Sunday, January 30, 2011

The Ratings Charade Continues: A CLO Investigation, Part I

The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.

Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.

We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.

If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.

Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.

That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)

When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.

So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."

Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):
Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.
Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).

Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.

Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.

Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.

So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.

That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."

Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.

(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")

Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"

Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)

That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.

[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]

Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.

This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.

Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:

These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.

Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...

Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?

Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.

He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?

Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.

Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.

How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.

Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.

So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.

Wednesday, January 12, 2011



In the world of securitization or sukuk issuance, SPV (Special Purpose Vehicle) is normally established based on the common law distinction between legal and equitable right/ownership where the trustee i.e. the SPV is considered to assume legal ownership (right as recognized by court of law) of the underlying asset used in sukuk or securitization for the benefit of the beneficiary (whose interest or right is recognized by the court of equity), and as such a split is thereby caused to the concept of ownership as a result of which the beneficiary is not empowered to take or assumed all rights as an established owner of the asset as is required by Shariah law if he is truly to be considered as a true owner as per the Shariah provisions that will give him several rights that include right of free disposal and possession without restriction.
It can be argued that having what is called beneficial interest in the underlying asset as described above is not enough to give the respective holders of the sukuk a full right of ownership as envisaged under the Shariah as all their rights are exercisable only through the trustee/SPV. The purpose to have this structure involving SPVs is to achieve what is said to be bankruptcy remoteness meaning that whatever happens to the originator will not make the asset in the custody (legal ownership) of the SPV vulnerable to any action by possible creditors of the originator thank to the fact that it is transferred to the legal ownership of the trustee; the fact that will insulate the same from any possible recovery action by other potential creditors of the originator.
This above effect will however only arise if the SPV is truly an independent entity that has no connection with the originator, and such an entity is known as orphan SPV rather than a subsidiary of the originator. What actually happens is that it is normally the potential originator (the party seeking the funding) that will make effort to establish the SPV, and this SPV is not supposed to hold any asset other than the underlying asset to be transferred to it upon the issuance of the sukuk. The SPV also will normally have a very minimum share capital and staff, and in fact it is a mere tool to facilitate the transfer and issuance of the sukuk/bond, and as such is not supposed to conduct any real business activities or trading for the benefit of the sukuk holder notwithstanding the fact that in the case of sukuk al-ijarah for example, the asset will be rented back to the originator and the resulting rental streams from the originator will be used to pay the sukuk holders on periodic basis as a form of profit or income.
Unless and until true/full ownership is duly transferred to the sukuk holders in its fullest sense, it is difficult to treat the structure using SPVs as truly truthful to the concept of ownership as envisaged under the Shariah. Additionally if at the end of the tenure, the originator is obliged to redeem (repurchase) the asset, then this is another indication that what is intended is no more than lending and borrowing arrangement between the originator and the sukuk holders where the SPV will in real sense effectively act as the trustee appointed to hold the underlying asset as collateral.
In contrast, under a traditional mudarabah structure, the mudarib/manager of the mudarabah investment fund is in fact a trading agent to the capital providers/investors and as such assumes the role of a “trustee” from Islamic law perspective. However this mudarib cum “trustee” is not supposed to be a non-active party as far as business or trading activities are concerned unlike the trustee in the context of the structure using the SPV. The mudarib is supposed to conduct trading for the benefit of the investor with a view to create profit that is to be shared based on an agreed ratio. At the end of the mudarabah tenure, all trading assets that are still under the custody of the mudarib, if any, need to sold in an open market to turn them into cash again to know whether there is any profit (or loss) out of the trading activities conducted during the duration. In the case of many sukuk however, the underlying asset is normally to be repurchased by the originator at the end of the tenure as part of an undertaking or binding promise to repurchase at nominal value. If the reason and motivation for the establishment of the SPV, as it seems from this interpretation, is just to create an element of collateral for the benefit of the sukuk/bond holder (especially in the case where there has been no true sale affected between the originator and the SPV or where there is an undertaking (or binding promise) to redeem or repurchase the sukuk/asset) i.e. when the underlying asset under the control of the trustee (SPV) is more in essence of a collateral rather than the one truly belongs to the sukuk holders in the true Shariah sense then the Shariah compliance aspect of the sukuk as investment certificates will be compromised. Therefore it is very important to ensure that true ownership with all its risk and return implications including all rights accorded to a true owner as granted by Shariah are assumed by the sukuk holders, otherwise their entitlement to the income streams will remain doubtful. In this connection sukuk investors need to be warned and be truthfully told about the basic different between investing in sukuk and purchasing conventional bonds where, in the case of bonds, without doubt the SPV is a party who holds the underlying asset as collateral for the borrowing.

