ELF
Capital Management, LLC
(Endowment
Like Fund Management)
February
15, 2010
This is the ELF Capital Management, LLC Market Letter for the month ended January 2010. If you do not wish to be included in our circulation, please reply indicating your desire to be removed and we will be happy to oblige. Alternatively, any of your friends or colleagues may receive this on a regular basis by entering their email address on our list-server via this link. Feel free to forward this to any of your friends! Thanks for your interest and we hope you enjoy the letter.
Can CDO’s Revive the Global Economy?
CDOs –
those toxic concoction’s of “greedy Bankers” that nearly brought us to the
brink of Great Depression II. Could
they now be the best catalyst to grow the global economy? Are they really the evil brew that cast us
all close to the abyss?
Did you
know that the original construct for CDO securities emanated from creative
solutions that helped the
While
mortgage loans had been used since 1969 as collateral for the creation of
securities, popularly referred to as mortgage backed securities (MBS), it
wasn’t until 1982 that the first Collateralized Mortgage Obligation (CMO) was
conceived. “The CMO’s major financial
innovation, which is responsible for the rapid growth of this market, is that
it provides for redirecting underlying cash flows in order to create securities
that much more closely satisfy the asset/liability needs of institutional
investors.” – taken from my 1993 autographed book
by Dr. Frank Fabozzi on CMOs.
In early
1988 the US Treasury Department, together with Federal Banking Regulators,
began an earnest collaboration with a select group of Wall Street bankers to
save the economy from both the S&L and Latin American Debt crises. The offshoot of this collaboration was
creative innovations leveraging off of CMO technology – a second derivative
solution (see Figure 1 below). Not only
did the effort create solutions for the crisis at hand, these new innovations
had broader application at investment banks as well.
One of
those select investment bankers was a fellow from my former firm, Kidder
Peabody. It didn’t take long for Kidder
to see an opportunity to take this innovation further and on February 8, 1989,
Kidder launched the very first Collateralized Bond Obligation (CBO) backed by
high yield bonds. In June of that year,
I was hired into that unit and began to learn the “ins” and “outs” of CBO’s. I remember telling my wife, “honey, I’m
either going to become an expert in a dead language or be on the forefront of a
new industry”. A new industry it
was. By 1994, I held a leadership
position in that unit and we had created CBOs that were backed by “junk” bonds,
MBS and CMOs, and the last was backed by credit swaps linked to bank
loans. At the end of 1994, Kidder was
reorganized out of existence and I moved to
It came
with little surprise that the Collateralized Debt Obligation (CDO) business
went on to flourish with great exuberance.
Until greed, complexity and fear took hold and it flourished no
more. The innovation that had served
borrowers and lenders for almost 20 years now drew blame for bringing the
global economy to its knees.
Innovators, Imitators and Idiots
Leave it to
Warren Buffett, one of the world’s savviest investors, to characterize what
went wrong. In an interview during the
late fall of 2008, he gave a masterful explanation of how the world got into
this financial mess.
After being
asked, “Should wise people have known better?”
Buffett replied, “Of course they should have.” He then went on to explain that “there’s a
natural progression to how good ideas go wrong.” He called this progression the “three I’s”…
“First come
the innovators, who see
opportunities that other’s don’t. Then
come the imitators, who copy what
the innovators have done. And then come
the idiots, whose avarice
[insatiable desire for wealth] undoes the very innovations they are trying to
use to get rich.” In other words, it
wasn’t the CDOs that were the problem; it was the idiocy that followed that got
us into this mess.
While the
first CBOs were backed by “junk” bonds, the size of the high yield market and economic
opportunities – in terms of yield spreads – limited the ability to continue
issuing CBO securities from that market sector.
During 1991-1992, the focus then shifted from high yield bonds to
residential mortgage securities. Not
only was the mortgage market the largest sector of the world’s debt market, MBS
and CMOs were challenging for the average institutional investor to understand
and account for. The security selection
process and accounting for them was very tedious and burdensome.
In the
early 1990’s, CBOs backed by a portfolio of MBS and CMO securities
significantly reduced complexity rather than added to it. And, the two most prominent selling points
were that this type of CBO:
·
Served
as a starting point for investors not familiar with MBS investing. They offered investors a way to invest in
these assets without have to hire their own mortgage analysts. I.e., the CBO came with an outsourced asset
management solution.
·
Also,
CBOs reduced the administrative and accounting burdens of directly holding MBS
and CMO securities. The CBO issuing
company took on those tasks and simplified the effort by paying out interest
quarterly or semi-annually and returning principal at maturity. And, the CBO issuer reported its Net Asset
Value (NAV) on a monthly basis – so investors could have an idea of how secure
their principal was.
