The Financial Times “'Tranche warfare' breaks out over CDOs” and “'Super-senior' CDO investors begin to flex their muscles” give us great insight into the future losers and super losers in the CDO world. It is still too early to call anyone actual winners, though the vultures are raising capital. The senior tranches make up the majority of funding for CDOs and are usually rated triple-Aor double-A. The smaller lower rated tranches are the first to take losses.
The FT unveils the mystery of super-senior tranches. It is not necessarily the highest tranche in the stack, but the top part of a senior triple-A rated tranche. After the initial cleaving of the tranches, the bottom of the senior triple-A rated tranches is sliced off to create a higher paying triple-A rated sub-tranche. This sub-tranche will take the first hits for its parent, the super-senior. You don’t have to get into CDO squared to get multilevel complexity.
A large portion of the of the super-senior tranches are held by major investment banks such as Citigroup (C), Merrill Lynch (MER) and Lehman Brothers (LEH). These tranches were harder to market due to their lower interest rates. The majority of bank CDO write downs were in the super-senior tranches. The super-seniors do have special privileges in the CDO trusts. When a triggering event occurs, the super-senior can call for acceleration or complete liquidation. Triggering events include both ratings downgrades and a threshold of delinquencies.
Acceleration is the option to redirect all cash flows to the senior tranches until they are fully amortized. American International (AIG) Group felt the pain of acceleration in its $5.9B write down. Some banks have opted for liquidation to stop the pain. However liquidation can lead to losses of up to 40%.
Not all CDO trusts are crystal clear on senior rights, leaving the door wide open for litigation. Deutsche Bank (DB) and Wells Fargo (WFC), as trustees, have sued to ensure payments continue for certain tranches. During the boom, little attention was paid to clauses pertaining to events that should never happen.
Disclosure: Author is long C and WFC.
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The FT unveils the mystery of super-senior tranches. It is not necessarily the highest tranche in the stack, but the top part of a senior triple-A rated tranche. After the initial cleaving of the tranches, the bottom of the senior triple-A rated tranches is sliced off to create a higher paying triple-A rated sub-tranche. This sub-tranche will take the first hits for its parent, the super-senior. You don’t have to get into CDO squared to get multilevel complexity.
A large portion of the of the super-senior tranches are held by major investment banks such as Citigroup (C), Merrill Lynch (MER) and Lehman Brothers (LEH). These tranches were harder to market due to their lower interest rates. The majority of bank CDO write downs were in the super-senior tranches. The super-seniors do have special privileges in the CDO trusts. When a triggering event occurs, the super-senior can call for acceleration or complete liquidation. Triggering events include both ratings downgrades and a threshold of delinquencies.
Acceleration is the option to redirect all cash flows to the senior tranches until they are fully amortized. American International (AIG) Group felt the pain of acceleration in its $5.9B write down. Some banks have opted for liquidation to stop the pain. However liquidation can lead to losses of up to 40%.
Not all CDO trusts are crystal clear on senior rights, leaving the door wide open for litigation. Deutsche Bank (DB) and Wells Fargo (WFC), as trustees, have sued to ensure payments continue for certain tranches. During the boom, little attention was paid to clauses pertaining to events that should never happen.
Disclosure: Author is long C and WFC.
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