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Walter Kurtz
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Sober Look (www.SoberLook.com) is a financial blog that deals with issues in capital markets, risk management, the economy, the financial services industry, and regulatory policy, with emphasis on finance education. The goal is to get beyond the hype and hysteria and focus on real issues, using... More
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  • Rough road for munis
     
     
    Even with the advantage of paying tax free interest, municipal bonds in many instances are yielding more than their corporate equivalents.
    Bloomberg: State and local governments that sold $43.8 billion of taxable Build America Bonds this year will pay $385 million a year more in interest than similarly rated corporate borrowers, based on data compiled by Bloomberg.


    The spread between corporates and munis varies along the yield curve. In the short end the tax advantage keeps the spread (corporate yield minus muni yield) positive, but for the longer maturities the spread reverses.




    This means that in spite of the tax advantage of municipal bonds, given the choice between two equally rated long duration bonds with the same coupon, investors prefer the corporate paper. Clearly unlike corporate bonds, munis have lower analyst coverage and are viewed as a specialty market. Buyers of longer-term munis tend to be specialized muni funds, while corporate paper is held by institutional investors, fixed income funds, etc.

    But that's only part of the story. If the risks were truly equivalent, over time the spread would tend to zero. The spread however shows incremental credit risk of municipal bonds over the longer time periods. But how is that possible, given that unlike corporations, municipalities "can raise fees or taxes to make up for deficits. Corporations are at least 90 times more likely to default than local governments, according to Moody’s Investors Service"? (Bloomberg)

    The reason given by Bloomberg is poor transparency of municipal issuers.
    The public paid extra costs for borrowing with tax-exempt bonds because local governments resist providing investors the same level of disclosure as corporate borrowers, which file quarterly reports.

    Municipalities typically file financial statements only once a year. Detroit, the largest U.S. city with a less-than- investment-grade credit rating, released its annual report for fiscal 2007 in March, more than 18 months later.


    But other reasons include the deterioration of state budgets and the risk that in the long run munis may lose their tax-free status at the Federal level. But there is something else. Private investors continue to be nervous when dealing with governments as political risk enters into the picture. Who is to say that 10-20 years down the road, municipalities will not walk away from their obligations. There is only so much pain that angry taxpayers in various states may be able to take. And for now that risk is costing municipal issuers the extra spread.
    Oct 27 4:40 PM | Link | Comment!
  • Harvard's big swap unwind
     
     
    As we discussed a few months back, Harvard's lesson in Asset/Liability management had indeed been costly. What has come to light recently is the pain Harvard took on their interest rate hedges. As the school went on their construction spree and undertook a variety of capital projects in the last few years, they were running exposure to short-term rates. This was due to the way the university was financing these capital projects (which is typical for such financing).

    In order to lock in their short-term rates on the capital projects' debt, they swapped floating for fixed (agreeing to pay fixed rate and receive floating). Simple enough. But as the rates collapsed late last year, Harvard got a massive margin call on the swaps. Again, this is standard - the value of the swaps went against them (they continued to pay the same fixed rate but were expected to receive floating rate that's significantly lower) and banks called for margin. In principal, that should be OK as well, because the swap losses should be offset by Harvard's lower financing costs.





    But a couple things went wrong. Some of their capital projects were put on hold, so they couldn't take advantage of cheap financing. At the same time their liquidity in the endowment became significantly constrained because of the nature of their illiquid investments. And with the economy collapsing, unencumbered donations nearly dried up. The margin call was much more than they could handle and Harvard ended up issuing bonds to cover losses. They ultimately decided to get out of their exposure (possibly at the worst time.) They unwound some $1.1 billion of swaps. However, rather than unwinding the remainder of the hedges (and paying the losses upfront), they simply locked in the losses with offsetting swaps, creating a long-term liability stream. Here is the statement on the offsetting trades:

    Harvard (see attached): ... in fiscal 2009, the University entered into additional interest rate exchange agreements with a notional value of $764.0 million, under which the University receives a fixed rate and pays a variable rate. These new interest rate exchange agreements, or ‘offsetting’ agreements, were intended to reduce the risk of further losses in value (with associated collateral posting requirements) within the portfolio of interest rate exchange agreements.


    In fact this unwind and others like it at the time caused the 30-year swap spreads to go negative. The overall impact on Harvard's financials was severe:

    Bloomberg: Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.


    So how can a bunch of really smart people run into so much trouble with a hedging program. The consultants out there are shouting - you should have hired us to do this. This is too complex for you Harvard guys.

    Bloomberg: “It says that people don’t understand the complexity of the products they are buying and selling that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California. ... “It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.


    "so highly complex"? This is how this particular consultant gets paid, by making sure that everything in finance is "too complex" to do without his guidance. In fact this is not about complexity, it's about the practicalities and appropriateness of financial products. And this is when academia often fails - the rule of "we must hedge everything with swaps" was put in place by someone who is not only clueless about the simple mechanics of margin, but also doesn't understand the purpose of hedging.

