"Tranche Warfare" Over CDOs
As the subprime meltdown and the credit crisis deepen, the investors in collateralized debt obligations (CDOs) are fighting over the scraps, according to articles from the Financial Times On-Line by Michael Mackenzie and Aline Van Duyn. CDOs are structured credit vehicles made up of several different layers of bonds, called tranches. Each tranche has a different level of risk and a different credit rating. The senior tranches, which provide the majority of the funding of the underlying assets, are rated the highest because the smaller subordinate tranches are the first to absorb losses from problems with the underlying assets.
To juice returns, a small slice of the bottom level of the senior tranche can be split off and sold. That slice retains its AAA rating but pays out a higher return because its investors would lose money before the remaining AAA tranche above it. The remainder of the senior tranche is called the “super-senior” because selling the extra slice was deemed to have removed the marginal risk that it would suffer any losses.
Investors in all tranches but the super-senior tranche are discovering that, when a structured deal flounders, their investment is at risk. Also, they are learning that they can be quickly stripped of their rights over assets when a deal is either liquidated or left to die slowly over time. The super-senior investors are taking advantage of little-noticed terms in the structuring of these instruments that allows them to seize control of the assets and shut off payments to the other tranches. They are making sure that they get their investment back before anybody else sees a cent.
In addition to allowing super-senior investors to take control of all the income, under these “event of default” provisions, the senior holders can also accelerate payments from the CDO. This leaves the junior investors with the prospect of no interest payments for months or years and no say in deciding whether or not the instrument should be liquidated. Many investors in the junior tranches were unaware of this provision showing how little investors were told about the exact terms and conditions of the deal in the rush to complete it. These investors may have been lulled into a false sense of security on the strength of the credit rating.
It also turns out that investment banks are large holders of the super-senior tranche either because they never sold them or their off-balance sheet investment vehicles that bought a lot of this paper were forced back on their balance sheet. This helps to explain the roughly $230 billion in write-downs on CDOs by investment banks.
According to Morgan Stanley strategist Vishwanath Tirupattur, “A good portion of the banking sector’s write-downs to date stem from super-senior holdings. Thus far, a majority of deals being liquidated are the one where banks are the super-senior holders. This is an incentive to liquidate and not endure further pain.”
Not surprisingly, these developments are spurring litigation among the various tranche holders and the trustees. Once again, the investment banks seem to be watching out for their own interests and not those of the investors to whom they sold the CDO tranches.
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