Here’s something to consider ahead of the European Central Bank meeting on Thursday.
While investors will be looking for signs that the ECB may be preparing to wean banks off their liquidity programmes, Moody’s warned on Wednesday that such operations may cause conflict of interests for structured finance originators — the banks that create CDOs and the like. Here’s the statement:
London, 04 November 2009 — In the current market conditions, it is common for notes issued by a structured finance issuer to be acquired by the related originator and used as collateral under a central bank repo.
As the sole noteholder, an originator may direct the trustee and issuer to waive breaches of transaction documents or consent to the modification of transaction documents.
Given that originators are typically parties to various transaction documents, they may pass noteholder resolutions that are favourable for them in some other capacity and potentially prejudicial [detrimental] to the credit quality of the notes. For example, Moody’s recently became aware of a noteholder resolution directing the issuer and trustee to waive certain rating trigger breaches relating to the originator.
Nonetheless, since notes require a minimum rating to be eligible as collateral under central bank repo transactions, Moody’s considers it unlikely that an originator would wish to procure any waiver or amendment that has a negative rating effect. In the case of the transaction referred to above, following discussions with Moody’s, the originator amended the relevant resolution so as to avoid a rating action.
Therefore, although the acquisition of notes by an originator may cause a conflict of interests, the likelihood of it having a rating impact is low, at least so long as the notes are expected to be used as repo collateral.
FT Alphaville will attempt to translate.
Banks have been creating structured finance bonds to use as collateral for central bank operations. The banks post the notes at places like the ECB in exchange for cash (otherwise known as liquidity). Now, the banks don’t intend to sell these things — they are intended purely for the repo ops. Hence the notes are issued by a related entity (an SPV or the like) and often bought back by the originator (the bank) to be used as collateral. Crucially the central banks often have ratings criteria for the kind of stuff they’ll accept as collateral. The ECB for instance, accepts ratings of BBB- and above only.
Now once the bank buys back the notes, and if it’s the only holder of the notes, it may want to restructure them for some economically-advantageous reason. It has an added advantage (or, conflict of interest) since, as the originator, it has access to deal terms and documents that may help in doing this. Moody’s cites the example of one noteholder resolution suggesting the issuer and trustee waive rating trigger breaches (which can set off unwinds) relating to the originator.
Crucially though, the banks need to maintain ratings on the notes if they are to use them as central bank collateral. So in the above instance, Moody’s simply warned the bank that waiving the trigger breaches would end up in a downgrade; Et voila, the resolution was amended to avoid ratings action.
So central bank repos have a tendency to cause conflicts of interest since they encourage originators to acquire structured finance notes in anticipation of using them as collateral — and may lead them to use their position as originator to restructure the deal in their interests — using those deal documents. But they discourage ratings downgrades, at least by Moody’s, since originators will be loathe to risk a downgrade.
Well, that’s all fine then.
Related links:
Collateral damage at the ECB - FT Alphaville
Why the ECB is a good bank with rubbish assets - FT Alphaville
