Credit Markets and Rating Agency 'Refinement'

This is a follow on from my analysis in May into the credit markets and rating agencies, when Fitch assured that it would continue to monitor GGP assets in the context of bankruptcy proceedings (although the implication was for further downgrades).

Rating Agency Antics Fuel Uncertainty
This process continued last month when Standard & Poor's began to tighten their criteria for rating CMBS, with figures quoted as high as $235bn worth of commercial bonds under threat of losing their AAA status.  Now in the WSJ today, Standard & Poor announced that it has just reversed "its evaluation of a clutch of mortgage bonds backed by commercial property." It has re-rated a number which are part of the GG-10 benchmark securitization back to the crucial AAA status required for TALF legacy eligibility - and all just a week after downgrading them.

GG-10 is a large $8bn commercial mortgage backed security bond, that has large numbers of loans resecuritized each year across the market by dealers - so ratings on this baby serve as a bellwether for the health (or problems) of the wider commercial credit market. Looking into S&P's published methodology refinement in more detail, the Fed's desire to support commercial real estate is certainly a possible factor in this turnaround.

If so then that should come as no surprise - the impartiality of rating agencies has always been questionable. Note: for more on this, I highly recommend reviewing this great commentary by Linda Lowell of Housing Wire, on the ratings agencies and their impact on CMBS markets (particularly how S&P could not provide any meaningful backing to JP Morgan analysts regarding their previous change that lead to the downgrades). 

Suffice to say that the late June rally in CMBS resecuritizations was impacted by the ratings downgrade rumours and counter-rumours, as dealers were unable to price with certainty, unsure that triple-A paper classes at the time still would be so for much longer.

What Are S&P Changing?
So behind all this, quoting from the S&P methodology changes announced, the following key aspects are being amended:

• Amending how losses and recoveries resulting from 'AAA' rating scenarios for super-senior classes in US conduit/fusion CMBS are assessed.
• Differentiating the timing of losses from 'AAA' term and maturity default tests when cash flow modelling transactions.
• Spreading out losses that are applied to a transaction's certificates over a longer period of time.
  
  

The latter is the most meaningful change, since it allows for exceptional short-term losses to be effectively averaged, and hence to smooth out rating changes and thus reduce the occurrence of short term rating changes that are subsequently reversed.

S&P Methodology Outlined
For those interested, from Standard & Poor's own paper is the refined 3-step approach that they will be using for rating conduit and fusion transactions:

1. Aggregate recoveries from defaults in the 'AAA' scenario and credit impaired assets up to the crossover date. [NB Crossover date is the time where allocation of principal and losses to the super seniors change to pro rata from sequential]
2. For cash flow modelling, assume loans will not default for 3yrs and apply a 24mth recovery period before losses up to 30% would be applied (at the end of the fifth year). Any additional losses applied the following month, expect losses due to maturity.
3. Use Trepp's cash flow model to apply recoveries through the capital structure of the transaction to determine which certificates had an ending balance of $0, and would therefore retain their 'AAA' ratings.

Credit Market Evolution
This report on Sribd from Deutsche entitled 'The Future Refinancing Crisis in CRE' is another one worth reviewing, to understand the refinancing challenges within CRE right now. 

On a side note, the markets have been changing the structuring of resecuritisation in the last few years, in order to juice up tranches and create more AAA-rated bonds as assets became distressed.  How?  By moving away from the much maligned CDO to re-REMIC's (REsecuritization of Real Estate Mortgage Investment Conduits).

To see how these can be misused, take a look at this crap published by Fannie Mae back in December 2007 - see page 2 for the re-REMIC's section in which they state:

"Market participants know that almost any type of MBS can be used as collateral for Fannie Mae REMICs."

I think we're starting to see part of the problem Fannie, when you openly state almost any MBS will do. How to mortgage the future of the next generation in America through incompetence in one easy step. Let's take a look back at how the process used to work for the banks in the good old days...

"So, if I offer you this enormous stash of our sub-prime mortgage backed securities, you'll give me REMIC's in exchange?", asks the disbelieving banker.