After
having created and managed dozens of CBOs in the early 1990’s, the product
still seems quite elementary to me. Yet,
I understand that they involve so many inter-related concepts that they are not
often simple to explain. So, what is a
CBO?
CBO’s 101
The first
thing to understand is that a CBO is a derivative security. For the sake of argument, let’s say that a
derivative is any security or financial instrument that either mimics or passes
along all of, part of or the inverse of
the economic opportunity of another security or financial instrument – call
options and put options are an example of this kind. Another type of derivative is one that
bundles the economic opportunity of two or more securities or financial
instruments – a convertible bond is an example of this type.
A
convertible bond is one that pays interest and returns principal at maturity,
like a typical corporate bond. Yet the
bond can also be converted into the issuer’s common stock. So, the bond’s pricing will be influenced by
either the greater of its yield to maturity relative to the market or the price
of the issuers stock net of any conversion costs.
When seeking to understand
any derivative instrument, the best way to start is to “break it down” into
smaller parts or concepts and then look at each part in isolation. Figure 2 above is an overview of the very
first high yield backed CBO. [Actually,
the first CBO did not have CDO Mezzanine Notes.
I added them for later discussion purposes.]
Next, let
me define some of the terminology:
·
Collateralized
Bond Obligation (CBO) – CDO Notes whose principal interest payments are backed
by a portfolio of Bonds (the Collateral);
·
Collateralized
Loan Obligation (CLO) – CDO Notes backed by un-securitized loan agreements
·
Collateralized
Mortgage Obligation (CMO) – Securities backed by mortgage loans
·
Collateralized
Debt Obligation (CDO) – a general term for all of the above. The term CDO was coined in the late 1990’s
after the above products went “mainstream”.
Referring
to Figure 2 above, we can begin to understand of how a fully managed CDO
structure is organized:
·
A
company is formed and it gets initial funding through issuing debt and nominal
equity – at this point, the CDO Notes come into existence (the Notes are
originated)
·
At
the same time, a number of service providers are hired to: A) invest and protect its assets; B)
administer its operations; and, C) report financial information to its share and
Note holders. (Each of the service
provider’s specific roles is depicted.)
Figure 3,
below, illustrates how the fully managed CDO company operates.
As mentioned above, the
life cycle of a CDO begins when the holding company is formed and issues CDO
Notes and nominal equity. From the
issuance proceeds, it pays for its initial organization costs and invests the
rest into MBS and or other investments.
When initially invested, the portfolio should be constructed to generate
sufficient income to safely and securely pay interest to its CDO Note holders
and the company’s other expenses.
Typically, those in the industry refer to this as managing a “cash flow
arbitrage”. In a fully managed CDO, the
asset manager’s role is to: A) select
the initial investments; B) continually monitor the quality of the portfolio
investments; and, C) make substitutions to maintain or improve the quality of
the collateral over time. On or before
the CDO Notes mature, the portfolio investments are liquidated and the CDO Note
holders receive their principal back at maturity. Once all of the CDO Notes are repaid, the CDO
Company terminates and any residual is paid out to the equity holders.
In some CDO
structures, the notes have a provision whereby the portfolio must begin to be
liquidated if the portfolio quality and or interest or principal coverage dips
below a certain point. This may also
trigger an early retirement of all or a portion of the CDO Notes. This is commonly referred to as a defeasance clause or unwind trigger. If the entire portfolio has to be liquidated
and all of the CDO Notes become required to mature early, losses can be
sustained by the Note holders. Whether a
particular CDO Note holder loses principal or not depends greatly the seniority
of the investor’s Notes in the CDO Company’s capital structure. Here’s a good point to introduce how a CDO
structure re-allocates risk to its investors.
In Figure 4
above, we can see that our sample CDO Company has three layers of Notes
(tranches) and a layer of equity in its capital structure. The equity layer is the first to sustain
losses and the Senior CDO Notes are the last to lose. Upon liquidation, the Senior Notes are paid
off first; the Mezzanine Notes are paid off second and so on. In our example above, the CDO company has $90
million after the collateral portfolio is liquidated. The Senior and Mezzanine Note holders get
their entire principal back, while the Sub Notes get half their money back and
the equity holders suffer a complete loss.
This is a
simple illustration of risk allocation and some CDO structures were developed
with greater creativity than exhibited above.
If these
innovative products were so good, where did it go wrong?
