Structured investment vehicles were among the most prominent victims of the credit crunch, creating an unprecedented set of challenges for debt restructuring. Philip Alexander looks at how the market is managing the process.

In restructuring leveraged loans, the financial sector can call on at least two decades of prior experience. By contrast, before 2007 there had never been a default among the structured investment vehicles (SIVs) set up by banks or hedge funds to engage in coupon arbitrage between short-term borrowing and long-term lending. So the sudden squeeze in the commercial paper and medium-term note (MTN) markets has triggered the first wave of distress in a sector that was worth an estimated $400bn before the crisis. A major distinction that proved crucial when the crunch hit is between SIVs sponsored by a bank and those set up by hedge funds that do not have sufficient capital to extend a liquidity line to their troubled vehicle.

In both cases, solutions attempted so far focused on preventing a firesale of illiquid structured assets into a market that has dried up. “Liquidating the assets that are in the portfolio in the short term is likely to be value destructive. You are more likely to hand value to the buyers,” says Matthew Prest, head of the European special situations group at Close Brothers in London.

If a SIV becomes insolvent, this is a particular challenge, according to Richard Heis, UK restructuring partner at KPMG. “The conventional wisdom is that, if you have a whole bunch of financial assets, the receiver or liquidator should not really be gambling by holding them and possibly making losses, so the principle is to sell. But in today’s climate, selling a large holding of mortgage-backed securities (MBS) or collateralised debt obligations (CDOs) into the current market would be potentially disastrous.”

Bank bail-out prospects falter

For unsponsored SIVs, the Cheyne Finance vehicle has been setting insolvency precedents (see below). For SIVs with bank sponsorship, the sponsor can bring its vehicle on balance sheet, but there is a range of methods to do this, says Geoff Fuller, a partner at law firm Allen & Overy in London.

Mr Fuller recently advised on a deal for Citi to provide support to six of its SIVs to sustain their top Aaa/P-1 credit ratings from Moody’s. The ratings agency was concerned that falling net asset values – defined as the difference between the asset portfolio’s market value and the notional outstanding senior liabilities – were eroding the equity capital cushion that is supposed to protect the senior noteholders.

“If the P-1 ratings were lost, under their specific documentation the SIVs would go into defeasance, which means being forced to sell assets and pay off investors on a fixed timetable,” says Mr Fuller.

Citi opted to inject mezzanine capital into the structure, to rebuild the cushion for senior noteholders. “There was obviously a lot of discussion with the ratings agency and the trustees, and internally on the regulatory capital implications, but the basic idea was to create this extra level of capital that was not originally envisaged by the documents,” says Mr Fuller.

The deal was also structured to avoid requiring resolutions of approval from noteholders – an aim that is likely to be shared by other banks that bail out their vehicles. Many SIVs have more than 100 outstanding series of notes, each of which would require a separate meeting to win agreement, and all would typically need a 21-day notice period. Such schemes of arrangement could take years to agree, which is not practical given the speed with which market conditions are changing, Mr Fuller notes.

Different triggers

However, Mr Fuller points out that other SIVs had different triggers in their structures that could force them into defeasance or the acceleration of repayments. The capital loss trigger in Citi’s SIVs related to realised losses (arising on the sale or default of assets), whereas the limit in other vehicles related to mark-to-market values. For a SIV in deep trouble, a bank could offer a full liquidity backstop for all senior debt, effectively transforming it into a simpler conduit structure. Before the crisis, SIVs typically only had a liquidity line from their sponsoring bank to cover about 8% of the senior debt.

A full guarantee reassures investors and ratings agencies but it is much more expensive. Consequently, Mr Prest warns against assuming that sponsoring banks will, for reputational reasons, fund the vehicles they created – even if many of the senior noteholders are the banks’ major institutional clients. In February 2008, Standard Chartered defied expectations by putting its Whistlejacket SIV into receivership.

Mr Heis at KPMG believes the prospects for banks to rescue their proprietary SIVs have deteriorated since a spate of such moves in the third quarter of 2007. “The market has slipped further, so it’s a question of how much money are you having to put in to prop things up? The worse the market gets, the more your commitment if you want to keep things going.”

Menu for creditors

If restructuring becomes unavoidable, it is still possible to avert a forced sale of assets, says Mr Prest. This involves drafting a menu of deals for the diverse creditors, and migrating pools of assets and the relevant investors over to a new set of vehicles. Investment funds facing redemptions that simply want cash up front will take the appropriate haircut immediately and the rest will retain their interest in the new entity.

“A one-size-fits-all restructuring will not work, so you securitise the asset pool and offer different kinds of security to investors to meet their various requirements. The question then is how those new securities are valued and how they are linked to the underlying asset pool,” says Mr Prest.

Inevitably, it is tough to win agreement on such complex deals. But Tony Lomas, business recovery partner at accountants PricewaterhouseCoopers (PwC), observes that the threat of value breaking through all debt classes – even the most senior – if assets are sold hastily is encouraging co-operation among creditors. Such tolerance may not extend to the collateral managers of the SIV itself, he warns, some of whom have already been displaced by irate noteholders and trustees. Even if the existing manager is retained, terms need to be renegotiated, he says. “The fund managers are typically paid a percentage of the value of the portfolio, and on performance. Now that the portfolio value has declined and no performance fee has been earned, the cash flow for the managers has been substantially tightened,” he says.

