Taking out the leverage

The FT has an article today on re-equitisation. The basic idea is that some assets can be structured in such a way as to generate a bond-like series of cashflows, but rather than tranching them into a true bond plus a residual, it can make sense to treat the whole investment as an equity. The key advantage is flexibility: you don't have to worry about bond defaults if things go badly, giving you more freedom to wait out problems.

The private equity industry has known this for a long time. By structuring an investment as unlisted equity, they have been able to take advantage of good opportunities with uncertain payback horizons. The example the FT cites is a real estate investment, an area which has not historically been favoured by private equity, but these are new times. (Another area where equity like financing is preferred is of course sharia-compliant finance, but that is another story.)

Reequitisation, then, is a logical trend. After the recent turmoil, many investors would be happy with boring, safe investments that beat cash. If zero or low leverage equity investments in cash cow assets provide that, then for a while at least, investors will be buying them with alacrity.

Update. There is an article with a similar theme, albeit dressed up in rather grandiose language, in the FT.

Understanding ABS

The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:

It's important for people to realize that the credit crunch was not caused by securitization -- it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.

It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.

Another key issue is that people didn't - and to some extent still don't - understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.

AAA to A3 check, 2/3 A3 to AAA mate

Sorry, I couldn't resist the bastard cross of chess and bond ratings. Let me explain. Once upon a time there was a leveraged loan CDO arranged by Goldman called Greywolf. Greywolf, which sounds like a monster who wants to gobble up your money, was in fact a monster who wanted to gobble up your money. In the fullness of time, the AAA tranche was downgraded to A-, or A3 in Moody's speak. Now, according to Bloomberg, Morgan Stanley is doing the Re-REMIC (aka CDO-squared) trick on the Greywolf AAAs. That is, they are buying the AAAs into a SPV and issuing two tranches of notes on the other side, a CDO-squared structure. Bloomberg suggests the tranching is roughly two of AAA to one of Baa2.

My only question, really, is if these new bonds are downgraded too, will someone else step in and ReRe-Remic them?