Tranche Retention in the sub-prime CDO Market

Bloomberg has a fascinating story today titled How Lou Lucido Let AIG Lose $35 Billion With Goldman Sachs CDOs.

Without having to ask AIG’s permission, firms such as TCW, hired to oversee funds called collateralized debt obligations, replaced maturing assets with junk that quickly went bad. Managers including Lucido said they didn’t realize how severe the mortgage crash would be and were called upon by CDO contracts to reinvest. At the same time, buying riskier assets could mean bigger paydays.

Lucido’s team, following criteria set by [under-writer] Goldman Sachs, changed almost one-third of the collateral in Davis Square III after the CDO’s creation in 2004, according to data compiled by Bloomberg from Moody’s Investors Service reports. The securities were mostly backed by the types of newer loans that are going bad at more than twice the rate of older ones. By November 2008, after U.S. taxpayers rescued AIG with a bailout that later swelled to $182.3 billion, even the highest-rated parts of Davis Square III had lost almost half their value.

When the Financial Products unit agreed to guarantee certain top-rated CDO pieces, it didn’t envision that assets added later could cause losses, according to a person with knowledge of AIG’s thinking who spoke on condition of anonymity because he wasn’t authorized to comment.

As long as managers adhered to investment criteria outlined in the prospectus, there was little AIG could do, according to Mark Herr, a spokesman for the insurer.

The tiniest slice, less than 1 percent in the case of Davis Square III, was made up of what’s called equity, which wasn’t rated by credit companies. Equity investors were paid only after everyone else. They received a higher return while the going was good because they took the most risk and were the first ones wiped out if borrowers quit paying their mortgages.

While Lucido said he didn’t own a stake in Davis Square III, he said he did have his own money riding on the equity pieces of some CDOs.

Goldman Sachs did own an equity stake in Davis Square III, according to Michael DuVally, a spokesman for the firm, who declined to say how much it was. Even so, the bank didn’t try to influence TCW’s investment decisions, DuVally said.

It didn’t have to. TCW was promised 20 percent of what was left over after equity investors got 10 percent returns, according to a Goldman Sachs sales pitch to potential equity investors dated September 2004. That was on top of its fee of 0.10 percent of the CDO’s assets, according to the prospectus.

[Andrey Krakovsky, chief investment officer at New York-based asset manager Tacticus Capital LLC,] said managers often owned equity pieces of CDOs and earned fees linked to their returns.

More than $16 billion of CDOs managed by TCW have defaulted, been liquidated or stopped paying some investors, according to RBS Securities Inc.

TCW now finds itself defending Gundlach’s team at the same time it’s suing him for having “no understanding or respect for the obligations of a fiduciary,” according to a complaint filed Jan. 7 in Los Angeles Superior Court.

It is unfortunate, but nowhere does the article discuss the track record records of the managers of these CDOs. Like so much other smiley-boy stuff, it prefers to talk about “experience”.

However, my point in highlighting this article has more to do with tranche-retention than investment management. Tranche retention has been both disparaged and and praised as a method for encouraging investment managers to think about what they’re doing; this article represents another small, but useful, point against the concept.

One Response to “Tranche Retention in the sub-prime CDO Market”

  1. […] so hard for me! Assiduous Readers will know that CDOs have been in the news quite a lot lately:Tranche Retention in the sub-prime CDO Market, The Story of the CDO Market Meltdown and Hull & White on AAA Tranches of Subprime. In the […]

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