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GREG LIPPMANN (DEUTSCHE BANK SECURI) <GREGLIP@BBOTG>


Tuesday, August 29, 2006 2:12 PM
PAOLO.PELLEGRINI <paolo.pellegrini@paul sonco.com>; NLOBACCARO
<nlobaccaro@gweiss.com>;'EKOSNIK <ekosnik@hginvestors.com>; MARC
<MARC@JANAPARTNERS.COM>; RICHARD BARRERA (GLENVIEW CAPITAL
MAN) <RBARRERA2@BBOTG>; PAOLO PELLEGRINI (PAULSON & CO. INC.)
<PPELLEGRINI3@BBOTG>; DAVID MACKNIGHT (MASON CAPITAL
MANAGE) <DMACKNIGHT@BBOTG>; ALAN FOURNIER (PENNANT CAPITAL)
<AFOURNIER@BBOTG>; MICHAEL PENDY (DUQUESNE CAPITAL MAN)
<GMPENDY@BBOTG>; NICK LOBACCARO (GEORGE WEISS ASSOCIA)
<NLOBA@BBOTG>; EDWARD KOSNIK (HUNTER GLOBAL INVEST)
<EKOSNIK@BBOTG>; JEREMY COON (PASSPORT MANAGEMENT,)
<JMCPASSPORT@BBOTG>; JAMES DIDDEN (GSO CAPITAL PARTNERS)
<JDIDDEN2@BBOTG>; GREGORY PAPPAJOHN (VARA CAPITAL LLC)
<GPAPPAJOHN4@BBOTG>; BRADLEY WICKENS (SPINNAKER CAPITAL LT)
<BWICKENS1@BBOTG>; MICHELLE BORRE (OPPENHEIMERFUNDS, IN)
<MBORRE1@BBOTG>; CEMIL URGANCI (ASHMORE GROUP LIMITE)
<CURGANCII@BBOTG>; PAUL TWITCHELL (WHITEBOX ADVISORS, L)
<PTWITCH@BBOTG>; SHAILESH VASUNDHRA (DEEPHAVEN CAPITAL MA)
<SVASUND@BBOTG>; ANTHONY BOZZA (SAB CAPITAL MANAGEME)
<ABOZZA@BBOTG>; BRAD ROSENBERG (PAULSON & CO. INC.)
<BSROSENBERG@BBOTG>; TYLER DUNCAN (WAYZATA INVESTMENT P)
<TJDUNCAN@BBOTG>; STEVE ROTH (GLG PARTNERS LP)
<WOODY2@BBOTG>; DAVID GERSZEWSKI (AUTONOMY CAPITAL RES)
<DAVIDG@BBOTG>; LEV MIKHEEV (MOORE EUROPE CAPITAL)
<LVMIKHEEV@BBOTG>; STEFAN TSONEV (UBS LIMITED)
<TSONEVS@BBOTG>; WYATT WACHTEL (YORK CAPITAL MANAGEM)
<WJWACHTEL@BBOTG>; RENE HO (MORGAN (J.P.)) <RENEHO@BBOTG>;
JOHN GISBORNE (TORONTO DOMINION BAN) <JGISBORNE@BBOTG>;
MATTHEW J KEEGAN (OSPRAIE M ANAGEMENT L) <MAKEEGAN@BBOTG>;
PHILIP GUTFLEISH (ELM RIDGE VALUE ADVI) <PGUTFLEISH2@BBOTG>;
JEFF MOSKOWITZ (MORGAN STANLEY) <JMOSK@BBOTG>; KENNETH COE
(TALEK INVESTMENTS LL) <KCOE1@BBOTG>, MATTHEW BASS (GSO
CAPITAL PARTNERS) <MBASS1@BBOTG>; ROPER STRYPE (RUBICON FUND
MANAGEM) <RSTRYPEI@BBOTG>, ROBERT NEMETH (ELM RIDGE VALUE
ADVI) <RNEMETH1@BBOTG>; MARC LEHMANN (JANA PARTNERS LLC.)
<MARCLEHMANN@BBOTG>; JEREMY SCHIFFMAN (TPG-AXON CAPITAL
MAN) <JSCHIFFMAN@BBOTG>; JORIS HOEDEMAEKERS (OASIS CAPITAL
(UK) L) <JORISI@BBOTG>; NEL JOSHI (DEEPHAVEN CAPITAL MA)
<NJOSHI@BBOTG>; DANIEL DONOVAN (GDG) <DDONOVAN5@BBOTG>;
RAGHU RAGHAVENDRA (MOORE EUROPE CAPITAL)
<RAGHAVENDRA@BBOTG>; CHAD KLINGHOFFER (GLENVIEW CAPITAL
MAN) <CKLINGHOFFER@BBOTG>; JOSH ADAM (GLG INC.)
<JOSHADAM@BBOTG>; JEREMY SIMON (TPG-AXON CAPITAL MAN)
<JSIMONTPG@BBOTG>; BRIAN VAHEY (KING STREET CAPITAL)
<BVAHEY@BBOTG>; DEAN CARLSON (SUSQUEHANNA INVESTME)
<DCARL@BBOTG>; JEAN FAU (DARBY CAPITAL IRELAN) <JFAU@BBOTG>;
VARUN GOSAIN (CONSTELLATION CAPITA) <VGOSAINI@BBOTG>; MAULIN
SHAH (POLYGON INVESTMENT P) <MAULIN_SHAH@BBOTG>; HARRY
MAMAYSKY (OLD LANE, LP) <H MAMAYSKY@BBOTG>
Fwd: Two Jim Grant articles on CDOs
15664357.htm
Permanent Subcommittee on Investigations

