CDO PIK: Satisfaction Guaranteed or Double Your Trash Back

When I attended the U.S. Army Northern Warfare School back in 1980, I was amused to see that all of the trash dumpsters at Fort Greeley, Alaska were stenciled with “Satisfaction Guaranteed or Double Your Trash Back”. I was reminded of this slogan the other day when I was doing some reading about the unfolding derivatives fiasco. I’ll get back to the quip about trash near the end of this blog entry.

Let me start with some background: Just like in the traditional bond world, with Collateralized Debt Obligations (CDOs) it is always the holder of the highest rated (“senior”) paper that gets paid first. Each grade level, “class”, “slice” or “tranche” has its own risk level. Starting from the bottom, the lowest level tranche and then moderate risk “mezzanines” have to successively support the more senior tranches. The very lowest level tranches (called “junk” or even “toxic waste” in the bond world) are the riskiest. In a default situation, those investors holding paper in the lower level tranches will probably get nothing, or perhaps 5 cents on the dollar if they are lucky.

Now here is where it gets interesting: Some of the folks that have established the tranche ratings for CDOs for the past few years have played a little fast and loose with their terminology, effectively over-rating them. A lot of “B” rated CDO paper really should have been rated “BB”, or even “BBB”. Indirectly, this has made the investments even riskier, because lower rated tranches have higher margin (“leverage”) requirements. When an investment goes bad, the degree of risk is directly proportional to the amount leverage employed. Highly leveraged investments can “go south” in spectacular ways. It isn’t unusual in the CDO world for some tranches to\ use 25-to-1 or even 30-to-1 leverage.

A recent Financial Times article titled “Credit crisis to worsen as banks cut and run” noted that as public scrutiny has increased, the margin requirements for various CDOs tranches are suddenly getting more stringent. The article mentions:
“The Bear Stearns hedge funds were big holders of these instruments and the news two weeks ago that the funds were in serious trouble has led to much greater concern about the valuation of CDOs of ABS [asset-backed securities] held by other funds.
According to bankers and hedge funds involved in these and similar markets, this has led investment banks to begin reassessing their exposure to funds that are investing in ABS and CDOs of ABS with borrowed money.
Matt King, analyst at Citigroup, has estimated that funds invested in CDOs of ABS are likely to see some significant increases in the amount of margin they are required to post against their investments.
This “margin” in simple terms governs the amount of leverage, or borrowed money, they can use in their investments.
For example, Mr King expects that for the safest AAA-rated slices of these deals, margin requirements would rise from about 2-4 per cent now to nearer 8-10 per cent.
At the other end of the scale, the riskiest equity tranches would see margin rates increase from 50-100 per cent, which is to say banks will not lend to funds investing in these slices of risk.
“Over the near term, the biggest risk is probably that of forced selling driven by potential margin calls or investor redemptions,” Mr King says.
“We argue that this is likely to be a big problem only for a small number of people, but that its full effects may not yet have been seen.”

In reaction to this article, Yves Smith, co-editor of the Naked Capitalism blog noted on the revised margin requirements: “The question now becomes how quickly this development will work through the system and now many players will be affected. We’ve already seen Brookstreet forced onto the shoals by margin calls; the question is how many other hedge funds will follow. The secondary effect will be that hedge funds who have subprime exposure are facing redemptions (some like United Capital Markets have halted them). They were already faced with the prospect of having to sell fund assets in a weak market to pay exiting investors; reduced leverage will only make a bad situation worse (the implicit vote of no confidence by the dealer community will make it less likely that speculative buyers will step forward). The good side is, if we believe the report in a recent issue of Bloomberg Magazine, hedge funds are smaller participants in the subprime-related CDO market than thought earlier, owning 3% of the investment grade portions and 10% of the equity tranches.”

I have read that a lot of CDO derivatives contracts are written with a Payment in Kind (PIK) recourse clause. In the context of CDOs, a PIK clause guarantees that if an obligation cannot be paid in cash, then it can be settled with the transfer of additional CDO paper. When default rates spike (as they have done recently with sub-prime mortgages) and a CDO party stops paying current interest (for lack of cash), they can hand over additional debt obligations, as a payment in kind. But what if that paper is also worthless, or nearly worthless? (This is the “double your trash back” that I mentioned.) Worthless PIK settlements could very well happen in coming months, as the US coastal residential real estate market unravels. This could get very ugly in a hurry. Changing margin regulations may make some holders of CDOs forced sellers, setting in motion a downward spiral in CDOs. If the sub-prime CDO failures start to snowball, beware! The liquidation could turn into a reverse bidding or “race to the bottom” situation, as anxious investors try to recoup something, anything from their initial investment. If and when this happens, it could make the $3.6 Billion Long-Term Capital Management (LTCM) bailout and the more recent $4.6 Billion lost by Amaranth Advisors look like minor hiccups, by comparison.

Those of you that have read SurvivalBlog since its early days will remember that I’ve issued warnings about the derivatives market in general and the credit derivatives market in particular, since late 2005. My advice hasn’t changed much. It remains: Be aware. Be prepared. Diversify. Minimize your exposure to both the real estate bubble and the credit derivatives market–directly or indirectly.