"Sure, we luuurve you guys - you're one of our biggest clients, and we just keep on buying these.. cos.. hell, I don't know but we do. Anyway, the government wants us to buy 'em." replies the Fannie Mae redneck employee.

"I love this job.. ok fine in that case here's $50bn of our worst shit we couldn't sell to Bernie Madoff, and in exchange we'll have those nice AAA-rated Fannie re-REMIC's and sell them onto clients. As a sweetener, we'll even throw in vouchers for you and your family to have a 3 course meal at Cracker Barrel." 

"HELL YES!" replies the Fannie Mae redneck. "If there's Cracker Barrel in the deal, then you've got yourself one."

However back to reality, and re-REMIC tranches are attained in a different way to the particularly special blend of bullshit that the banks came up with previously to produce AAA-grade paper from sub-prime toxicity. Rating levels now are attained with a heavy emphasis on collateralisation - hence why rating changes like today increase uncertainty and problems.

For example, triple-A paper in recent offerings has had the most extraordinary 50% subordination levels; in English that means these would still be AAA rated if half the underlying properties burned down and none of them were insured (which they are). At least in theory, these CMBS are almost unnecessarily safe, thus should not ever be downgraded.

A trader is quoted in a Commercial Mortgage journal as stating that: "The life insurance companies are driving this. For regulatory capital reasons, they benefit from holding bonds that have more ratings stability."

Credit Future
This activity had lead to tighter spreads in the resecuritization market for super-senior bonds, leading to increases in their prices on the market and a general upturn in activity at last. However the junior tranche CMBS going out onto the market still have a significantly higher 30% subordination rate, which is a lot better than the triple-A class deals of old.

To me that is a sign that the quality of the bonds is improving to instill genuine confidence in the AAA-rating once again, and rightly so. Going back to the rating agencies, these sorts of problems then derail such progress by increasing the spreads.

GGP
Despite this, looking back at GGP, this is all part of wider series of moves by the government towards improving the credit markets and is to be welcomed by shareholders as a further means of assisting the firm in restructuring.

Indications continue to be reported that the government is open to reassessing TALF terms and conditions, but these mostly are around an extension to the scheme time frame, not a meaningful change to the criteria. Talking of GGP, there has been little going on besides some arguing between GGP and Hugo Boss relating to the latter wishing to terminate a signed lease early due to delays. Boss are likely to have that dismissed and are just trying their luck with a filing like this.

Otherwise the rulings today are largely unimportant, or have already been made (e.g. around the Success Fee). Somebody needs to slip a bottle of whisky to the good judge and tell him to hurry up and make his decision on the SPE inclusion issue…

The Art Of (Self) Assessment

It's that time of the year once more, when bankers are expected to select a number of colleagues who we have tenuously worked with over the past year, and ask them to provide constructive, impartial feedback on our performance.

In the name of self-assessment, we seek to better ourselves as individuals.. to make the world a better place. And more importantly determine the size of our bonuses.

The whole process is about as impartial and representative as reading the average pile of resumes that are ending up on my desk for a role we've got open - i.e. nothing more than a partisan sales pitch. Assessments are more an art than science.

The key for any graduate wondering how to climb the greasy pole, is to always select your assessor targets early in the year. I started buttering up a select few around March - inviting them out for drinks on me for example. It's amazing how much goodwill a bottle of champagne buys. A couple of tickets to a football game is a virtual guarantee of performance inflation.

Most important of all, is to combine all of this with being unjustifiably nice to them throughout the year, even when they deserve a verbal slap for incompetence.

Such self control means the end result is always fun to behold; by next month, as the glowing reviews flow in for me, others who don't prepare in advance repeat the same cycle of suddenly realising too late that they've spent most of the year pissing off people that now matter to them in a way that really matters - financially.

"Emerging Investor is a wonderful chap, a credit to the bank - and clearly one of a deserving elite that requires a fat cheque to retain his services."

Having had a browse of the Yahoo board for the first time yesterday, the above would be a lot more constructive feedback than the first comment I noticed about one of my early GGP legal analysis posts. Not anything about what I actually said - no, just some waffle about not liking the white text on a black background - clearly the author is senior management material.At this stage of the year, senior managers also frequently apply another subtle tactic, as they realise the value in being seen to 'deliver something' impressive by November. Typically from now the industry sees a flurry of small projects kicking off, combined with a hiring spree as consultants are pulled on board with no regard for cost or efficiency - all in order to further aforementioned manager's potential bonus.

