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.