The long-term view

Although market valuations of SIVs have been in freefall according to Moody’s calculations (see chart), Martin Gudgeon, who runs Blackstone’s European restructuring advisory group, says it is too soon to be sure if the decline is fundamentally justified. This means that original investors who take the long view and hold the restructured SIV paper to maturity could benefit if the underlying credit impairment is not as severe as current crisis-hit asset prices imply. Allen & Overy’s Mr Fuller points out that Citi reported total exposure to US subprime mortgages in its SIVs at just 0.4% in October 2007; by contrast, some of the so-called “SIV-lites” had covenants allowing them to invest purely in one asset class.

Mr Gudgeon has advised on Golden Key, a SIV-lite set up by Swiss fund Avendis with funding from Barclays Capital, which was entirely exposed to US residential MBS.

Valuations in dispute

According to Skip Curth, partner in Ernst & Young’s structured finance advisory team in New York, creditors are therefore having to look much harder at valuations of specific instruments in the portfolios, where they once rolled commercial paper without detailed examination. “People have had to look at their positions in a more granular way than just saying ‘what’s the last quote we got for that’. Now it is about having to model CDOs and asset-backed securities (ABS), about having to understand the variety of risks that are out there for this kind of instrument,” he says.

In this context, the adoption of International Financial Reporting Standards (IFRS) by some banks may further complicate the restructuring process. Doug McPhee, a valuations specialist at KPMG, emphasises the need to capture the spirit of the code’s mark-to-market principles in assessing SIV holdings. “What the standards and the regulators want is for ‘fair value’ to mean just that: willing buyer, willing seller, not just marking assets down to the worst case.”

Mr Gudgeon goes further, arguing that if creditors are willing to avoid a forced sale of assets then the priority is to understand the difference between the market value placed on the asset in an illiquid market and the fundamental value. Because Blackstone restricts itself from any investment in situations handled by its advisory practice, he is able to transfer valuations specialists temporarily from Blackstone’s ABS investing teams to model asset values for his advisory clients – right down to underlying mortgages if necessary.

Given the importance of a valuation that wins the trust of all creditors, there is general agreement that restructuring advisers must be independent. Potentially, if creditors require the restructuring to offer a cash alternative funded from a sale of assets then this would probably involve selecting the sales team of an investment bank. Beyond this role, however, restructurings are likely to sideline banks that were involved in structuring SIVs, despite their obvious expertise.

“The issue is that there is just a small group of investment banks that set up these SIVs, and they are the ones that decided their original value,” says Mr Gudgeon. Given the fall in value since then, creditors would be unwilling to turn to the same banks for market pricing.

That reluctance will be greater still, says Mr Prest, if the originating banks also have distressed trading desks seeking to pick up debt on the cheap from forced sellers.

This is all providing plenty of new business for the relevant independent professionals, but Mr Curth is probably not alone in expressing the sentiment that he would rather be advising on new deals than sorting out the structures that turned sour.

CHEYNE PROVIDES DIRECTION

Traditionally, restructuring deals have involved banks that regard risk as a threat to be controlled with pre-set interest margins, and more aggressive investment funds that see risk as an opportunity for higher coupons. The structured investment vehicle (SIV) crisis has brought a third category to the negotiating table, says Matthew French, a partner at Lovells in London: “People who were just parking some spare cash for a few extra basis points, for whom the risk of loss comes as a total surprise.” This includes retail money-market funds, corporate treasuries and US municipal authorities.

To add to the difficulty of engaging parties new to insolvency situations, the SIVs exist in their own legal world. “They were built to meet the investors’ requirements as a matter of private contract. So we have to disapply a lot of what we know about insolvency from the Insolvency Act and the statutes,” says Mr French. For these reasons, he moved to resolve potential disputes breaking out over SIV Portfolio plc (formerly known as Cheyne Finance plc), where he advises partners at Deloitte who are acting as its receivers.

Late last year, the receivers sought court direction on two key questions surrounding SIV Portfolio. The first ruling confirmed that SIV Portfolio should continue to repay shorter maturing liabilities in full, despite entering receivership. But this left longer maturing creditors worried that the cash would run out by the time their notes matured.

As a result, receivers subsequently sought a second ruling, which confirmed that the prospect of funds running out justified the receivers calling an “insolvency event” under the transaction document. This has the effect of bringing the treatment of short and long-dated liabilities into line, pari passu, to receive a proportionate distribution among all of the senior secured creditors.

Under insolvency statutes, an ‘insolvency event’ only occurs at the point when an entity is or is ‘about to become’ unable to repay. “Before the receivers went in, SIV Portfolio had sold assets and built up a cash buffer, and you can stay liquid for a long time by selling more assets,” says Mr French. The ruling created an extra-statutory precedent, permitting the receivers of SIV Portfolio to declare ‘insolvency’ because the vehicle would become unable to repay at a foreseeable time in the future.

“This is an exceptional situation, where immediate cash flow tests of insolvency under the insolvency legislation are less relevant. You know for sure what your liabilities are and you also know exactly what you own. The only variable is what the assets may prove to be worth,” says Mr French.

This clarified the conditions for declaring an insolvency event; and the Rhinebridge SIV followed Cheyne into insolvency shortly after this ruling. But Richard Heis, UK restructuring partner at KPMG, warns that the risk of creditor grievances over SIVs and SIV-lites is far from eliminated. In particular, the exact date on which an acceleration event is declared could provoke problems due to SIVs’ dependence on regular refinancing rollovers.

“If one holder has commercial paper maturing on Tuesday and one on Thursday, and the acceleration occurs on Wednesday, then the Tuesday creditor gets under the wire and is repaid on time but the Thursday guy is prevented from getting his money paid out,” says Mr Heis.

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