Only minor rumblings on the GGP front: the judge has ordered the firm to pay Deutsche Bank the full amount of the non-default contract rate for two malls. The headlines cite the additional $2.89m GGP must pay, but at LIBOR +6% this is an entirely fair ruling.

The only other news is that GGP have applied to extend the time frame allowed within Chapter 11 to finalise and submit a restructuring plan. This will be heard on July 22nd, along with hearings to approve the success and DIP financing fees. This request to extend has been triggered due to several factors. Firstly the underlying complexity of GGP's credit structuring, and sheer number of individual creditors, means that completing this task by mid-August was always ambitious at best.

Otherwise though, the cynic in me cannot help but observe that Chapter 11 protection is an advantageous position for GGP to be in right now. While it remains here, partially shielded from the slowly passing economic downturn, its pressing need to refinance is removed, and it can happily sweep its excess cash flows from all its entities centrally, and use these to fund operations and loan repayments - all while continuing negotiations.

It is now the creditors on the back foot and more interested in seeing GGP restructure and refinance so that they can at least re-access the principle from their CMBS's, which is a good example of Chapter 11 positively incentivising.

Oh, and do take a moment to read this classic story doing the rounds right now. The Goldmangate scandal relates to a dodgy Russian programmer (referred to as a 'strat' internally at GS), who decided to further the national stereotype with some good old corporate espionage. Old Twinkle Toes Aleynikov, hatched a plan to download all of the algorithmic code for Goldman's infamous 'black box', which is actually a swarm of machines that make automated trades in response to news and events, and which brings in millions of dollars of pure profit each year.

Every major bank has a black box, but Goldmans is the most famous as they were an early and prominent pioneer of algo trading. Unfortunately Aleynikov seems to have not been especially bright, and either assumed the security around this was not high (picture a financial Fort Knox in reality), or that his idea of zipping, encrypting and sending out in smaller chunks to an external server was subtle.

Of course, that triggered the internal alarms and the rest is history with the FBI.

"..if you think about it, instead of getting their panties in a bunch over a coupla jacked megabytes of data, the Masters o' the U should be looking at this whole thing as a source of pride. Everybody wants a piece of their shit." Bess Levin, Dealbreaker

You can always trust Dealbreaker to say it like it should be said.

Exploiting Loopholes

The golden rule with tennis, as with finance, is to always put your money on the Swiss. Tough luck on poor old Andy Roddick though, the guy was rightly gutted and is too good to only win a single major in his career so let's hope he comes back and wins another.

So the final legal submissions have now been made - this includes General Growth's post-hearing submissions against MetLife and against ING Clarion and Wells Fargo. The Committee of Unsecured Creditors, and the unsecured lenders ING Clarion, Helios AMC, and of course MetLife. They are really just summarising the arguments already put forwards, although additionally MetLife submitted a motion to dismiss evidence submitted by GGP because the "Movants [MetLife] were not provided with a copy to review."

The evidence itself is a summary of the MetLife Debtor groups that own the two malls in question in this appeal. Ultimately they were included to provide evidence of the consolidation benefit to GGP that would come about from their inclusion in Chapter 11. Again, whether this is accepted or rejected is arbitrary and will have little bearing on the overall decision.

Additionally I recommend reviewing two interesting analysis papers discussing the impact of the GGP bankruptcy on the CMBS industry. The first is entitled The GGP Bankruptcy So Far: Grounds for Concern, Sources for Hope, (thanks to GGP Freak for bringing that to my attention - you mentioned it is from a post on one of the boards so perhaps you could post the link). Either way, the article provides an interesting additional summary from legal experts.