The Idiocy That Followed
When demand
for a financial product becomes exuberant, bad things happen. When demand out strips supply, quality
standards go down.
In the
early days of CBO issuance, investment bankers introduced the concept to
investment managers as a new type of managed fund structure. This was because the investment management
function provided the credibility and expertise to ensure that the economics of
the structure would work. The bankers
and managers then enlisted the institutional sales and trading function to
introduce the product to potential investors.
All worked together collaboratively to bring the product to market –
sales and trading introduced, investment managers educated and bankers
initiated the structure. This was the
effort that existed when I left the business.
By the mid
2000’s, when I would get the chance to see a more current CBO model, I began to
notice that some CBO structures had come to become more streamlined – a few of
the service provider team had been stripped out of the product. Figures 5 and 6 below reveal what I saw.
What
surprised me in these minimally managed structures was that the active manage
feature was stripped out, along with administration, accounting, audit and
financial guaranty functions. These were
the very functions that simplified the investment and added the transparency
and reporting functions that kept investors informed.
While I
can’t say that the minimally managed CDO structures reflected in Figures 5 and
6 above reflected the entire market at the time, it showed me that the few we
saw reflected significantly reduced quality in the product.
Despite
this, the deals sold into the market.
This was a clear sign that investors were so enamored by the CDO’s
offerings that they tolerated less from the structures.
Another
example of investor tolerance came to me when I had the opportunity to speak
with one of the former Lehman brokers who purportedly specialized in selling
CDOs. Having some background with them
myself, I asked several questions about the latest issues he was selling. Unfortunately, he could only speak to me
about the securities ratings and yield as he was unfamiliar with the CDO
Company’s structure and the assets that backed the CDO Notes. He was a successful specialist that wasn’t
very familiar with what he was selling?
Only an
eager and tolerant investor base could allow this. Until CDO investors, all at once, decided to
tolerate it no more. By fall of 2008,
the market for CDOs had grinded to a halt and the largest holders of CDO Notes,
the banks, had been forced to take paper losses against their capital due to
mark to market accounting rules. With no
liquidity in the CDO markets and a few distressed sellers, the trading prices of
CDOs went significantly lower and banks kept having to write them down on their
books. The banking systems went into a
downward “death spiral” and individuals were frightened to the point of panic.
Then, the
US Government stepped in…
Where Are We Now?
With the initial
TARP loans into the banking system and the Federal Reserve Bank’s (FRB’s)
monetary policy efforts, things have very much settled down in the banking
system. Banks are lending under
significantly stricter lending criteria and the world equity and bond markets
have risen greatly from the March 2009 lows.
If I had to
put my finger on one factor that caused the stock and bond market’s turnaround
from the March 2009 lows, I’d say that the mandate by Congress to the Financial
Accounting Standards Board (FASB) to revise the mark to market valuation rules
would be it. Within a week of that
event, the stock and bond markets began a rally that continued through to the
end of last year. Yet, the market for
CDO Notes still has a long way to go to be considered active. The market is no longer “frozen; but it is
only a trickle.
Consumers
are beginning to spend again and producers are beginning to rebuild
inventories. Corporate earnings reported
for the 4th quarter of 2009, on average, have bested expectations by
better than 11%. By all accounts, it
looks as if we are on a slow path to recovering from one of the worst
recessions in most of our lifetimes. The
largest overhanging cloud however, is that unemployment remains high – yet, the
rate of layoffs has diminished and there has been growing increases in
temporary labor employment. The signs of
recovery look solid – yet slow.
While
In every
past recession, it has been small business that created the new jobs needed to
sustain a recovery. Many “smalls” have
cut expenses to the bone and used available capital just to stay afloat during
the worst days of the recession. As
business activity picks up, many need additional cash to help finance that
growth. Jobs are part of that
equation. Yet the banks are imposing too
strict lending standards to help right now.
Borrowed money is the least expensive source of capital for most small
companies.
Yet, I can
understand why banks are so strict. It
all leads back to the CDO Notes remaining on their books. As a result, they have limited capital to lend
and need to rebuild their own capital and reserves. The FRB’s keeping short term interest rates
at a near 0% is helping banks recover, but the recovery is slow. One would have thought that since FASB eased
the mark to market rules, banks would have been able to “write upwards” the
CDO Notes on their books and have greater available financial capital to lend. Unfortunately, CDO Note holders and their independent
auditors continue to struggle with the mark to market rules and haven’t fully
written up the valuations.
I was out
to dinner last month with an audit partner from a large international public
accounting firm. Over dinner, we discussed
some of the challenges we were facing in our own business endeavors.
