Liquidating

LIQUIDATING….Earlier this week I was musing about the problem of valuing all the CDOs and SIVs that are at the core of the subprime/credit crisis. It’s certainly true that if no one is confident about how to value these instruments then the market for commerical paper freezes up, causing the broader financial markets to freeze up in turn. But the reason I was puzzled about this is that CDOs are collections of underlying securities, and if push comes to shove you can always unbundle the CDOs and put the underlying stuff on the market. It’s not pretty, but it would be a way to put a value on everything.

Today, via Atrios, we learn what happens if you announce that you’re going to do exactly that:

[Standard & Poor’s] said it slashed its ratings on Carina CDO Ltd’s top tranche of securities by 11 notches to the junk level of BB from the top-notch triple-A after it received a notice on Nov. 1 saying that the controlling noteholders had told the trustee to liquidate.

….The trustee of the Carina CDO has started selling the asset-backed securities — residential-mortgage backed securities and CDOs — making up the CDO at the direction of the structure’s noteholders, S&P said.

….The ratings cut on the Carina CDO is more severe than would be justified by the deterioration of the underlying assets because a decision to liquidate would depress prices and affect all notes that were issued, S&P said.

Italics mine. Like Atrios, I don’t really understand exactly what’s going on here. But it sure sounds like S&P is sending a message to anyone else who might be thinking of liquidating a CDO and thereby revealing what the underlying assets are really worth. Are they really that scared? Any experts care to weigh in on this?

UPDATE: Tanta from Calculated Risk doesn’t quite answer all my questions (who could?), but in comments she answers some of them:

The really relevant bit is this: “after it received a notice on Nov. 1 saying that the controlling noteholders had told the trustee to liquidate.”

CDOs are not in the normal course of events managed by “controlling noteholders”; they are managed by a portfolio manager on behalf of the noteholders. However, lots of these deals have verbiage in the deal docs that say if certain “trigger events” happen (usually, there is insufficient credit enhancement for the senior noteholders in the form of overcollateralization), the senior noteholders can take control of the thing from the portfolio manager. (They then become the “controlling class.”) They can decide whether to keep the deal going, if it’s passing through any cash flow at all, or they can decide to start liquidating.

Thing is, in a nutshell, as soon as you have any decision made by a controlling class, you already have a CDO in big trouble, because it’s already gotten to the point where the noteholders took over from the manager, and this probably happened because the deal isn’t generating enough cash flow to fund its required overcollateralization. So it’s not like any old CDO selling assets, it’s like a CDO that has already be repossessed by its noteholders selling assets. Of course, it’s possible that the original deal underwriter is also a senior noteholder and therefore part of the controlling class. If that is so–I’d have to look it up for this deal–then there’s really the potential for a nasty conflict of interest.

The other pertinent language is “a decision to liquidate would depress prices and affect all notes that were issued.” The stress on “all notes,” not “depress prices.” The senior noteholders are supposed to have the right to take control in order to protect their interests (one of the perks of being in senior position). You expect a liquidation to hurt the junior noteholders more than the seniors. If, however, this action really is driving down the price of the senior notes, not just the juniors, then something very curious is going on. The rating agency may be reacting to a really badly written deal document that gives “controlling class” rights to someone with interests that are not really aligned with the rest of the senior noteholders. This can also mean that somebody didn’t hedge a position as advertised, leaving no choice for the controlling class but to liquidate even when it would do better by allowing the deal to continue to cash-flow.

It is a long explanation and it’s hard to put in a nutshell. That is why your basic business press doesn’t even try to explain it, and ends up writing articles that confuse everybody.