Zombie Securitization Market (and other bad metaphors)
Securitization refuses to die. Bloomberg is reporting that Morgan Stanley is planning to breathe new life into a recently downgraded CLO originally packaged by Goldman Sachs in 2007. Some key details are lacking in the Bloomberg piece, but here’s what I can piece together from the article and some other digging. I’ll do my best to put it in plain English so you can see how (I think) this works.
Quick Primer on Securitization
In 2007, Goldman securitized a basket of $502 million of secured corporate loans. What I mean by “securized” is that Goldman sold the loans to a special-purpose legal entity called Greywolf CLO I, which financed this purchase by issuing $502 million in securities backed by those loans. So basically, Goldman sold the loans to a special legal entity that it created (for a fee), which sold interests in those loans as an investment product to a bunch of investors (probably mostly institutional investors like pension funds and maybe some hedge funds).
Now, the securities issued by Greywolf are not all samey-samey (or “pari passu” in the jagon). One (or more) batch of securities (“tranches” in the jargon) were designated to be first in line to absorb any losses on the loans (“subordinated” in the jargon) and hence more-risky. This of course is by design. Because of the presence of these more-risky subordinated securities, the rest of the securities are somewhat protected against those first losses (“senior” in the jargon), and hence are less risky.
How do we know how risky the senior and subordinated tranches are? This is where the rating agency comes in. For a fee, the agency will take a look at the portfolio of loans and the relative sizes of the tranches (that is, how much first loss protection is absorbed by the junior tranches), do some fancy math, and presto! They have their ratings. The senior tranche gets rated super-safe (“AAA”) and the subordinated stuff gets rated not-as-safe. Now again, this is all by design. Goldman, like the rating agency, has it’s own fancy mathematical models to figure out how big the subordinated tranches have to be in order to just barely get the top AAA rating for the senior tranche. What’s more, they probably repeated the process on the subordinated tranches—slicing them up so that some bits are kinda-safe (“investment grade”) and the ugliest bits are absolute garbage (appropriately called “junk,” or in the more colorful language of this crisis “toxic waste”). That part’s not so important right now. What you need to know is that Goldman (for a fee) chopped-up a portfolio of corporate loans into more-safe and less-safe bits, and sold off those bits to investors in the form of rated (again for a fee) securities. That’s securitization.
[NB: More specifically, it’s a CLO or Collateralized Loan Obligation, a kind of loan securitization.]
What Morgan Did
So far, we’ve only been addressing Goldman’s original securitization of the loans, which took place in 2007. Fast forward to 2009. In June of this year, the rating agency that had originally rated the senior tranche AAA back in 2007, reassessed this rating and downgraded the senior tranche to a lower rating (A3, which is still in the investment grade category, but much less desireable than AAA). Times have changed, and the securities that the agency ostensibly thought were super-safe in 2007 are now considered only sorta-safe.
Investors love AAA securities like Garfield loves lasagna. They can’t get enough. But the securities originally sold in 2007 are no longer AAA. The lasagna went bad. Enter Morgan Stanley. Morgan sees in these Greywolf securities an opportunity to do something very similar to what Goldman did with the basket loans in the first place. They can buy-up the spoiled senior securities originally issued by Greywolf, sell them to a special-purpose entity, and sell-off new tranches of securities backed by the once-AAA (now A3) Greywolf senior securities. Just like what Goldman had done in 2007, they can do some math to find the magic level of subordination required to mint a good chunk of brand-new AAA securities out of a bigger chunk of now-lesser-rated old Greywolf securities. That is, they take some of the spoiled lasagna, scrape off the bad layer and sell the rest of the layers as a good-as-new (if smaller) piece of pasta. Oh, and they sell the bad layer too. This is re-securitization.
Why Do I Care?
The Bloomberg article gives off the impression that Morgan’s “first of its kind” transaction to repackage an underperforming CLO security is something innovative. In my opinion, it’s not. Resecuritizing CLOs (or pieces thereof) is basically a copy-cat of the outstanding practice of resecuritizing other types of securitized products, such as mortgage securitizations (e.g. REMICs). And resecuritization in general is basically a re-hash of the idea that gave rise to securitizing the original loans/mortgages/etc. in the first place. There’s nothing groundbreaking here—at least not from what I read in the Bloomberg article.
What’s interesting to me about this story are two things. For one, it tells me that investors still have an appetite for newly minted securitized products. I had thought investors no longer trusted securitization. The conventional wisdom for at least the past two years seemed to have been that the models used to structure the deals were broken and/or based on flawed assumptions, that the underlying assets were worse than advertised, and that the ratings agencies were either complicit in deception or simply incompetent. I had thought that securitization—as a process by which risky loans could be classed-up into AAA bits, less-than-AAA bits, and dreck—was dead and burried; that we had seen the last such deal to be birthed and were simply waiting for the inevitable extinction of the species as deals were unwound or died of natural causes. But this deal tells me there is some activity still going on and that investors are still willing to buy newly AAA-stamped products. Is the trust back?
For two, the article is just an interesting story of Wall Street one-upsmanship. Goldman created the structure in 2007, and Morgan subsequently pinched the restructuring job from under their noses when an opportunity arose after the June downgrade. Morgan doesn’t have any special sauce here. Anyone capable of doing a CLO deal could have done it. And who knows; maybe others were trying? But Morgan moved fastest. I wonder if Goldman isn’t a bit embarrassed.
