Jefferson’s Hildene Says S&P Ratings for Bank CDOs Are Too Low

Hildene Capital Management LLC, a hedge fund with 24 percent annual returns since 2008 from wagers on a type of bank bonds, says Standard & Poor’s ratings of the debt are too low.

Brett Jefferson, who founded the firm in 2007, says the credit-rating company is using a “ludicrous” methodology for assessing TruPS CDOs, which are collateralized debt obligations backed by trust-preferred securities. S&P ranks most of the bonds as speculative grade, forcing the smaller banks that own them to hold extra capital or sell at a loss, according to Hildene, which manages about $400 million.

As the mortgage bubble popped, Congressional investigators blamed S&P, a unit of New York-based McGraw-Hill Cos., for inflating its grades on securities backed by mortgage bonds, allowing investors to amass debt that turned out to be toxic. Now, as Jefferson sees it, S&P is roiling the $53 billion market for the bank debt CDOs with overly pessimistic grades.

“The S&P securitization group’s negligence is creating an iron grip on capital that is preventing recovery for these organizations,” Jefferson wrote in a letter dated March 23 to Henry Albulescu, an S&P executive who helps grade the bonds.

80% Failure Rate

By Hildene’s calculations, S&P’s ratings for the TruPS CDOs imply that about 80 percent of banks in the U.S. will fail over the next 20 years.

“It makes no sense,” Jefferson said in a telephone interview. “They refuse to answer any questions.”

Hildene Capital invests in the securities, so it would probably profit if their ratings were raised and that increased demand for them. Jefferson said he last spoke with S&P’s analysts in December.

Ed Sweeney, an S&P spokesman, said that the analysts responsible for the ratings weren’t available for comment on Hildene’s concerns. Albulescu didn’t respond to messages seeking a response.

“Even a substantial improvement in the credit quality of the assets held by trust preferred CDOs would not result in significant upgrades,” Albulescu wrote in a report dated March

16. “We have not seen significant improvement in the credit quality of the small banks.”

S&P gives lower ratings to 87 percent of 180 TruPS CDO securities that also have scores from Moody’s Investors Service, according to data provided by Hildene. In 53 cases, S&P grades a bond CCC+ or lower, which means “currently vulnerable” to default, while Moody’s rates it investment grade.


“For ratings-sensitive investors such as banks and insurance companies, it’s quite painful to hold CCC assets,” said Ratul Roy, a structured credit analyst at Citigroup Inc. in New York.

The bonds are similar to other complex investments devised by Wall Street banks that took pools of assets such as mortgages and sliced them into pieces, many of which got top credit ratings. In this case, the assets were TruPS, securities typically issued by banks that counted as capital for regulatory purposes because they rank between common stock and senior debt in a bankruptcy.

The prices of TruPS CDOs have climbed since Hildene started investing in them. Senior first-priority bonds are generally trading at more than 50 cents on the dollar now, compared with about 40 cents in 2009, according to Citigroup’s Roy.

Between 2000 and 2007, Wall Street bankers created 108 TruPS CDOs, helping community banks raise billions of dollars of capital at low cost, researchers at the Federal Reserve Bank of Philadelphia wrote in a paper last year. Many of those same banks also invested in such deals, a decision that backfired when the mortgage market crashed and bank failures escalated.

Revised Methodology

In July 2008, S&P announced that it was considering downgrading all TruPS CDOs, saying the financial crisis made it more likely that banks would defer payments. Ratings for the bonds plunged, with some downgraded from AAA to CCC. That forced some banks and insurers to sell the securities or hold more cash to back them, and cut the amount of money hedge funds could borrow against them. Ratings that are too low are as important a problem as those that are inflated, according to Gene Phillips, a director at New York-based consulting firm PF2 Securities Evaluations Inc.

“It actually forces some people, some funds, some banks, to realize a loss, even when it’s fictitious,” Phillips said in a telephone interview. “That’s a real frustration, especially if they’re wrong.”

One reason S&P’s ratings are so low is that the company treats any bank that is deferring payments on its TruPS as defaulting, Jefferson said. Issuers of the securities can delay payments for five years and can make up the missed coupons later. S&P also doesn’t disclose its grades for the small banks whose securities are included in the CDOs, he said.

Bank Failures

The Federal Deposit Insurance Corp.’s confidential list of “problem” banks -- those deemed to be at greater risk of collapsing -- fell for a third straight quarter to 813 from 844, the agency said last month. There were 18 failures in the three-month period that ended Dec. 31, bringing the year’s total to 92, compared with 157 in 2010.

Banks that issued securities included in the CDOs defaulted at about a 10 percent rate from 2007 to 2011, double the 5 percent rate for all lenders insured by the FDIC during the period, according to the Philadelphia Fed paper. TruPS are rated lower than bonds issued by the banks would be because they rank lower in bankruptcy, Albulescu wrote in the March 16 report.

Default Probabilities

The banks that issued the securities “tend, on average, to be smaller and less capitalized than the majority of the FDIC-insured banks, and therefore, generally more likely to defer/default,” Albulescu wrote.

On TruPS CDOs also rated by Moody’s, S&P’s grades are about six levels lower on average, the difference between CCC and BB, according to the Hildene data. The biggest discrepancy is 13 levels, such as on the most-senior portion of a CDO issued in 2004 called Trapeza CDO VI, which is graded Aa3 by Moody’s and CCC+ by S&P, the data show.

“Yes, there can be differences of opinion,” Jefferson said. “If one person is rating something AAA and another person is rating it BB+, somebody’s right and somebody’s wrong.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE