“There are three universal lies: Margins are weak, but we’ll make it up in volume; the check’s in the mail; and I won’t come in your mouth” is really a thing that Partiarch Partners founder and CEO Lynn Tilton says, but "we'll double down and make up all our losses" probably deserves a spot on the list too. That seems to have been MBIA's plan when it entered into some cockamamie CDO transactions with Patriarch in 2003. These ... did not work out for MBIA, and so in 2009 they sued, and today Tilton won the lawsuit, and also may have won some hearts in the courtroom:
Thirteen witnesses presented evidence to Judge Sweet in the lawsuit. He praised Ms. Tilton's testimony in a section of the lawsuit on "witness credibility."
Ms. Tilton is a well-known Wall Street personality, with a penchant for brazen remarks and an eye-catching style uncommon in the financial industry.
"She was vigorous, authoritative, informed and almost entirely supported by documentary evidence," Judge Sweet wrote.
The case is a pretty nutty example of pre-crisis structured finance practices. The story begins with MBIA having written some insurance policies on some distressed-debt CDOs. Those policies were looking bad:
The Identified CDOs were expected to have a shortfall on their insured notes of between $91 and $198 million according to MBIA’s estimates, or even up to $287 million according to Patriarch’s estimates. MBIA began to explore plans to remediate the troubled CDO transactions ... and at the time was not optimistic as to the likelihood of finding a way to achieve the desired remediation. ...
Mark Zucker (“Zucker”), then Global Head of Structured Finance at MBIA, raised concerns about the loss reserves for the Identified CDOs with several members of MBIA senior management, including MBIA CEO Jay Brown and MBIA COO Gary Dunton. ... MBIA’s senior management was sent a memo in April 2003 indicating that the loss reserves were not large enough to cover the expected shortfalls in the Identified CDOs.
So apparently "remediate" means basically "make more valuable without putting any new money in," which is a neat trick, but remember this was all in 2003 so MBIA was still full of the starry-eyed optimism that ultimately served it so well. "Well, these deals are losing us money, what should we do?" "I dunno, why don't we try making money?"
So they did. Having no expertise with that they turned to Lynn Tilton, who was I guess vigorous and authoritative in her pitch:
MBIA turned to Patriarch to remediate the Identified CDOs. In March 2003, Tilton marketed Patriarch to MBIA, describing her company as a “solution provider” possessing the necessary structure and experience to repair and restore the Identified CDOs. Tilton proposed a strategy consisting of multiple components: (i) MBIA would transfer management of the Identified CDOs to affiliates of Patriarch; (ii) Patriarch would create and manage a new CDO that would issue different classes of notes; (iii) MBIA would insure the senior notes in the new CDO; and (iv) Patriarch would contribute the junior notes from the new CDO (i.e., the Class B Notes) to the Identified CDOs as needed to enhance the collateral value of those transactions. ... Patriarch proposed that it would actively manage the collateral pool of the proposed CDO. Tilton informed MBIA that she expected the cash flows generated for the junior notes to “be substantial.”
After discussing various options, in April 2003 the parties agreed to a strategy with three basic components: (1) MBIA would replace the managers of the Identified CDOs with Patriarch affiliates; (2) MBIA would insure the senior notes of a new Patriarch sponsored CDO, Zohar I; and (3) a portion of any value created in the unfunded Zohar I junior notes (the B Notes) would be used, under certain conditions, to remediate the Identified CDOs.
This new CDO was named Zohar I, and "MBIA ultimately decided not to become an investor in Zohar I, and by April 2003, the parties had agreed that the transaction would “not require MBIA to contribute any new capital.” Got it? MBIA was going to insure a senior tranche of a CDO - $450mm worth - and that CDO was going to buy distressed corporate loans, which "were sold on the secondary market at a steep discount to their face value and could ultimately pay interest and principal." It was going to pay $450mm for $750mm face amount of those loans, using the cash flow to pay off the MBIA-insured $450mm senior tranche. Up to 80% of anything left over - $300mm, if the loans paid out at par1 - would go to "remediate" MBIA's old, broken CDOs; the rest would go to Patriarch. Basically Patriarch would get a free equity tranche in the deal.
