A Tour of Structured Finance Products: The Good, Bad, and Weird
Book: Structured Finance and Collateralized Debt Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6
Chapter 15 is Tavakoli’s guided tour of structured finance products that didn’t quite fit into earlier chapters. Some of these are legitimate tools with real uses. Some are dangerous. Some are just strange.
Multisector CDOs: CDOs Squared and Cubed
CDOs-squared (CDO2) are CDOs backed by tranches of other CDOs. CDOs-cubed go one level deeper. These appeared in 1999.
The logic for legitimate versions: investors who had accumulated CDO positions wanted to securitize those positions to get capital relief or achieve specific ratings.
The abuse: banks and investment banks stuffing unsellable mezzanine tranches of their CDOs into a new CDO-squared, wrapping the whole thing with a monoline guarantee, and selling it to investors who couldn’t possibly price what they were buying.
Tavakoli is direct: “These deals are nearly impossible for sophisticated investors to fairly value, and they are not worth the work. Many of these deals seem to have been constructed solely to offload the risky CDO tranches.”
If you ever see a deal whose collateral is itself mezzanine tranches of subprime-backed CDOs, that deal is complex enough to hide almost any amount of risk. Walk away.
Future Flows: Payment Rights Securitizations
This one is actually clever and has genuine use cases.
Banks in emerging market countries like Turkey can do export businesses that generate foreign currency receivables. These receivables pass through international correspondent banks before reaching the local bank. By selling the rights to those future foreign currency flows to an offshore special purpose vehicle, you can potentially get a higher rating than the sovereign rating of the country where the bank is based.
Vakif Bank in Turkey was rated B by Fitch. Turkey itself was rated B. But Vakif’s payment rights securitization got a BBB rating because the cash flows were captured offshore before they ever touched Turkish soil.
Tavakoli spends time on the caveats, and she is not kind about how rating agencies handle political risk. Her basic point: if you are relying on a rating agency to assess whether a government will seize your assets during a political crisis, you are relying on people who are guessing. The rating agency’s “expertise” on political stability often amounts to visiting a luxury hotel in the capital city and concluding things seem stable.
Her rule: treat these transactions as their own category. Use common sense and good documentation. Don’t just trust the rating.
Constant Proportion Debt Obligations (CPDOs)
ABN AMRO launched CPDOs in summer 2006. The pitch: yields like junk bonds, safety like U.S. Treasuries, AAA-rated.
The reality: a leveraged bet on credit default swap indexes, leveraged up to 15 times. The AAA rating was misleading from the start.
Tavakoli wrote to the SEC in February 2007 warning about CPDOs before they imploded. Her letter was the first one the SEC posted on its website in that comment round. In it she recommended revoking the NRSRO designation from rating agencies for structured finance products.
The structural problem with CPDOs: they sold protection on credit index rolls every six months. Every roll created mark-to-market risk. Front-running by hedge funds was essentially guaranteed. High leverage meant any credit spread widening could wipe out principal quickly. And the product’s high yield was funded by that leverage, not by any genuine safety margin.
By late 2007 it was clear principal losses would occur, exactly as she had predicted.
Constant Proportion Portfolio Insurance (CPPI)
CPPI wraps a risky product inside a zero-coupon bond to make it look principal-protected. You put 75 cents into a five-year zero-coupon bond that grows to par. You invest the other 25 cents in something risky like a leveraged super senior.
If the risky piece loses everything, you still get your principal back at maturity. Safety!
Tavakoli’s objection is not that the principal protection is fake. She acknowledges it works if you hold to maturity. Her objections are:
- The product is opaque and used as a parking lot for risky investments that couldn’t be sold any other way
- If you sell before maturity you lose principal
- Over five years you could have invested in T-bills and earned more with full liquidity
Managers describe CPPI as “dynamically hedged,” which she translates as “death by one thousand cuts” on liquidity and interest earnings.
Hollywood Funding: When Insurance Is Not a Guarantee
Lexington Insurance, an AIG subsidiary rated AAA, issued insurance contracts to provide credit enhancement for Hollywood Funding deals 4, 5, and 6. These CDOs were supposed to be backed by future revenues from movies that would be made.
The movies were never made.
Lexington’s position: we wrote an insurance contract, not a financial guarantee. Insurance requires an actual loss to occur before payment is due. Since no films were made, no revenues existed, no loss occurred, therefore no payment.
Investors who had bought the AAA-rated notes found out the hard way that an insurance contract is not the same as a financial guarantee. S&P downgraded the deals from AAA to BB.
The broader lesson Tavakoli draws: never treat a rating agency rating as assurance that the documentation is legally sound. Rating agencies don’t take losses. Investors do.
Transformers: The Toy That Doesn’t Transform
A transformer is an SPE set up by a multiline insurance company to act as a counterparty in credit default swap contracts. The idea is to let insurance companies participate in the CDS market while giving CDS buyers the contractual protections they expect.
Tavakoli tells a story about one of these. An investment bank sent her a two-page document asking if her bank would intermediate a transformer transaction. Four guys in excellent suits showed up to persuade her.
She declined, and she explains why clearly. The SPE’s only asset was an insurance contract. If a credit event occurred, the SPE could only pay after the insurance company resolved its own claim through whatever process it followed, potentially including bankruptcy proceedings. The SPE had no way to make a timely payment under credit default swap terms.
The investment bank was offering standard CDS intermediation fees while asking her to take the timing risk of the insurance company’s payout process. She passed on that.
Life Settlements: Gaslighting on SEC Letterhead
This section is uncomfortable in a different way.
In 2004, a salesman approached Tavakoli about a life settlement product. He wanted her to help find a $100 million credit line for a fund buying rights to life insurance death benefits from terminally ill or very elderly people.
Life settlements are legal. The underlying concept has genuine uses, especially for people who need cash and have life insurance policies. The problem with this specific fund was everything else:
- 12.5 percent up-front fees
- The CEO had no experience with these products
- The CEO’s previous fund was under SEC investigation for a “Ponzi-like scheme”
- Non-arm’s-length agreements and conflicts of interest throughout
- Investors could lose their entire investment and still owe more money in premium payments
The salesman kept invoking the SEC’s name. The fund was registered with the SEC. The prospectus was on the SEC’s website.
Tavakoli’s clarification: the SEC does not endorse or validate investments by posting their documents. Anyone can post documents on the SEC website. The SEC steps in only if there is an actual securities law violation after the fact.
The technique of implying SEC sponsorship is called gaslighting. It worked on plenty of other potential investors.
Special Purpose Acquisition Companies (SPACs)
SPACs give managers a blank check. Investors put in cash. The manager goes find something to acquire. The quality of the investment entirely depends on the character and competence of the manager.
Tavakoli’s point is that all companies have some element of this. You trust management to allocate capital well. When management’s interests are clearly aligned with shareholders – Berkshire Hathaway is her example – that trust is warranted. When they aren’t, it isn’t.