Maintaining his client’s privacy, as is customary in both of our businesses;
he mentioned that he was grappling with the fair valuation of CDO Notes on
one of his clients books. He had quotes
from two outside sources that were lower than what the client desired to report
using an alternative valuation method. We
didn’t resolve the matter over dinner as I wasn’t as familiar with the FASB
rules as with CDO’s and we didn’t want to spend the entire evening discussing
it. However, when I returned to my office, I looked
over the new Fair Value Measurement guidance.
The key
provisions of the new FASB accounting guidance “provides clarification that in circumstances
in which a quoted price in an active market for the identical liability [a CDO
Note for instance] is not available, a reporting entity is required to measure
fair value using one or more of the following techniques:
- A valuation technique that
uses:
- The quoted price of the
identical liability when traded as an asset
- Quoted prices for similar
liabilities when traded as assets.
- Another valuation technique
that is consistent with the principals of Topic 820. two examples would be an income approach,
such as a present value technique, or a market approach, such as a
technique that is based on the amount at the measurement date that the
reporting entity would pay to transfer the identical liability or would
receive to enter into the identical liability.”
How’s that
for a mouthful? As challenging as it is
to read for a non-audit professional, it is equally challenging for an auditor
to begin to apply. It seems fairly easy
to determine whether or not there is an active market for a particular CDO Note. However, it’s not so easy to determine
whether a similar liability is actively traded without doing enough work to
identify a similar one. And, it takes
much more forensic work and analysis to attest to a “modeled” approach - not to
mention, having the expertise to understand what to look for.
The key
words in the FASB guidance seem to be “active market”. If CDOs were trading in an active market,
market forces would create an accurate fair value for these securities. However, there is no active market for them
at present. Yes, there seems to be
willing buyers, but these buyers want the CDO Notes at bargain basement
prices. The holders don’t want to sell
at these prices as the economy is mending and the Notes are still paying
interest. If you had a CDO that you
could sell at a 10% or higher yield in order to then lend the money received
from the sale at 5% or 6%, what would you do?
You’d hold onto the CDO Notes!
That’s largely what we’re seeing now and banks have precious little
money to loan – with the money they do have to loan, they want very it
safe. It’s all about supply and demand
dynamics.
We’re also
hearing that loan demand is very low at present. The only question I would pose to that
statement is: Is loan demand low because
borrowers are discouraged by strict lending standards? Some “small” business owners that I’ve talked
to think so. So, we find ourselves back
to the question at the beginning of this article: Could CDOs now be the best catalyst to grow
the global economy?
Currently,
the US Government and its agencies through its TARP investments and holdings at
Fannie Mae and Freddie Mac have considerable investments in mortgage
securities. And, they want to spend more
taxpayer’s money on jobs stimulation programs.
Both Democrats and Republicans don’t have a good track record when it
comes to fiscal responsibility. On the
other hand, if more focus and effort were given to reviving the CDO markets, a
free market solution could occur with the same or better result. The former will force higher taxes and the
latter solution could reduce them.
Which
alternative do you like better?
Market Update
While the
markets rose splendidly in the first half of January, concerns about a possible
debt crisis forming in
We remain
optimistic and since the beginning of the year began to lighten our exposure in
high yield debt and moved a portion of that money into equities – buying into
the correction. At this writing, those
decisions look good. We ended the month
of January down 3.80% and up 47.64% for the last twelve months. Here are some comparative numbers for you to
review:
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February
2003. ELF manages a strategic allocation
of primarily exchange-traded index funds (ETFs), and may invest in other
carefully selected securities. ELF may
also employ hedging techniques, through the use of short positions and
options. ELF manages individual
portfolio accounts for both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
ELF’s
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.
Broad market
index information provided is solely for the purpose of comparison. This index data was obtained from third party
sources believed reliable; however, ELF does not guaranty its accuracy. An investment account managed by ELF should
not be construed as an investment in an index or in a program that seeks to
replicate any index. In most cases,
investors choose a market “index” having comparable characteristics to their
portfolio as a benchmark. An ETF is a
security that tracks an index benchmark or components thereof. As ELF actively manages a strategic
allocation of primarily ETFs, selecting a comparable benchmark poses
significant challenges. Over time, the
broad market indices provided above may exhibit more, similar or less
variability of returns and risk than ELF’s strategic allocation. As well, the broad market index information
provided above reflects gross returns and have not been reduced by any
estimated fees or expenses that a person might incur in trying to replicate an
index.