certain capped administrative expenses and service provider fees and payment of interest on the most senior rated class or classes of Notes (for example, on all AAA rated Notes), is used to pay down principal on each class of Notes sequentially. 7. Events of Default. a. The less senior classes of Notes are structured so that if interest is not paid, it is deferred and paid when cash is available. Failure to pay this interest does not constitute an Event of Default. Principal is not due and owing on any class of Notes until its maturity date which is typically several years after the longest maturity asset in the underlying portfolio (which is significantly longer than anyone expects such classes of Notes to actually be outstanding). b. Failure to meet the eligibility criteria when selecting assets and the asset acquisition and sale covenants may not result in an Event of Default under the Indenture; instead such failure may constitute an Event of Default under the Collateral Management Agreement permitting the removal and replacement of the Collateral Manager. c. Except for certain balance sheet deals in which the originator of the assets sells them to the CDO issuer with representations and warranties regarding the assets which, if breached, requires the repurchase or substitution of the asset, CDOs typically do not include asset level representations except for ownership of the assets free and clear of all encumbrances other than the security interest created by the Indenture. d. Failure to meet certain financial tests (other than having an overcollateralization ratio of less than 100%) does not result in an Event of Default; rather these tests function as triggers diverting cash flow in the waterfall to pay down typically the most senior class of Notes until the tests are once again met. e. Thus the Events of Default under the Indenture typically include: (1) Failure to pay interest on those senior rated classes of Notes which do not have interest deferral features; (2) Breaches of transaction level representations, warranties and covenants (other than those mentioned above which are typically carved out) after notice and cure period; (3) An overcollateralization ratio of less than 100%; and 5

7 (4) Actions taken in connection with an insolvency or bankruptcy of the issuer, which is a bankruptcy remote entity and with respect to which all involved in the transaction agree not to initiate bankruptcy proceedings. 8. Remedies upon an Event of Default. a. The Controlling Class determines whether or not to accelerate. The Controlling Class is either the senior most class of Noteholders or, if a monoline has wrapped the senior most class of Notes, the monoline insurer so long as it has not defaulted on its financial guarantee and is not itself insolvent. b. The reinvestment period terminates automatically. c. Even after acceleration, the Trustee must continue to hold the collateral, the Collateral Manager must manage it and cash continues to be paid out under the applicable waterfall provisions unless the Trustee determines that the collateral may be sold at a price sufficient to pay all Noteholders in full under the applicable waterfall or the Trustee is directed by a certain percentage of one or more classes of Noteholders to sell the collateral (typically all classes of rated Notes participate in this decision, not just the Controlling Class). V. Real Life Problems with CDOs during the Credit Crunch. A. Noteholders 1. Notes are held by the DTC (or by the DTC for Euroclear or Clearstream) so it may be impossible for the Issuer, Collateral Manager or Trustee to know who the beneficial owners of the Notes are. Usually the investment bank that structured and sold the original deal and makes the secondary market in the transaction keeps track of who buys but many of these investment banks have fired the people who worked on these deals and lost this institutional knowledge. It is very difficult to restructure or amend transactions or create consensus on when to liquidate after an Event of Default and acceleration when you cannot work directly with the beneficial owners but must work through the DTC. 2. The beneficial owners of any particular class of Notes may not have the same economic interests since many of these Notes have been sold in the secondary market to buyers of distressed securities at deeply reduced prices who may want a liquidation at less than par since that will result in a gain for them. 3. If the beneficial owner of a Note has entered into a credit default swap in which it has bought credit protection from a credit worthy counterparty with respect to the Note, such beneficial owner may not pay attention to requests relating to the Note and the credit default swap counterparty does not receive this information nor have any right to act with respect to it if it does receive it. B. Difficulties in valuing assets. 6