It agrees that the notion of 'bad faith' is unlikely to stand up to analysis and sway the impending decision, although here the authors focus on the eleventh hour dismissal of independent directors as the other key factor instead of GGP's ability to prove its decentralised structure and hence requirement to include SPE's in Chapter 11 not directly in default. As I have said previously, many of the arguments being made in this case are being made for the cameras, and this view is clearly shared:

"in the GGP bankruptcy, it seems that the independent director issue may not be fully pursued because of the practicalities of the situation. In the view of some, even if the motions to dismiss are not granted, it is important that these arguments are made, if only to force a decision that will at least provide a benchmark against which lenders can attempt to structure and price transactions going forward."

Also interesting is this observation on the impact of the agreed DIP financing loan from Farallon Capital Management, part of which will be used to pay off the Goldman Sachs loan: "Using the $400 million DIP loan to retire the Goldman Sachs facility effectively increases the leverage on these assets by almost 100 percent."

The second article 'CMBS Bankruptcy Remote Structuring and the Recession: Revisiting the Benefits', was published last week by the Bureau of National Affairs. It provides a much more detailed analysis of CMBS structuring, and crucially an analysis on how the GGP rulings to date are impacting the industry. One telling remark is that the SPE bankruptcy remote structure has been "largely untested" to date, and only once these are resolved will the credit markets be able to move forwards with confidence and accurately rate and price risk into credit investments.

Where this article is useful is in summarising key ways in which SPE's "theoretically mitigates" risks:

1. Independent Directors to vote/approve the commencement of bankruptcy proceedings - the controversial one that we know about from its alleged 'misuse' during GGP's filing, which illustrated contractual holes.
2. Limits Debt that an entity can incur - both secured and unsecured, the court rulings have upheld this concept and ensured that GGP will not be able to load them up with additional debt as a result of their inclusion in Chapter 11.
3. Ensure that SPE assets/liabilities are not consolidated with those of a parent or affiliate that is involved in a bankruptcy - in reality this has not taken place in GGP's case from their inclusion in Chapter 11 either, although there would be a significant benefit from consolidation of net cash flows and of course negotiations.

As if anybody needed confirmation that the markets were being presumptuous about CMBS's, the article comments: "CMBS sponsors and lenders, supported by many of the credit rating agencies, relied heavily on the assumption that the remote bankruptcy provisions, specifically the independent director provisions, in the SPE’s governing documents would provide protection against an SPE borrower filing for voluntary bankruptcy."

Where the article becomes much more interesting is an examination of the circumstances in which GGP has been able to utilise cash flows as a collateral. Normally it would not be allowed, unless the lender consents, or the debtor convinces the court that "the lender’s interest in the cash collateral is ‘adequately protected.' "

This notion of 'adequate protection' means proving to the court that "the collateral is not being dissipated to the ultimate detriment of the lender. Typically this condition is satisfied if the property continues to generate cash flow and the lender is given a lien on post-petition income to replace the cash collateral that is expended." Despite the turbulence in commercial real estate valuations, it is fair to assume that the value of the assets exceeds debt in all cases before the court at present.

As such this is precisely what the Courts have awarded all of GGP's lenders who have appealed for their respective malls to be removed from Chapter 11. Despite a lien on cash collateral not being as appealing to lenders than instant access to the cash flows from the malls, income is safeguarded by the decisions made by Judge Gropper, by ensuring they are serviced and repaid in the event of liquidation.

The article concludes a summary of ways in which the GGP rulings to date are impacting the industry and a realistic assessment of the next steps relating to restructuring. Ultimately the ability of GGP to control the independent directors of its SPE's is seen as a key weakness in the current structure of SPE's. The legal authors point out that despite this it is very much legal, :

"Despite the fact that the removal and replacement of the independent directors may have violated the spirit of the original agreement with the lenders, GGP’s actions were permitted under state law and do not appear to have been prohibited by the organizational documents of the SPE borrowers."

In fact, the article even advises lenders able to who have the opportunity to "revisit the governance terms of borrower SPEs, would be well advised to consider modifying the 'remove and replace' provisions relating to the independent directors."

In many ways this suggests that GGP's bankruptcy is unique in another sense, due to timing and its ability to exploit weaknesses in the contracts that will be closed in the future. That being the case, any investors contemplating on taking positions in other REIT's in a similar position to GGP should exercise caution. It would be unwise to simplistically assume that other companies will necessarily be able to exploit this loophole for long, and so need to investigate the underlying SPE structures and contracts.

