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Joshua Siegel is bringing back a version of one of the most toxic financial vehicles ever devised and arguing that this time it’s going to be different.
His StoneCastle Financial is among the funds that are reviving the collateralized debt obligation, or CDO.
CDOs stuffed with mortgages and their derivatives caused billions in losses around the world during the 2008 crisis. The CDO that StoneCastle put together is another kind. It’s backed by subordinated debt issued by about 35 community banks, some of them so small they don’t have credit ratings. Subordinated debt is paid off last in a bankruptcy, so issuers typically compensate buyers with higher yields than on other borrowings.
Citigroup Inc., which completed the $250 million deal for New York-based StoneCastle this month, calls it a collateralized loan obligation, but it’s a structured security that walks and talks like a CDO. Moody’s Investors Service plans to give it a rating of A3, six grades below Aaa, according to people with knowledge of the deal. Bank bonds rated A typically yield 2.5 percent. Through the wonders of financial engineering, StoneCastle’s Community Funding CLO yields 5.75 percent.
“A CDO is just another word for financing,” Siegel said in an e-mail. “What matters are what assets are being financed.”
This isn’t the first time Siegel pooled small-bank debt into a structured financial product. At Salomon Smith Barney in the late 1990s, he proposed bundling banks’ trust-preferred securities, a predecessor to subordinated debt, into so-called TruPS CDOs. Geographic Diversity
In a 2001 research report, Siegel divided the U.S. into five regions and wrote that the geographic diversity of the banks whose TruPS he used -- picking debt from different areas -- would make the CDOs safer.
Sales of new TruPS CDOs multiplied in the next seven years by a staggering 7,722 percent, rising to issuance of $60 billion by 2007, according to the Federal Reserve.
In all, Siegel said he put together about 13 TruPS CDOs. “There was a cult following,” he said.
But banks failed all over the country in the 2008 credit crunch, throwing shade on Siegel’s original theory about regional diversification. Larry Cordell, a vice president at the Federal Reserve Bank of Philadelphia, said that’s because too many banks’ portfolios were concentrated in real estate and mortgages. They weren’t diversified enough, he said. The market for TruPS CDO collapsed. Some investors are still waiting to be repaid.
Today’s CDOs are a better bet because the banks have learned from the credit crunch. They’re stronger, with more capital and better regulation, Siegel said in an interview.
Because of tougher capital requirements and tighter oversight in the wake of the 2008 crisis, widespread bank defaults would seem less likely, said Ricardo Diaz, head of fixed income for Atlanta-based investment manager FIG Partners.
TruPS issuance has fallen to zero while publicly traded banks sold $12.3 billion of sub-debt, as it’s called, in 2013, about four times what they issued between 2009 and 2012, according to SNL Financial. Brett Jefferson, president of Hildene Capital Management in Stamford, Connecticut, said that sub-debt CDOs are simply a retooling of TruPS CDOs. “It’s a flavor of the old deals,” Siegel said.
TARP Exits
The popularity of sub-debt among smaller banks has been sparked partly by the U.S. Treasury Department’s Small Business Lending Fund. Starting next year, banks remaining in the program will see their rates jump to 9 percent from a borrowing rate of as low as an initial 1 percent. The fund loaned $2.7 billion to 137 community banks, which were supposed to use the money to increase their small business lending. Instead, many of the participants used it to pay off debt from the Troubled Asset Relief Program, according to TARP’s special inspector general.
The Fed is also doing its part to make sub-debt attractive to banks. Aside from low interest rates, the central bank has said sub-debt can be categorized as regulatory capital, the cash cushion all banks need to keep to stay in compliance post-crisis regulations. And the interest is tax deductible for the smallest banks.
Another sub-debt CDO is being put together by Emanuel “Manny” Friedman, co-founder and chief executive officer of EJF Capital in Virginia.
EJF’s CDO
EJF’s CDO would be tied mostly to recently issued sub-debt of community banks and bank holding companies for more than 20 community banks, according to people with knowledge of the offering.
The strength of the securities rests on bank credit profiles that EJF, underwriter Sandler O’Neill & Partners and Moody’s, which is rating the deal, are not broadly disclosing.
EJF didn’t return calls and e-mail messages seeking comment. Calls to Angel Oak Capital, which is helping to pool the underlying assets, were not returned. Sandler O’Neill declined to comment.
Moody’s plans to rate the senior notes Aa2, two levels below its highest grade. Moody’s spokesman Thomas Lemmon said a strength of the transaction is that EJF and Angel Oak are retaining the most risky 20 percent of the deal -- similar to the 18 percent that Siegel said StoneCastle was retaining of the Community Funding CLO.
“All the ingredients are there for it to expand into a larger market again,” Siegel said.