Wall Street & The Financial Crisis


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Message Sent: 08/29/2006 09:12:02
From: GREGLIP@BBOTGIGREG LIPPMANNIDEUTSCHE BANK SECURIl]7261328663
To: paolo.pellegrini@paulsonco.comPAOLO.PELLEGRNI I|
To: nlobaccaro@gweiss.comINLOBACCAROI II
To: ekosnik@hginvestors.comEKOSNIKI I|

To: MARC@JANAPARTNERS.COMMARC|I I

To: RBARRERA2@BBOTGIRICHARD BARRERAIGLEN VIEW CAPITAL MANI I


To: PPELLEGRINI3@BBOTGIPAOLO PELLEGRINIIPAULSON & CO. INC.| I
To: DMACKNIGHT@BBOTGIDAVID MACKNIGHTIMASON CAPITAL MANAGE I
To: AFOURNIER@BBOTGIALAN FOURNIERIPENNANT CAPITAL! I
To: GMPENDY@BBOTG!MICHAEL PENDYIDUQUESNE CAPITAL MAN| I
To: NLOBA@BBOTGINICK LOBACCAROIGEORGE WEISS ASSOCIAI
To: EKOSNTK@BBOTGIEDWARD KOSNIKIHUNTER GLOBAL INVEST| I
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To: MBORRE I@BBOTG|MICHELLE BORRE|OPPENHEIMERFUNDS, IN| I
To: CURGANCII@BBOTGICEML URGANCIIASHMORE GROUP LIMITE I
To: PTWITCH@)BBOTGIPAUL TWITCHELL!WHITEBOX ADVISORS, LI I
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To: ABOZZA@BBOTGIANTHONY BOZZAISAB CAPITAL MANAGEMEI I
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To: WJWACHTEL@BBOTGIWYATT WACHTEL|YORK CAPITAL MANAGEMII
To: RENEHO@BBOTG|RENE HOIMORGAN (JP.)!!
To: JGISBORNE@BBOTG|JOHN GISBORNEITORONTO DOMINION BAN! !
To: MAKEEGAN@BBOTG|MATTHEW J KEEGANIOSPRAIE MANAGEMENT LI I
To: PGUTFLEISH2@BBOTG|PHILIP GUTFLEISHIELM RIDGE VALUE ADVII I
To: JMOSK@BBOTGlJEFF MOSKOWITZIMORGAN.STANLEY! !
To: KCOE1@BBOTGIKENNETH COEITALEK INVESTMENTS LLI I
To: MBASSI@BBOTGIMATTHEW BASSIGSO CAPITAL PARTNERS! I
To: RSTRYPEI@BBOTG|ROPER STRYPEIRUBICON FUND MANAGEMI I
To: RNEMETHI@BBOTGIROBERT NEMETHIELM RIDGE VALUE ADVII I
To: MARCLEHMANN@BBOTGIMARC LEHMANNIJANA PARTNERS T.IC.1I
To: JSCHIFFMAN@BBOTGJEREMY SCHIFFMANITPG-AXON CAPITAL MAN! !
To: JORISI@BBOTGIJORIS HOEDEMAEKERSIOASIS CAPITAL (UK) LI !
To: NJOSHI@BBOTGINEIL JOSHIIDEEPHAVEN CAPITAL MA! !
To: DDONOVAN5@BBOTGDANIEL DONOVANIGDGI
To: RAGHAVENDRA@BBOTGIRAGHU RAGHAVENDRAIMOORE EUROPE CAPITALI!
To: CKLINGH1IOFFER@BBOTGICHAD KLINGHOFFERIGLENVIEW CAPITAL MAN! !
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To: BVAHEY@BBOTGIBRIAN VAHEYIKING STREET CAPITAL! !
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To: VGOSAINI@BBOTGIVARUN GOSAINICONSTELLATION CAPITA!!