And finally:

"As the GGP bankruptcy progresses, given the uncertainties in the valuation of commercial real estate in the current markets, it will be interesting to see whether GGP attempts to reduce required interest payments based on the current market value of its properties and, if it does, how the bankruptcy court will determine the valuations of these properties and how reduced values will affect the commingled use of cash collateral."

Bear in mind how early into the bankruptcy process this all is - decisions made now can be amended throughout GGP's period in Chapter 11 on appeal. Meantime all of the information is before the court, suggesting a ruling is impending.

Addendum: just tidied up this post - you could tell I wrote and posted it during the Wimbledon Final, what a bloody mess it was...

Greed Guarantees It Will Happen Again

It is interesting how everything in life is cyclical. You're born a disgusting, wrinkly ball akin to the stomach parasite from Alien, unable to speak or wipe your own bottom - and if lucky you end up that way again by your late-80's.

On the subject of cycles, do we truly learn from mistakes? Perhaps on a generational level, but surely not beyond that, which is why so many of the problems we are seeing now have happened before. It is the same point raised in the book 'The Millionaire Next Door', which observes how the wealth acquired by self-made millionaires through frugality is usually lost within a couple of generations, as their offspring piss it all away pursuing a materialistic utopia.

Anyway my point was actually around the whole Bernard Madoff fraud, and the absolute certainty that it will happen again in the future. I don't care what politicians and others in the press state about controls to prevent it, that is simply not the case. Wherever there are naive and/or lazy investors, there will be largely unregulated, opaque funds promising fabulous returns that seem too good to be true

In one sense everything is legal until you are caught - something that Enron illustrated impressively - although not a position I agree with, despite notions of 'right' and 'wrong' being grounded solely in perspective.

So it was with some interest that I got some perspective when I chanced upon a CMBS securitization dealer from another bank over at a Corney & Barrow champagne reception last Friday. It was completely random, at a wedding drinks bash: not mine, and sadly and not corporate - the days of charging everything back are sadly not yet there again.

I was most surprised to find out the trader worked for RBS, who having notched up losses to rival Citibank, and really are a basket case in the world of banking these days. My first question to him of course, apart from the standard piss-take "what's it like to work in the public sector these days?", was what he was still doing there with a job?

He confirmed my suspicions by admitting to being the only one left of a team of 25 a year ago. An interesting illustration of another factor reducing the CMBS transactions taking place, given the headcount reductions to support the transactions. In effect though, he is minding the shop with respect to their existing CMBS portfolio - but did add he is still an originator.

Obviously I had to bring up the subject of General Growth, more to see if he knew anything about it and the potential impact of the SPE ruling. He knew enough for me to have some fun ripping his industry apart, as I reminded him what a joke the previous contracts and sales processes had been.

He did not disagree, but gave the inside perspective - namely that it was really for the clients to complete the due diligence as they were the ones impacted. That is fair enough, but as I reminded him that is not really a valid view given the $50bn loss RBS took last year - it might just be arguable that they were impacted as well. He also confirmed the rumours I have heard that the industry is busy co-ordinating a complete re-structuring of SPE's and associated contracts that will supersede what is currently on the market.

Hardly a surprise, but what that does suggest is that when we finally receive a ruling it will not have nearly the ramifications that some would suggest. There is otherwise little news on the GGP front besides some minor legal applications ahead of future hearings.

Good news for me is that the functional spec will (at last!) be finished by the weekend. It has taken me about 2.5mths due to work, and after drafting up a high level technical spec next, I could in theory get it built in the next couple of weeks. However I will be moving onto the biggest job of all next - populating the site content. Rather more important at this stage, and given the site will provide industry grade investment research papers to registered users (for free), that is going to take time to get ready. I will be covering everything from corporate finance to investment products, market psychology and all trading products on the market, whether investors have access to them or not.

The key to successful investing, particularly for those aspiring to reach high net worth status, is building strong foundations - and that goes beyond simply building knowledge. Either way this site is going to be a more intelligent alternative to the main investment tabloids.