Monday, January 10, 2011



The guideline on Islamic REITS issued by the Malaysian Securities Commissions several years ago is a step in a direction to further develop Islamic finance, and such an initiative should be viewed as part of continuing efforts undertaken by the regulatory body in line with the vision to make Malaysia a leading player in Islamic finance. In essence, the Guideline seeks to address important issues surrounding asset classification with regard to investment in real estate to ensure Shariah compliance. It provides for criteria according to which a certain real estate or property is considered permissible for an investor to acquire with other investors as co-owners who are also holders of the investment trust fund.

Generally these criteria deal with the way the estates are utilized rather than their physical aspects; if they are utilized for purposes not repugnant to Shariah then they are considered permissible. Of course permissibility of an asset is also in the first place decided on the basis of whether it is halal asset or otherwise. Halalness of an asset is an issue which is entirely different from the way it is used or utilized in actual fact. Halal assets may be used both in Shariah and non-Shariah compliance ways. However, as it is clearly stated in the guideline, if the non-halal usage exceeds a certain benchmark, than the investors need to be advised by their relevant Shariah advisors to sell off their holding in the unit trust.

An example given in the FAQ section of the Guideline is a clear indication that the utility aspect of an asset is given prominence in deciding the Shariah compliant status of the relevant investment.

Any Islamic REIT as it is envisaged under the current scenario is still governed by another Guideline issue earlier by the SC in respect of normal REITs. In one aspect, the introduced Guideline on Islamic REITs can be considered as a supplement to the mentioned conventional Guideline which in itself is of general application governing all aspects of investment in REITs in Malaysia. Basically REITS are unit trusts where investors purchase units which form part of a larger pool of fund contributed by all investors who purchase units offered for sale by any unit trust or investment management companies. In every unit trust scheme there must be a trustee appointed to ensure that the fund management company functions in accordance with the duties as listed in the prospectus and also in accordance with the trust deed. Returns or income in REITs can come in two ways, firstly through dividends payout if the investors still keep their investment or any increased value of the units if sold by the investors.

From Islamic perspective the act of buying a unit in a unit trust fund/REIT may be said to constitute a financial or capital contribution or investment in a mudarabah scheme whereby such a contribution is handed over to the management company so that the later can purchase some assets to be used for income generation purpose. If these assets are rented out based on ijarah contract, an income stream is expected to flow throughout the duration of the investment period. This model or process is said to be governed by both mudarabah and Ijarah principles. The first principle governs the relationship between the investor and the asset or investment management company whereas the second as between the management company and the tenants. In short what is meant here is an investment scheme structures based on Mudarabah for the purpose of an acquisition of a certain piece of tangible asset so that it can be rented to third parties in a way that profitable returns or proceeds be made for the interest of the investor.

Notwithstanding this characteristic, one major different between Mudarabah and Islamic REITs investment scheme run as described above is that in Mudarabah the manager is to share profit based on a ratio agreed with the investor/owner of capital at the outset. In REITs however, the manager will not share any profit in the above manner but to be paid management fees as per the terms as normally expressed in the Prospectus. This fact makes Islamic REITs is said to be outside the scope of the normal mudarabah structure where there is going to be profit sharing between the manager and the investors as the first will not be paid any fee whatsoever for the management effort he is to be involved throughout the duration of the investment. When fees are collected by the manager, the structure may be said to have changed into a form of a fee-based agency relationship between the parties, and as such must follow all the established Shariah rules governing the same. Among others, management fees need to be fully specified so does the duration of the contract to avoid potential disputes, and more importantly it has to be made clear that as a paid agent the manager is to conduct the management in the best possible manner failing which a breach of an agency contract would occur.

As an interesting comparison, there are many similarities between Islamic REITS and sukuk al-ijarah as both schemes envisage acquisition of tangible assets that are to be rented out to third parties for an income stream payable to the investor during the relevant period he keeps his investment in the fund or sukuk. In the case of Islamic REITs there is an involvement of 3 other parties apart from the investor; the unit trust management company, the trustee and the third party tenant of the asset. In the case of sukuk al-Ijarah, according the way they have been structured all these while, instead of having a unit trust management and a trustee company in between, there is an SPV company specially established to issue the sukuk and another trustee/management company which function is similar to the scenario as applicable in the unit trust scheme as previously stated to manage the real estates. What will happen here is that the SPV will invite subscription from the potential investors to purchase sukuks for which certificates are issued to them in acknowledgement of their contribution or purchase. It may be said again that what the investors do is no other than providing money capital to the SPV in the context of mudarabah so that the later can use the fund or pool of fund contributed by all sukuk buyers to purchase certain real tangible assets to be employed for income stream generation in order to pay the investor periodically as agreed in the sukuk document or contract.

