Tuesday, February 7, 2012

Dealbreaker on the Hayes award and LCM VII CLO

By Tim Husson, PhD, Craig McCann, PhD, CFA, and Olivia Wang, PhD

Matt Levine at Dealbreaker posted last night on our work regarding the Hayes award and the LCM VII CLO. He interpreted some of the facts of the case differently, but we think he did touch upon the key issue: the proper disclosure of the decline in the market price of collateral on the closing date. We wanted to directly address a couple points he raised.

To be clear, at least by the closing date the CLO did track the daily mark-to-market value of the loans in the LCM VII portfolio using Markit’s database of loan values. These figures appear in Trustee Reports that were issued several months after closing—we have made those reports available for download on our website. This indicates that the CLO was aware of the mark-to-market losses on the closing date and was at least capable of determining that value during the warehousing period.

We have also uploaded the marketing materials presented to Mr. Hayes before his purchase, which state that changes in the market value of the E Notes will be a leveraged multiple of changes in the market value of the loans. Since the E Notes were the bottom ½ of 1%, plausible CDO valuation models suggest that leverage to be at least 20 to 1. With the warehoused loans down 5% in July, the market value of the E Notes was close to zero on the day they were sold to the public.

We don’t know exactly how loans were selected for the LCM VII portfolio. But we do know LCM had access to mark-to-market prices and Mr. Hayes didn’t, since as Matt points out he didn’t even know what the underlying loans were, nevermind their value. Big picture: Investors lost $75 million in LCM VII - entirely because of mark-to-market declines in the value of the loans not because of realized defaults on the loans - when it was liquidated in October 2008. Our main point is that $20 million of those $75 million in losses occurred before Banc of America sold the securities to investors, which investors at least deserved to know.

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