Back “in the day” you didn’t really care what default rights investors in senior tranches of your CDO negotiated for. Hell, the whole damn thing is insured. And, on top of that, there is a ton of junior stuff under them to absorb it all. Why not just given them what they want and pump the price up a little bit? Most commonly, senior tranches get the reins on payments out of the trusts if certain covenants are violated.
Usually that sort of thing activates if certain of the underlying instruments are downgraded, if payments are missed, or if total assets fall below a certain level. (Good luck substantiating this last one in a mark-to-market environment).
Lately, downgrades have been hitting many CDO structures and giving the senior note holders control over the entire CDO structure’s revenue. As you might imagine, junior note holders grow quickly irritated. A lot depends on who the senior note holders are.
If its a bank holding the top tier, as you might guess, they will often just liquidate. Other senior investors, however, are more likely to freeze out the junior investors and keep the income for themselves without liquidating. Not a bad setup if you are getting something like 100% coverage on the interest you expected when you bought the damn things. You have no balance sheet issues and the market is so out of whack you are likely to take a loss if you sell. So… why liquidate?
Much different the plight of the junior note holder who now can kiss any income goodbye and has little, if any, recourse if the seniors take over the show.
If you guessed that this particular scene is getting a lot of play right now, you’ve been paying close attention.
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Shame there’s nobody left on CDOs at banks to tell us what’s really going on…
as you describe it here, it sounds like the senior holders are screwing the junior ones by not liquidating. they are screwed either way.. if the bank liquidates, they get nothing back and lock in a -100% return. if the super senior keeps the deal alive, they still don’t get any cash in the interim, but have a shot at getting something if the assets make a miraculous recovery.
The trick is to talk to the trustees – they will know better than anyone what the real story is. . .
Just like the weatherman knows what the weather is gonna be for the next few days?
I’m guessing CDO isn’t career development office.
At least credit the Financial Times when you rip off their story from p. 25 in today’s paper.
Have any of the notes held with plan assets been hit yet? Curious to know what happens when the whole mess becomes an ERISA fiduciary issue.
Plan fiduciary here. Why would it be an erisa issue? Assuming the investment was done in a prudent manner, that is part of a well diversified portfolio, consistent with the plans objectives and time horizon. Individual investments in ERISA plans go bust all the time. You need to look at the total portfolio. Now if that was the only asset class and it was a bunch of crap, then you have an issue.
Erisa plans are limited to AAA bonds, right? If the AAA rating was completely due to mortgage insurance, and the mortgage insurer was wildly overexposed to default liability, is it still an acceptable erisa investment?
False: ERISA plans not limited to AAA bonds. The fiduciary simply needs to make sure the fund is invested prudently. That doesn’t mean 100% AAA bonds. Junk for example is fine, provided its part of a well diversified strategy.
My (clearly limited) understanding was that some of the strips classified as “notes” and held by benefit plan investors were questionable as to their classification and might be recharacterized as equity when the sh-t hit the fan and the plan fiduciaries were looking to make a case against the CDOs. Just wondering if that had happened anywhere.