In both instances as describe above, income or return to sukuk investors/holders of unit trust will come from the projected income stream generated through the utilization of the relevant assets and also from capital gain, if any, if the sukuk are sold back to or redeemed by the issuer (based on market value which is more that nominal value) or in the case of unit trusts when the holders dispose of their units in the market (ETF) at any given time or have them be repurchased by the unit trust management company at the current purchase price which is calculated on the basis of the NAV of the unit less management fees or charges.

The only issue that may be asked here relates to the Shariah position with regard to the fees as paid to the management company in the case of unit trusts including Islamic REITs in the context of our discussion. In classical mudarabah, return or income to the mudarib (the manager) is payable from a share of profit of the scheme if it turns out to be profitable, based on an agreed ratio say 40:60 for example. In the case of unit trust however the managers received their income from the fees charged to the fund irrespective of whether the scheme is profitable or not. Thus this scheme is not a straight forward mudarabah, but rather it can be classified as al-wakalah bi'l ujur meaning hiring someone to act as an agent with fee.

In the context of sukuk al-ijarah, this is not an issue given the fact that in many cases as it has been practiced, these sukuk are issued by companies or governments to fund infrastructure projects whereby certain assets are sold by the originators (public or private) to the SPVs (the issuers) which will purchase them with the use of the fund collected through sukuk subscription, and then the originators will rent the assets from the SPVs for a certain period of time commensurate with the lifespan of the sukuk by making periodic rental payments to the investors through the SPVs. Normally these SPVs are formed by the originators specifically for the purpose of facilitating the whole securitization as these SPVs are there to ensure that the pool of investment of the sukuk holders are utilized to purchase the assets that are to be rented out to generate incomes in the form of a rental stream that will subsequently be passed on to them at the relevant intervals. In the normal Mudarabah structure, the Mudarib/manager is to engage in trading/renting activities with truly third parties or the market at large and not with the providers of capital as seen in the context of the originators as described above. So as far as this aspect is concerned, it seems that the REITs is closure to the original spirit of the Mudarabah ( except for the issue related to fees collected by the REIT manager) where assets are rented out to true third parties to generate income streams. It the case of sukuk al-ijarah, the major Shariah issue is whether there is a true sale between the originator and the SPV (at the start of the process) as to warrant a transfer of true ownership to the investors through the SPV given the fact that the SPV is established by the originator or sometimes its subsidiary. Secondly there is an issue of redemption of the sukuk by the originator at the end of the tenure of the sukuk; whether it is again a true sale as between the parties (based on market value) or a redemption of a collateral by an assumed borrower (the originator) if such a sale/resale is based on a nominal value in which case the true ownership by sukuk holders are not correctly reflected.

In the Middle-east particularly in the past 20-25 years, there used to be another method to achieve similar objectives that seems to be well within the framework of a true Mudarabah. There were many so-called Islamic investment companies that established and managed special real estate funds on the basis of Mudarabah. The general public were invited to contribute to these funds that would be used specifically for real estate investment both in local and oversea markets. Interestingly, in many instances one of the clauses of the mudarabah agreement employed for this purpose would say " whatever will be bestowed upon us by Allah as a result of this scheme will be shared between us in the ratio of so and so…". This is a typical mudarabah scheme whereby the manager is to be remunerated when there are actual profits generated by the venture.

In conclusion, whether potential investors would prefer to buy sukuk al-ijrah, Islamic REITs or to take part in the traditional mudarabah scheme with less Shariah compliance issues as explained, the underlying Islamic rule is that by buying such sukuk or Islamic REIT units or to participate in traditional mudarabah funds, they in fact need to be ensured to acquire the ownership in the relevant assets or real estates which justify their entitlement to the associated returns or incomes. However as owners they should never forget the fact that according to the Shariah law, they also bear the ownership risk (daman al-milk) in respect of the underlying assets or real estates that they own, as Islam dictates that income or return is in exchange for ownership risk assumed ( al-Ghunm bi'l ghurm). Notwithstanding what has been previously stated, investment in real tangible assets and the employment of the ijarah principles relating to the utilization of these assets to create income streams are held to be valid (if done correctly) according to almost all Muslim jurists in contrast to the investment in debts securities which is not generally or globally accepted especially when these securities are not structured, negotiated or sold/purchased in a manner that is consistent with the generally accepted view on money exchange and debt trading in Islamic law.