    What is the purpose of hedging here? For Harvard it was to avoid paying really high rates on their financing. But what is high? If LIBOR was at 4.5% when they started on their projects, would it be that difficult for them to pay 5% or 6%? Probably not. The real pain would kick in above say 8%. Hedging for this type of situation should be viewed as a form of insurance. And as we all know, when you buy insurance, the cost depends on your deductible. So Harvard instead of entering into swaps, could have easily bought some interest rate caps struck at say 8%, making sure they never have to pay above that level. It's a high deductible, making these caps reasonably inexpensive. In retrospect it would have been money wasted, but as with any insurance, you buy it hoping it will be wasted.

    Alternatively, if they didn't want to pay upfront premium for caps, they could have put on cancellable swaps. The right to cancel would have made their fixed payments higher (depending on maturity, maybe a percent more). But they could have simply cancelled them last year with no breakup costs or margin call. It's a standard and fairly liquid product (in the category of "swaptions"). Of course some would say - oooo, this is too exotic. This concept is actually commonplace, as the "option to cancel" is built into most people's mortgage. When mortgage rates drop, most can refinance with no penalty of unwinding the old mortgage (something borrowers generally can't do in the UK for example). If you refinanced your mortgage before, you've exercised your "option to cancel".

    The media is making this sound as though it's a "bad investment" gone wrong - mostly because they don't understand the situation, and it creates good hype. In reality it's simply an issue of sound asset/liability management, proper usage of financial tools, and a bit of common sense. Makes for a good Harvard Business Case study.


    Harvard- Financial Report

    SoberLook.com
    Oct 20 5:25 PM | Link | Comment!
  • CDO equity holders extract value by selling their votes
     
     
    Imagine that you are a holder of a senior tranche of a CDO. You've been through hell and back, and now you have hopes of recovering some non-zero value from the bond. You value the collateral and figure that over time you may get say 50 cents on the dollar.

    When you bought these specific bonds, you knew (maybe) that the subordinated note (equity) holders have some rights, including the ability to liquidate the collateral. But that's OK you thought, because the equity holders will have no incentive to sell the collateral at anything but the top price because they would be taking the first loss.

    But what happens if the equity holders are wiped out anyway? Even if the collateral is sold at top current prices, the equity value is zero - all the residual value goes to the senior note holders and there is nothing left for the equity. That makes sense - if the senior note holder is hoping to get 50 cents on the dollar, the equity has to be worthless. But not so fast.

    You wake up one morning and learn that the equity holders decided to liquidate the collateral at 5 cents on the dollar. And the reason they are doing that is that the collateral buyer has bribed them. Yes that's right, they have been paid to allow liquidation at rock bottom prices. They are wiped out anyway, so why not sell their vote? Now the 5 cents is going to you, the senior bond holder, because in a liquidation you get paid first. And that's it, you are not getting a penny more because there is no more collateral left.

    Crazy story? Nope. This is real. The senior note holder is Citigroup. The collateral purchaser (at 5 cents on the dollar) is TPG Credit Management (part of TPG, one of the largest private equity fund managers.)

    Bloomberg: A fund associated with TPG is exploiting an unintended wrinkle in the $650 billion market for CDOs by asking holders of the riskiest portions to allow asset sales in exchange for millions of dollars in fees. While equity holders have the right to decide which assets the CDOs sell because they’re first in line for losses, they may no longer have the incentive to ensure that assets are sold at fair value because their investments have been wiped out ...
    ...
    Julie Braun, chief operating officer of TPG Credit, said in an Oct. 9 letter to Tropic CDO V noteholders that Trust Preferred Solutions LLC is seeking to buy $115 million of securities issued by 20 finance companies including Centra Financial Statutory Trust II and Forstrom Capital Trust II for 5 cents on the dollar. Investors must agree by Oct. 23, the letter said. Trust Preferred Solutions is a TPG Credit investment vehicle.


    In this particular case TPG Credit is targeting CDOs (called TruPS) that have trust preferred securities as collateral (see primer below). The interest on these securities in the collateral pool is often deferrable for up to 5 years and maturities go out to 30 years. With the shakeup in the banking sector the securities aren't worth much, but are on average worth more than 5 cents on the dollar.

    This maneuver by TPG is legal and follows the indenture documents. Citigroup is obviously not too happy and is preparing to fight.

    Bloomberg: While Tropic CDO V’s [TruPS targeted by TPG] equity holders haven’t received payments in a year, they’ll get “a consent payment equal to half of the aggregate purchase price of the subject securities, unfairly benefiting the preferred shareholders at the sole expense of the noteholders,” Huang [representing Citi] said in the letter.

    “We intend to hold the issuer, its directors and the trustee responsible for any transaction that improperly impairs our collateral or interferes with our legal and contractual rights,” Huang wrote.



    Trust Preferred CDO Primer
    Oct 19 11:21 AM | Link | Comment!
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