To: MAULIN SHAH@BBOTGIMAULIN SHAH|POLYGON INVESTMENT P| I
To: H.MAMAYSKY@BBOTG|HARRY MAMAYSKY|OLD LANE. LP!!

----- Original MessageFrom: Greg Lippmann <greg.lippmann@db.com>


At: 8/28 17:32:17

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Structured Complacency
Credit markets are sanguine. Structured credit is
proliferating. Could the first fact be related to the second?
Yes, we say. There?s no end of explanation for the mysterious
willingness of bond buyers and bank-loan investors to accept persistently
modest returns over riskless government yields. Liquidity has been
superabundant, hedge-fund assets are on the prowl, yield thirst goes
unslaked?all these causes are put forward. We are about to suggest
another explanation for the bewildering complacency of lenders. Spreads
are tight in part because of the growing number of collateralized debt
obligations (CDOs). What these entities share is a strong propensity to
buy and a low propensity to sell. A new fact commands the attention of
lenders and borrowers: Financial engineering is displacing credit
analysis.
Definitions are in order. A CDO is a debt-acquisition enterprise. It
raises money from investors. It acquires assets with the proceeds?bonds,
bank loans, mortgages, asset-backed securitics, etc. It can buy
floating-rate assets or fixed-, senior claims or subordinated. In 2005,
no less than $250 billion of CDOs came into the world, 59% more than in
analysis, we venture the following capsule distinction: financial
engineering is the science of structuring cash flows; credit analysis is
the art of getting paid.
The liabilities side of a CDO balance sheet is what gives the structure
its distinctive investment personality. The liabilities are layered.
Field-strip a typical $100 million CDO and you find, first, a large swath
of ?senior? liabilities, say $70 million worth, rated triple-A; a $20
million ?junior? slice rated single- or double-A; a $3 million mezzanine
piece rated triple-B; and $7 million of unrated equity.
The top-rated assets are not inherently triple-A. Their
strength derives rather from the vulnerability of the assets underneath.
The equity tranche is most exposed; to it goes the first loss. When it
has borne all it can bear (i.e., $7 million), the next loss goes to the

