Here’s a structured finance blast from the past; some trouble in mezzanine tranches of ABS CDOs.
Last week the ailing (in fact, almost dead) bond insurer Ambac announced it would commute its remaining $16.4bn of of exposure to Collateralised Debt Obligations of Asset-Backed Securities. That is, it will terminate CDS on the CDOs by making an agreed-upon payment to the insured counterparties.
That might be good news for investors in the senior tranches of CDOs, who could still eke out some value from the securities. But middle-of-the-CDO-structure mezzanine tranche investors are about to get hosed, according to rating agency Moody’s. (And just forget about junior investors).
As a reminder, the mezz tranche sits below the senior tranche in a typical CDO structure, and above the junior, or equity tranche. Mezz investors get paid after the senior bondholders, but before the junior ones. And mezz investors typically get paid slightly higher rates than senior investors, to compensate for the added risk, but nothing as juicy as the yields paid to equity investors.
Here’s Moody’s:
. . . Ten high-grade ABS CDOs issued between 2005 and 2007, all of which are in EoD [Event of Default], accounted for two-thirds of the total CDS trades outstanding with Ambac. The commutation gives control of the liquidation of the deals to senior noteholders, who may have stronger incentive to liquidate opportunistically. The commutation is a credit negative for the mezzanine noteholders as liquidation would result in the cut off of future cash flows. Given that most recent ABS CDOs are under-collateralized, principal recovery for these noteholders after liquidation will likely be minimal. The commutation has no credit impact on the junior noteholders as these noteholders already do not receive any cash flows.
We don’t know who holds the mezz positions on Ambac’s just-commuted ABS CDOs, but we can point you in the direction of this now-famous 2008 letter, by Pershing Square Capital’s Bill Ackman. It’s on the subject of shorting the monolines, and lists Ambac’s 2004-2007 ABS CDOs by name.
Ackman, of course, made a killing on the trade.
In fact, now that subprime’s back in the headlines, the whole thing is worth re-reading.
Some additional mezzanine flashbacks below.
Related links:
Bill Ackman’s letter to the regulators in full, and his monoline model – FT Alphaville, January 2008
CDO wipeout: AAA noteholders get nothing – FT Alphaville, December 2007
Fundamentals, not liquidity conditions, are behind MBS crash – FT Alphaville, November 2007
The full subprime letter from Hayman’s Kyle Bass – FT Alphaville, August 2007
Subprime conspiracy unearthed, maybe – FT Alphaville, August 2007
CDOs – a trillion here, a trillion there - FT Alphaville, July 2007