Junior Tranches First in Line

It’s not just random Americans getting hit with gotcha fees and term changes that could use a “vanilla contract”, check out this amazing story:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

The moves are unusual in that the most senior creditors are typically the first in line to get paid. Fitch analyst Karen Trebach said the use of reserve funds may help cause or add to losses for holders of the CDO’s remaining classes.

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Here’s FT Alphaville:

In short, Goldman Sachs paid off (at face value) some junior tranches of two CDOs — Abacus 2006-13 and Abacus 2006-17 — at the expense of senior tranches.

That’s a practice virtually unheard of in CDO circles — and is extremely surprising given that one of the basic ideas of structured finance is to have clear and legally-binding payment waterfall structures. Holders of the A tranche get paid first out of available CDO cashflows, followed by the B tranche and then the equity tranche, etc. But the documentation for the two Abacus deals seems to have allowed the issuer (Goldman) to use its “sole discretion” to redeem the notes without regard to seniority.

The FT Alphaville article has a lot more in it. Keep an eye on this story, it’s fascinating. If only there was more financial literacy available to these people, perhaps they would have understood what they were signing. Or perhaps these contracts are in such a state that they are virtual handshakes and a wink, things that could read 12 different ways depending on how useful it is to cooperate at any moment.

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4 Responses to Junior Tranches First in Line

  1. Darius says:

    Ha ha. What’s wrong with a handshake and a wink?

    The abject failure of the supposedly-financially-literate to stop screwing each other before it was too late was going to be the centerpiece of a snarky comment in the “Who Owns Fin Lit?” post, explaining what a thoroughly pointless question that was, and why “financial literacy” is such a red herring. But you said you wanted to table the “serious debate” so I refrained.

    For the record, I don’t think Willis goes near far enough. “Financial Innovation” isn’t just incompatible with efficient division-of-labor/distribution-of-expertise, and it doesn’t just create a principal/agent problem from hell. It guarantees that even the best-case scenario is a lemon market. If a product can be made arbitrarily complex, the producer’s marginal cost of increasing information asymmetry by obfuscating, altering, redefining, or simply refusing to disclose indicators of quality is always going to exceed the buyer/consumer’s marginal cost of reducing asymmetry by acquiring, maintaining, and applying the expertise necessary to perform an appraisal of the product. And we don’t have to argue about whether producer/suppliers have an incentive to increase aymmetry, do we?

    I think the far more damning paper is the one about the Computational Complexity of Derivatives (http://www.cs.princeton.edu/~rongge/). Also some potentially relevant (though utterly unsurprising) purely theoretical stuff from a different field altogether. Some folks at Max Planck have been demonstrating that robust unstable attractors are not just possible, but common, in certain types of synchronizing networks. Which happen to be somewhat similar to financial markets (see http://www.nld.ds.mpg.de/~timme/ for some of the papers) though I don’t think they mention that.

    The idea is that when there’s even a very small amount of noise present, catastrophic collapses (desynchronization events) of the kind which have been historically observed in financial markets, are “robust.” Meaning they’re a predictable, recurring feature of that type of system, rather than a transient anomaly, or a feature of only particular instances of such a system. I’m pretty sure that if financial literacy had anything to do with it markets wouldn’t still be blowing up in our faces.

  2. Another crack in the facade of trust built over structured finance. Nobody asks ‘why?’ If a hedge fund crashes in the forest and no one is around to hear, does in make a sound?

    Chalk it up to simple greed … that isn’t a good enough answer. The rats are cashing out of a sinking financial ship, leaving the suckers to drown.

    well … the seniors can go to court and attempt to alter reality. Waste of time …

  3. Seth says:

    Speaking of a hypothetical world in which there were regulators who considered it their job to regulate and had the budget and ambition to undertake it: doesn’t this violate the accounting rules which allow Goldman (or others packaging CDO) to treat the SPV as ‘independent’ and therefore OFF balance sheet?

    Returning to planet Earth — I’d love to understand the motivation. The junior holders were extra-special friends of the firm? Is there some linkage where making one or more of the juniors whole would in turn improve Goldman’s balance sheet via some other transaction?

    Sorry, I guess that would involve regulatory curiosity as well. I’m just off-world today.

    • Not the Mike You're Looking For says:

      Seth,

      The junior holders *were* the firm:

      (From the linked story:) “The derivatives were intended to pay off a Goldman Sachs unit if commercial-mortgage bonds defaulted.”

      My first thought was, “Why would GS do this? It’ll ruin their reputation, and they won’t get any future business.” Then, my second thought was, “Hahahahaha, where are these customers going to go? Bear Stearns? Lehman Brothers?”

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