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mezzanine tranche and the next to the junior slice. Only after all of
these levees are breached--$30 million worthdo losses cut into the value
of the senior segment.
The various segments are priced according to their risk, with
the senior-most yielding a few dozen basis points over Libor and the
equity segment returning 1,000 basis points over (or more). The cost to
create such a structure runs to about 1.5% of the balance-sheet footings.
Included are legal, rating and origination expenses. Annual management
fees may run to 50 basis points. Although some CDOs are ?static??the
assets with which they are seeded are the ones they keep?some latitude for
the managers is increasingly the norm.
Our ?typical? CDO is known as a ?cash? CDO. It is not to he
confused with a ?synthetic? CDO. Like the cash variety, a synthetic CDO
raises money from investors. Then it sells credit protection to other
investors, in the shape of credit default swaps (CDS). The cash CDO eams
income from the securities it holds. The synthetic CDO eairns income-from
the premium it writes.
In a few short years, these derivative structures have
marginalized the vast corporate bond market. Companies still issue public
debt, but Wall Street is trading less and less of it. The charm of the
old corporate arena?with its generously separated bids and offers and its
personable, richly compensated sales peopleproved its undoing. The
advent of price transparency through the TRACE reporting system hathed the
marketplace in sunlight. Blinking, the salespeople watched quotations
tighten and commission income dwindle.
?Banks that trade corporate bonds have been required to report
transactions to TRACE since 2002,? Bloomberg noted in a May 9 report on
the historic shift from cash transactions to derivative ones (?Derivatives
Make Nich Carraway, Corporate Bond Traders Obsolete,? is the headline).
?The system now provides prices and the amount of bonds exchanged in each
trade on 29,000 securities with in 15 minutes of a deal, according to
NASD. With the data available, there?s little need for guidance from

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analysts or salespeople.?
Observe, please, the analytical leap implied in the final
three words of the quotation: ?analvsts or salespeople.? Why should price
transparency make analysts obsolete? Hypothesis No. 1: Because, in an
efficient market, a security?s price is the unfailing measure of its
value. Hypothesis No. 2: Because, on Wall Street, the analysts are paid
out of the big fat commission pot. We lean toward No. 2.
Credit risk is ever present. Where it resides is the timely
question. Once upon a time, before ?disintermediation,? the risk of
default or nonpayment lay with the banks. It was the banks? business to
know more about their borrowers than anyone else. Come the junk-bond
revolution, the risk migrated out of the banks and into the securities
markets. Now comes the derivatives boom. Who are the keepers of the
flame of credit analysis in 2006?
We?re not sure?and neither is the International Monetary Fund.
?[R]ating agencies have played a significant role in the acceptance of
new products by investors, with the analysis and rating of structured
products heavily reliant on sophisticated quantitative modeling,? says
IMF?s 2006 Global Financial Stability Report (see Chapter 2, ?The
Influence of Credit Derivative and Structured Credit Markets on Financial
Stability?). ?Not surprisingly. The development of structured credit
markets has coincided with the increasing involvement of people with
advanced financial engineering skills required to measure and manage these
often complex risks. In fact, for many market participants, the
application of such skills may have become more important than fundamental
credit analysis.? This provocative thought is developed in a one-sentence
footnote, as follows: ?Discussions with market participants raised
questions as to whether the increased focus on ?structuring? skills,
relative to ?credit? analysis, may itself present a concern.?
Emphatically, the rating agencies are on the job. Since a CDO
without a triple-A-rated senior tranche would be unmarketablc, their
imprimatur is indispensable. For Moody?s Corp., the sole publicly traded
rating business, derivatives are the wave of the futurc?and of the