A friend brought this to my attention yesterday and my comment to him was that there is nothing intrinsically wrong CDOs, even CDOs comprised of the crappiest paper imaginable. The problem that caused the 2008 wipeout was that the creators of the crappy CDOs, abetted by the crooked ratings agencies, knowingly misrepresented the risks.
The "professional" money managers who were the buyers of those crappy CDOs played their role in the crisis by being so stupid and lazy (and perhaps corrupt) that they didn't do adequate due diligence to recognize that it was all a pile of garbage.
A friend brought this to my attention yesterday and my comment to him was that there is nothing intrinsically wrong CDOs, even CDOs comprised of the crappiest paper imaginable. The problem that caused the 2008 wipeout was that the creators of the crappy CDOs, abetted by the crooked ratings agencies, knowingly misrepresented the risks.
The "professional" money managers who were the buyers of those crappy CDOs played their role in the crisis by being so stupid and lazy (and perhaps corrupt) that they didn't do adequate due diligence to recognize that it was all a pile of garbage.
"they didn't do adequate due diligence to recognize that it was all a pile of garbage."
They didn't have to do anything, for many pensions the law said you can only buy AAA so they bought AAA. All part of FIRE perphaps? Rating agencies skated free, aren't they considered press? First amendment defense?
Stock symbols for Moody's mco and McGraw-Hill mhp tell the story....
I have no earthly idea. One of the side effects (or perhaps a primary effect) of the bailouts and quantitative easing is that it saved the careers of a lot of people who otherwise would have been shown to be utterly unqualified to manage money and would have had a difficult time finding work in finance, especially if the government reduced the size of the FIRE sector by letting firms run and staffed by idiots go bust.
I guess we'll have to wait and see if these guys have been chastened a bit since 2008. Even these bozos now know that financial instruments backed by the ability of deadbeats to make payments have a high propensity to blow up unless fully backed by the U.S. government. This is in stark contrast to what I've seen in real estate development and landlording, which appears to have been fully rescued thanks to all the money printing.
"they didn't do adequate due diligence to recognize that it was all a pile of garbage."
They didn't have to do anything, for many pensions the law said you can only buy AAA so they bought AAA. All part of FIRE perphaps? Rating agencies skated free, aren't they considered press? First amendment defense?
Stock symbols for Moody's mco and McGraw-Hill mhp tell the story....
They didn't have to do anything? Maybe in their minds but not reality. If I had that kind of attitude, I would just accept the rating of any sell side Wall Street analyst and buy stocks they that issue a "Strong Buy" recommendation on. I seem to recall Enron had a lot of strong buy recommendations.
The people managing the pension money should have taken the universe of AAA rated securities, evaluated them on their own (isn't that what these high-priced jackanapes are paid for?), and then bought only those securities that their own analysis told them were investments that would give a reasonable return.
The dishonesty and corruption in the bond markets defies belief at times. I learned a few years ago that money my grandfather had saved for his retirement was, over decades, constantly put into munipal bonds recommended by a broker that would ultimately default. And this occurred during the greatest bond market in living memory: starting in 1982 or so when my grandfather retired. I'm sure the broker made out like a bandit slinging trash to my grandfather. I will give the broker some credit for not utterly wiping out my grandfather. Nominally, he made roughly a 0% return over decades. However, had he just bought U.S. Treasury bonds and continued to reinvest them when they matured, he would have easily made a nominal 200% or so return.
As the market recovers and UST yields declines the depth and breadth of the credit markets expand further out the yield curve.
The very nature of the expansion means riskier and riskier instruments.
This instrument is simply part of the game.
Agreed. It's going to be interesting to see how junky the assets in the CDOs are, what kind yields the CDOs offer, and the story behind the CDOs to try to get their prices up. I somehow doubt they'll have as good a story as the debt of the companies that were drilling for hydrocarbons in the shale fields.
re: that they "should have taken the universe of AAA rated securities, evaluated them on their own", there really was little need. they bought the instruments because they offered higher yields. they offered higher yields because they were higher risk, and couldn't find buyers if they only matched the yields of instruments of intrinsically higher quality. they were AAA junk bonds, and the fakery of those AAA ratings was pretty obvious to anybody who cared to pay attention. certainly there were plenty of people, amateurs and not financial professionals, on this board who saw that the emperor had no clothes. the money managers were not incentivized to be careful. they were not incentivized to think about long term risks. all the incentives were for the next quarterly or annual bonus.
the reappearance of cdo's reveals we've taken another step towards another minsky moment. maybe ground zero won't be junk mortgages this time. maybe it will be junk corporate debt. but what are the odds that, fundamentally, "this time it's different"? i'm waiting for someone to say that the coming corporate debt collapse is "contained" to the energy sector.
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