8 1. Difficulties for the Collateral Manager valuing assets for purposes of the transaction document covenants when market prices or bids (firm or otherwise) are unavailable or unreliable. 2. Difficulties for the Trustee in determining the market value of assets after an Event of Default and acceleration, especially in the current market environment. Determining the market value of assets is outside the scope of the traditional role of the trustee and trustees do not have this expertise. Many rely on the Collateral Manager (when the Controlling Class permits them to) or must hire liquidation agents. Current market conditions further exacerbate this situation as market prices and bids (firm or otherwise) are frequently unavailable and may be unreliable. Even when bids are obtained, Trustees do not have the expertise to determine whether the bid price is either reasonable or market. C. Conflicts of Interest: 1. CDO Sponsor. 2. Collateral Manager. 3. Investment Bank. 4. Monoline Credit Enhancer. 5. Major Investors. D. Selective disclosure of material non-public information by Collateral Manager and/or Trustee. E. Trustee concerns 1. How to determine what is a commercially reasonable sale of assets for UCC purposes in today s market. 2. Indemnification of the Trustee by the Noteholders. F. Waterfall v. Subordination Provision Documentation Inconsistencies. 1. A number of CDOs include a specific waterfall which applies after an Event of Default to all collections and proceeds and requires that interest be paid on all AAA rated classes of Notes prior to the payment of principal on the most senior AAA rated class of Notes whereas the boilerplate subordination language at the end of the Indenture states that the senior most class of AAA rated notes is to be paid in full before any payment is made on any other class of Notes (which may include other AAA rated classes of Notes whose principal payments are subordinated under the waterfall but not their interest payments). 7

9 2. Trustees have instituted interpleader actions so that a court will determine ambiguous or conflicting provisions in transaction documents, including intercreditor disputes and issues relating to which provisions control payment; commonly at issue is the relationship between the priority of payments provisions and the subordination provisions in the indenture. VI. Lessons Learned A. Reliance on rating agencies v. independent due diligence. 1. Do rating agencies still play a valuable role? 2. Will changes and proposed changes in the rating process introduced by the rating agencies and/or SEC have a meaningful effect on the value of the ratings? B. Assumptions and stress tests used in models. 1. Do you use internal models? 2. How have they changed in light of the credit crunch? C. Diligence 1. How do you diligence transactions and has that changed in light of the credit crunch? 2. What diligence should be required by whom? To whom should such diligence be available? Is the market willing to pay for the additional diligence? D. Valuation 1. How has mark to market accounting effected valuations? 2. How do you value assets for which there is no public market? E. What changes should be made in documenting/structuring transactions? 1. Make sure complicated documents are internally consistent and consistent with the offering memo. Investment Bank) a. Role of outside counsel (Issuer, Trustee, Collateral Manager, b. Business people and lawyers involved in the deal should actually read all of the documents at least once when close to being final. 8

10 2. Rating agencies should revise restrictions which are so tight that they create unintended consequences and those negotiating the documents with the rating agencies should insist on this including: a. Defaulted Assets should include payment defaults, insolvency and other defaults provided acceleration has occurred with respect to such other defaults; b. Documents should permit sales of assets at less than par without requiring that amounts be reinvested equal to the par amount of the asset sold; c. Documents should contain separate waterfalls for application of proceeds post default or post acceleration to avoid ambiguities resulting from the interplay between the waterfall provisions and the subordination provisions. The subordinations provisions should clearly reflect that the post default/post acceleration waterfall controls the priority of these payments. 3. The Indenture should include the concept not only of the registered owner of the securities (frequently the DTC for the Notes) but also of the beneficial owners thereof which should be identified to the Trustee at closing and upon each transfer as part of the transfer restrictions with the Issuer and the Collateral Manager being permitted to obtain a list of beneficial owners and the beneficial owners being permitted to vote their economic interest in the deal for consents, amendments, etc. F. What improvements should be made in the investment process? Is it realistic to expect them to be made? review. 1. Very complex documents with investors given a very limited time to 2. What can deal sponsors, the investment banks placing the securities and the rating agencies do to assist investors while at the same time permitting investors to do their own independent due diligence and review? 3. How to deal with the exigencies of narrow spread windows for issuing the securities which create very tight time frames for investor diligence and review. 9

CDOs October 19, 2006

CDOs October 19, 2006 2006 Annual Meeting & Education Conference New York, NY CDOs Ozgur K. Bayazitoglu AIG Global Investment Group Keith M. Ashton TIAA-CREF Michael Lamont Deutsche Bank Securities Inc. Vicki E. Marmorstein