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present, besides. In the first quarter, structured finance generated
revenues of $176 million, nearly double the contribution of oldOline
corporate debt ratings.
Colleague Ian McCulley was unable to elicit from any agency
just what this booming business entails. But he did catch up with a junior
analyst at one ratings shop, who described his work in monitoring as many
as 20 CDOs a day. (Both the analyst?s name and his employer?s are being
withheld to protect the innocent.) ?Basically,? says our source, ?I go
through what they buy and sell each month. And I go through all of their
ratios. And I check to see if they have synthetics,? e.g., credit default
swaps. It?s all in an Excel model. The CDOs he checks are actively
managed. Interestingly, some of them invest in the tranches of other
CDOs, and they are called ?CDO squared.? It?s no easy matter to rate
these exotica, even with the help of a complex model developed for the
purpose by Moodys. Our admittedly green contact says he doubts that many
people really understand what these structures own, how their assets are
correlated or what might happen to them in the liquidation portion of a
credit cycle.
A skeptical friend of ours applauds the bank-loan-holding
CDOs. Michael Lewitt, president of Harch Capital Management, Boca Raton,
Fla., is the manager of 150 bank loans (which constitute a collateralized
loan obligation, or CLO, a species of CDO). He contends that the loan
structures do work?and Lewitt, in his professional capacity, is a hard man
to please. Yes, he readily acknowledges, credit spreads are too tight,
but ?even if a loan defaults, you still get recoveries of 95 cents on the
dollar, or even over par, so you are OK.? Lewitt is here referring to
senior loans. Beware, he says, the second-lien kind, which are really
?just bonds, and that?s where you will have some real capital impairment.?
Our investigation leads usto the same conclusion, though most
lenders and borrowers are wondering less about capital impairment than
about what took them so long to see the beauty of junior bank claims.
Among these merits is the east of early call (at the borrower?s behest and

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with fewer of the costs and restrictions typically associated with calling
a corporate bond) and the fact that they pay a floating, not a fixed, rate
of interest. Their issuance is soaring. According to Steven Miller,
manageing director of S&P?s Leveraged Commentary and Data Group, $16
billion of second-lien paper came to market in 2005. 35%more than in 2004.
And while junk-bond issuance last year totaled $75 billion, less will be
sold this year. ?Furthermore,? colleague McCulley observes, ?second liens
are tailor-made for the current state of the financial world, hedge funds .
absorb 37% and CLOs 48% of second lien issuance nowadays. Libbey Inc.,
the Toledo, Ohio, glassmaker profiled in the April 21 issue of Grant?s, is
among the companies that has recently forsaken the junk market for the
second-lien market, it expects to tap it any day.?
What?s there to be afraid of? a practitioner we know
rhetorically asks: ?For a deal that has locked in its liability costs for
in the market that would bring back credit spreads to more natural
levels.?
Be careful what you wish for, we say. The financial engineers
are up in the driver?s seat of credit, a fact that ought to worry everyone
except distressed investors. ?[Flor some mezzanine structured credit
products,? the aforementioned IMF paper speculates, ?zero recovery rates
are much more likely than on similarly rated corporate bonds. yet the
resulting default probabilities and expected losses are mapped into
traditional corporate bond ratings that tend to be in the 40%-60% range.?
No default epidemic is imminent, our friend Lewitt asserts.
Yet, he points out, something is bound to interrupt the present idyll.
Something ?systemic? is his nomination. ?These hedge funds are not a sign
of health and this equity day trading is not a sign of health. And having
a credit market priced on a non-credit basis?meaning priced off
quantitative and arbitrage bases and not on credit fundamentalsis not a
healthy thing.?
Credit markets ought to be priced on the basis of eredit, of
course?and, one day, most assuredly, they will be again.

