There are more questions than answers in the below — but here are two ratings actions that look set to light the blogosphere on fire:
Fitch Downgrades Abacus 2006-17; Removed from Watch Negative
NEW YORK–(BUSINESS WIRE)–Fitch Ratings has downgraded seven classes and removed nine classes issued by Abacus 2006-17 from Rating Watch Negative as a result of significant negative credit migration within the reference portfolio and within the eligible investment account. A complete list of rating actions follows at the end of this press release . . .
Fitch Downgrades Abacus 2006-13; Removed from Watch Negative
NEW YORK–(BUSINESS WIRE)–Fitch Ratings has downgraded 11 classes and removed 13 classes issued by Abacus 2006-13 from Rating Watch Negative as a result of significant negative credit migration within the reference portfolio and within the eligible investment account. A complete list of rating actions follows at the end of this press release . . .
Confused? So are we. Here’s the basic idea from Bloomberg:
Nov. 12 (Bloomberg) — Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.
Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.
. . .
Goldman Sachs packaged $1.4 billion of credit-default swaps into the CDOs when they were created in September 2006 and December 2006, Fitch said. The derivatives were intended to pay off a Goldman Sachs unit if commercial-mortgage bonds defaulted.
As the Bloomberg story says, that’s a rather unusual move in the CDO market. Traditionally, senior creditors are the first to get paid (hence the senior/junior categorisations – duh). But Goldman Sachs has effectively turned the established order of CDO payments topsy-turvy with these Abacus deals.
How did Goldman `get away’ with it?
By carefully constructing the deal to allow it the opportunity, of course. Here’s what Fitch says:
Classes marked paid in full (PIF) have been fully redeemed under the Optional Redemption provision. The provision allows the issuer to redeem the notes using principal proceeds from the eligible investment account. The notes may be redeemed without regard to sequential order. Principal proceeds may also be used to reinvest under the eligible investment criteria. Use of the proceeds are under the sole discretion of the issuer (Goldman Sachs).
A quick synthetic CDO explainer here. Unlike `normal’ CDOs, the underlying credit exposure of a synthetic CDO is based on credit default swaps rather than tangible assets (CMBS, RMBS and the like). In the Abacus cases the cash raised from selling the synthetic CDO tranches was put into an “eligible investment account” — and it’s from that account that the bank took cash to repay those junior noteholders. Before senior ones.
Why would Goldman do such a thing? There’s this in the Bloomberg story:
Motivations for such action could include ownership of the notes or separate bets against higher classes, according to Howard Hill, a former Babson Capital Management LLC portfolio manager who founded securitization-related departments at four of the primary dealers that trade with the Federal Reserve, among them Deutsche Bank AG and UBS AG
You just don’t know without seeing who owns all the positions related to the deal,” Hill, who now runs a blog from New Milford, Connecticut, said in a telephone interview.
Another layer to this CDO mystery is the question over just who was writing the CDS protection on the deals.
Synthetic CDOs almost always have a super senior swap written on them to offer the arranging bank protection against its position, and it’s usually LSS conduits and monoline insurers who write that protection. As Naked Capitalism’s Yves Smith notes any number of such organisations — ACA, MBIA, Ambac and AIG — could have had a hand in these deals.
And if it was AIG — the enormous insurer bailed-out by the US government last year — there’s the prospect the bank might have been of interest:
. . .if Goldman was left holding any of the AAA tranches (not impossible at all, it might not have placed all of the trade), it was already taken care of via AIG. It might have bought the junior tranches at distressed prices and decided to self-deal. Another possibility is that some of the junior tranche holders are preferred customers (a lot of hedge funds engaged in correlations trades using the lower-rated CDO tranches). A former monoline executive speculates:
Which suggests that maybe, presuming Goldman’s Abacus AAA holdings were `saved’ by the bailout of AIG (allowing the insurer to make good on the CDS payments) perhaps the bank felt the need to not collect again on the same (senior) bonds, and instead chose to divert some of the money to the junior tranches.
Maybe. Though Smith isn’t buying it:
The reason I doubt the benign interpretation, that Goldman was avoiding double-dipping, was that the firm is so busy trying to burnish its image that it would have made a point of this issue. Unless, of course, it does not want to remind the serfs that Goldman’s widely touted subprime short came at the expense of the great unwashed public.
In any case, one has to wonder how many of Goldman’s synthetic CDOs have this kind of junior/senior tranche flexibility written into them?
And why did Goldman see the need for such flexibility way back in 2006?
Related links:
Synthetic CDOs: Not saving anything – FT Alphaville
The CDO unwind waiting to happen – FT Alphaville