Ponder for a minute how nuts this is. MBIA was willing to insure the new senior notes at a 100% LTV, based on trading prices: every dollar used to buy new loans would come from new senior investors buying new MBIA guaranteed notes; on day one the CDO's market value would be equal to the face amount of its guaranteed senior debt. But the new loans would appreciate in value so much that not only would MBIA not have to pay out on these new guarantees, it would get some free money to pay off its old guarantees, which had blown up. This must have sounded brilliant in 2003!
Also this happened:
At closing, the Class A Notes received an initial rating of AAA/AA by S&P and Aaa/Aa2 by Moody’s, indicating a low risk of default. The Rating Agencies provided the initial rating on the Class A Notes based on a model portfolio of then unidentified – and unpurchased – collateral that reflected the criteria set forth in the Indenture.
Holy crap! Remember - I cannot emphasize this enough - the capital structure looks like this:2
And those Class A notes were rated AAA/AA. Before the agencies even knew what those distressed loans were. Also at least $50mm of the B notes were supposed to get an investment grade rating. They were already underwater!
Anyway that didn't work out - though actually for reasons that confirm Tilton's basic strategy. The value of the loans really did appreciate rapidly! Just, before she bought them:
After Zohar I closed, the market for distressed debt changed in a way that impaired Patriarch’s ability to carry out the original strategy of buying distressed loans. By February 2004, “the market for opportunity in buying discounted distressed loans had closed,” because “[o]thers had found the opportunity and increased the price levels.” As Murtagh testified, “[t]he market was rallying [in 2004], and that’s not good for a distressed buyer. And that generally is what was happening at that time frame. The price – bond prices were going up, and Patriarch’s platform was at the time to buy distressed debt.”
That Zohar I was not able to buy suitable loan assets as had been contemplated threatened not only Patriarch’s ability to build value for the B Notes, but also its ability to ramp up and obtain a rating confirmation of the A Notes.
So why not completely change the strategy? After all, basically any strategy will work! It's 2004, what could possibly go wrong:
To save the Zohar I deal from failing, Patriarch proposed a revised investment strategy. Rather than buy loans on the secondary market at a steep discount, Zohar I would originate loans and lend money to companies at or close to 100 cents on the dollar and seek in return equity “kickers,” such as warrants or stock. If the borrowers could improve their financial performance, the kickers would increase in value.
Sure, whatever, no problem. MBIA had some misgivings but "did ultimately approve." And "The Rating Agencies confirmed that the First Supplemental Indenture did not adversely affect Zohar I’s assigned ratings." Everyone was nuts.
The capital structure went through some more changes, there were a Zohar II and a Zohar III, and "In January 2005, Zohar II closed and issued $1 billion in funded, senior notes," all guaranteed by MBIA. But they never got an investment grade rating on the B Notes, because the collateral value of Zohar I never got large enough to justify such a rating, and Tilton didn't apply for one because the A Notes were already AAA/AA rated and "a premature rating would have risked a downgrade of the A Notes by calling attention to the fact that the collateral balance remained deficient." MBIA got antsier about getting money for its B notes - which I guess required them to be rated - so that it could pay off its earlier, busted, CDOs. Friendships were sundered, fees were disputed, the financial crisis rolled around, and ultimately MBIA sued claiming that Tilton did them wrong by never getting the B Notes rated. Today they lost.
As well they should have. Tilton actually comes off really well in this opinion: her investments performed well, her decisions seem to have been good ones, and she stood up to MBIA when they did things like asking her to pay off their junior notes with senior noteholders' money. But MBIA looks ridiculous. They had losses on their initial CDOs, they'd under-reserved for those losses, they decided to cover them up by gambling on the junior securities of a new distressed-loan CDO, they changed strategies repeatedly to chase their losses, and they pushed for uneconomic decisions in what seems to have been a successful investment because they needed their cash sooner rather than later. That strategy worked out poorly for them here. Also, everywhere.
1.The leftovers would go to the Class B notes, which had a (meaningless-ish) face amount of $150mm. "Patriarch projected that the new CDO would generate sufficient revenue to cover 1.65 times the amount of the $150 million of issued par value Class B Notes ... Tilton expressed her belief that she would create value to the Class B Notes sufficient to cover any losses to the Identified CDOs."
2.To be clear:
At closing, Zohar I issued the B Notes in a face amount of $150 million to an affiliate of Patriarch called Octaluna. The B Notes paid no interest, did not mature until November 2018, and were issued for no cash.