Wednesday, April 2, 2008

Clarity provides comments on ABCP restructure plan

By: Daryl Ching, Clarity Financial Strategy

It has been quite some time since our last post. The analysis of the restructure plan has been far more difficult than we ever imagined, but we have reached a couple conclusions that I would like to share with readers of this blog.

It has become apparent to us, without much surprise that investors generally find the restructure plan completely incomprehensible. The truth is that there is absolutely no way a 385 page document and a two-hour presentation is nearly enough to help people understand the complex mechanics of ABCP. Even being in the industry, it took me months to wrap my head around the structures, and I have a finance background.

By now, most of you know that the Class A Notes for the CDO tranche are only being assigned a AA-rating from DBRS. Other rating agencies have declined to rate the structure. We believe this may either be because they did not deem the structure to be AA or have withdrawn ratings on leveraged super senior transactions altogether. We began our analysis by reviewing the CDO methodology used by DBRS and running the models that we usually would. The margin facility combined with underlying collateral to support margin calls is well over 100% of the leveraged super senior notes. The spread-loss triggers, which are benchmarks, that if crossed will cause margin calls are set a level far more remote than previous structures we have seen. So it is a better transaction than what we have seen in the past. Does this make us AA confident about the new notes?

While financial models are a great tool to assess value and risk, it is important to note that they have proven to be wrong. They generally look at credit cycles over a historic period and map out worst case scenarios with a certain confidence interval. However, we have seen things happen over the last couple months that were unthinkable a year ago. No financial model predicted:

  • The global liquidity crunch we are seeing today
  • AAA rated monocline credit insurers like Ambac asking for a bailout and losing 90% of its market share
  • Hundreds of billions of write downs from the world’s largest banks that were perceived to be conservative
  • The collapse of Bear Stearns and a potential sale at $250MM, once one of the world’s largest financial institutions
  • Citigroup, once the world’s largest bank losing half its market share

For these reasons, individuals, including myself have lost faith in quantitative models to predict risk. Even if the margin facility was $20 billion and the spread-loss triggers were set at 600 points, I’m not sure anyone would give a AAA stamp. Unfortunately, LSS CDOs have a high correlation with credit volatility and take on a significant amount of market risk. We may never see a AAA-rating again on this type of product again. It is important to keep in mind that you can never create a structure that has a 100% certainty of recovery. Unfortunately, you will always have “tail risk” or unlikely events that fall into the 1% bucket and they have happened.

So are the restructured notes solid? We think that the financial models have merit and need to be understood but must be supplemented with common sense. The credit protection provided for the restructured notes are certainly higher than we have seen in previous transactions and is likely the best deal we will be able to get based on negotiations from the Crawford Committee. Some economists believe we have seen the worst and are at the trough of the credit cycle. The credit markets have actually improved significantly in the last couple weeks. We heard news yesterday that UBS wrote down another $19 billion due to the mortgage fallout, but were able to raise $15 billion in fresh capital. Analysts have indicated that the worst might be over and investors have not given up on the large banks. The news was viewed positively as the Dow Jones continued to surge 3% despite this news. Credit spreads improved yesterday. So there may be light at the end of this tunnel and it may be within reach.

However, if the markets continue to decline the way they have from August to March, all bets are off. Two or three more Bear Stearns type incidents can rattle the market to the point where the new triggers will get breached and the margin facility will get fully drawn.

In short, we need to understand the financial models and take a view from macroeconomic perspective. Your views on the restructure plan will also depend on whether we will experience a deep recession and to what extent the credit markets will continue to get rattled with bad news. While we may not be AA confident, we still believe the restructured notes are sound and will return full value at maturity.

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