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English Majors? Revenge
Collateralized debt obligations are only baffling most of the
time. Gibberish, the technical literature may be, but a determined reader
can make out the occasional familiar English word or phrase. One such
word is ?assumption.? It turns out to be of critical importance to
understanding how these complex structures are designed, priced and sold.
Now begins another voyage of discovery. The destination: The
land of the CDOs. The missions: Understanding. We write on behalf of all
who stand suspicious but mute before the mathematical guardians of this $1
trillion market. Do you, Mr. or Ms. Former English Major, suspect that
there is a fly in the derivatives ointment but are afraid to express a
doubt in the company of quants? We are going to arm you with the facts.
By way of background, the housing market is only as strong as
the mortgage market. And the mortgage market, these days, is only as
strong as the CDOs into which are packed hundreds of billions of dollars
of housing-related debt (prime and subprime, ?cap corridor bonds,?
Alt-A-pass-through hybrids and others you may not want to ask about just
now). And the CDOs are only as viable as their equity base.
In previous issues, Grant?s has described these securities and
the risks that unsuspecting investors may run in holding them. This time
out, the focus is on the junior-most portion of the CDO liability
structure, i.e., the equity tranche. It?s the equity that bears the first
loss or, if all goes according to plan, eams the highest return. You
can?t sell a CDO without some sliver of equity?and sliver is the word.
High-grade deals are leveraged at 100:1 on up. Buyers of this derivatives
dynamite are said to include hedge funds as well as institutions in Japan,
South Korea and Southeast Asia.
In March, Moody?s performed the signal public service of
compiling actual returns on equity portions of 66 ?terminated? CDOs (i-e.,
entities that, for one reason or another, had reached the end of their
useful lives). It found that returns ranged from a negative 82% to a
positive 99% and that the median return was very close to zero. The

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Moody?s analysts were not dogmatic, however, because they could not be
sure what investors had paid for the securities they were examining:
?Unfortunately, the pricingof equity is the result of a highly private,
sometimes complex negotiation.? In a follow-up study of the equity
tranches of 10 terminated structured-finance CDOs, Moody?s last month
found that returns had ranged from a negative 59. 1% to a positive 70. 1%,
with the average at a negative 8.4%.
A curious layman will now begin to appreciate the significance
of the word ?assumptions? in the context of expected CDO returns
(especially when pricing is as transparent as a curtain of lead). With
enough of the right kind of assumptions, the equity -tranche buyer can
sleep the sleep of the confidently misinformed.
But such self-delusion will be a little harder to achieve since
publication of a July 26 report by Deutsche Bank entitled, ?High Grade ABS
CDOs? (in which ABS stands for ?asset-backed securities?). The analysis
calls into question the premises on which such derivatives are built and
sold. ?Modeling assumptions that simplify actual cash flows are
commonplace in the world of structured finance,? the authors note.
?However, while these adjustments are unlikely to significantly impact the
debt, they can have significant consequences on equity returns?especially
within a structure that is leveraged 100 to 200 times.?
And what might these dubious assumptions be? Asset and
liability cash-flow mismatch, is one. Something having to do with a fiveto seven-day ?trustee period? at the time of issuance is another, and
?risk mismatch in 2004 CDOs? is a third. A fourth involves the universal
impulse to reach for yield: ?In the current relatively tight spread
environment,? the report says, ?collateral managers have increasingly
turned to higher yielding alternative prime mortgage products to add
additional yield to the CDO portfolio.?
These are, or have been, the best of times for housing, the
Deutsche Bank authors observe. Drawing comfort from past performance,
investors have come to regard ?the structures and the various modeling
assumptions that are embedded within them? with unwarranted confidence.

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Especially is confidence unwarranted at a time of elevated leverage.
?I don?t want to suggest that anything malicious and
underhanded is going on here,? Anthony Thompson, managing director and
head of U.S. asset-backed security and CDO research for Deutsche Bank,
tells colleague Dan Gertner. ?I think the reality is that a lot of the
CDO architecture and technology was created 10 to 15 years ago when
spreads were wider, leverage was lower and where you didn?t have to be so
meticulous with your assumptions.? Buyers of these equity pieces are not
necessarily the world?s most sophisticated modelers of structured finance
securities, Thompson adds. ?1 would make the point that mortgages are
complicated still to most of the world. Mortgages levered 200 times are
even more complicated.?
By tweaking some standard assumptions to make them conform
with the 2006 marketplace, the Deutsche Bank study adjusts an ?idealized?
expected return of 19% to a more realistic 10.2% return. Note well,
however, as the authors add, that CDOs are built on many assumptions. They
acknowledge that they examined ?but a few pieces of the complex CDO
puzzle.?
Come the next bear market in mortgage debt, many more
assumptions will certainly come in for reappraisal. Knowing only this
much, the detached and calculating English major might well be able to
sweep up astonishing bargains.

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