As of March 31st, S&P reported 141 CDO events of default with all but two coming from the 2006/2007 vintages. By volume, US$157bn or 44% of 2006/2007 CDO issuance is in technical default.
According to S&P, thirteen CDOs are reportedly now in liquidation, while fifteen deals have already been liquidated. A total of 8% of 2006/2007 issuance is in some form of liquidation (14% mezzanine, 4% high grade and 12% CDO-squared). Those in the acceleration phase tally 16% (27% mezzanine, 11% high grade and 6% CDO-squared). CDO squared deals are those CDO deals that invested in other CDOs. Just think Jurassic Park and you’ll have it about right.
S&P said that liquidations would probably start to increase, and that structured finance CDOs and CDO-squareds from 2006 and 2007 are “the most vulnerable” to events of default (yet more reason to stick with seasoned Mortgage REITs) and possible liquidation following an event of default. Liquidations would be the end of the line for these troubled CDOs.
S&P’s report was prompted by a ratings action which lowered the ratings on 33 classes of notes – worth US$3.6bn – from across four ABS CDO transactions to single-D (far below CCC, the dreaded “triple hook” for investors), following news that the trustees had liquidated the portfolio collateral and have distributed or are in the final stages of distributing the proceeds to noteholders.
What is most interesting with respect to Alesco (AFN) is that S&P said the trustees for the four CDOs do not anticipate that the proceeds from the sale of the collateral (including the principal collection account, any proceeds in the super-senior reserve account, the CDS reserve account, etc.) will “be adequate to cover the required termination payments to the CDS counterparty, and that it is likely that proceeds will not be available for distribution to the notes junior to super-senior swap in the capital structure of the CDO transactions.” Hence the downgrade to single D.
While this structure is a little different than the Alesco CDOs, “super senior” means just that, and the trustees are not only indicating that the sale proceeds will be insufficient to make distributions to anyone junior to them, the text of the trustee’s notice also indicates that there may not even be enough value in the collateral to satisfy the capital structure’s king of the hill!
The fact that Alesco’s REIT status is at risk is really not news. Alesco has been relying on its Kleros CDOs to help satisfy its REIT qualification tests, and their default has put that qualification test in doubt. To say that the issue dominated the discussion during last quarter’s conference call with management would not be an overstatement.
AFN management also indicated during that call that continuing to meet the REIT classification would not be an issue, and that they were working on ways to replace the Kleros income. However, increasing rates of liquidation would finally put these crippled CDOs out of their misery, and it puts Alesco in an increasingly hot foot race with the Kleros noteholders and their lawyers.
Maintaining REIT status is important to investors because it requires those entities that claim it to distribute a minimum of 90% of taxable gross income to shareholders. The REIT laws were developed by the Treasury to encourage capital formation around housing and commercial real estate, and it rewards this by not taxing REITs at the corporate level. Zero taxes.
In return, REITs must derive 95% of their gross income from “real estate related activities”. Real estate related activities has recently meant a lot of different things to a lot of different people, but to AFN it included the income on the spread between the assets held in the Kleros CDOs and the cost of servicing the Kleros notes paired to them.
Well, as it turned out there would be very little income generated by the Kleros assets. What remains is now being diverted to the senior noteholders, away from AFN, so there is no spread to collect, and the note holders – through the Kleros trustee – have declared an event of default on the notes for failure to meet the over-collateralization tests. The note holders do not have any recourse to AFN, so AFN’s exposure is limited to its own net investment, which it has already written off anyway.
The Alesco story is nothing if not intriguing, and I would say it is one of the more interesting shows going on in the REIT world right now. It is run by the Philadelphia-based Cohen family, who run a veritable MacDonald’s Farm of CDOs through the family of REITs they control. They have an experienced, qualified, and capable team, and to varying degrees they have also put their money where their mouth is with significant insider purchases. However, an even more significant insider purchaser pattern persisted at Thornburg Mortgage (TMA), and not even that commitment could prevent management’s stakes from being vaporized into their worst dilutive dreams.
Also, as I wrote in an earlier article, the mark to market write downs on AFNs assets alone have been so substantial that just by adopting FAS 159, which AFN plans to do, AFN would add approximately $2.7 billion in GAAP book value, or $45.03 per share, to stockholders equity. Much of that comes from writing down the liabilities paired with the already cratered Kleros CDO assets that are the subject of this post. Some of it also comes from investments in Trust Preferred’s issued by regional banks and mortgage lenders, and that part of the portfolio may be the next shoe to drop.
Ignoring the Trust Preferred issue (some TruPs were bought from regional banks with heavy exposure to local home builders), there may be about $6-$7 dollars in GAAP book value left when all is said and done. Because AFN’s assets are almost all match funded with long-term, non-recourse debt, what value remains continues to be safe from margin calls.
Nevertheless, because REIT status guarantees that investors receive the majority of taxable income generated by those assets, however meager they may be in AFN’s case, most investors do not underestimate the claim on earnings that REIT status affords them, and nor should you.
If, as S&P postulates, the risk of CDO liquidations is rising and that the 2006/2007 vintage CDOs are the most vulnerable, this would put the Kleros family of CDOs in an increasingly tenuous position. Because the noteholders are taking the trouble to liquidate these CDOs regardless of the value of the collateral, it heightens the risk of AFN losing its REIT status by eliminating its last “practical” line of defense against a total Kleros liquidation, which is: why would anybody bother?
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