Friday, October 16, 2009

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
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