The legal dispute surrounding the two Beacon Hill collateralized bond obligations (CBOs) poses a hard lesson for structured finance investors. The CBO investors have been trying to get Beacon Hill Asset Management to step down as manager since last year – after the US Securities and exchange Commission pressurized the firm to come clean on losses it was hiding on the hedge funds it managed.

But could these investors have looked over the CBO documentation more carefully and demanded more flexibility in replacing the manager? Janet Tavakoli, a structured financing consultant, says yes.

“Just look at how long it is taking the Enron and WorldCom cases to move forward. So much time is spent on gathering evidence that by the time and investor wants to replace its manager your CDO is already suffering from reputation risk. No one will want to touch your tranches, and if you try to sell them people will say ‘no thanks, I know who the manager is,” she explains.

It is even more difficult to gauge how well the actual operational risk management heads, senior executives or not, understand documentation issues related to manager agreements, derivatives and other structured product contracts. Nonetheless, it is clear that more investors are spending money on independent consultants in the structured finance field to help the firm make decisions concerning them. “Often lawyers are not aware of the potential problems,” Tavakoli asserts.

This is not to say that the operational risk management head needs to be sitting in on negotiations. Even though AXA Investment Management has an operational risk management department, its front line must be sharply aware of International Swaps and Derivatives Association (ISDA) master agreements. US Generally Accepted Accounting Principles (GAAP), French GAAP and IAS 39 when it considers new deals.

“Whether we are managing or investing in a CDO we have to really understand the accounting treatment of everything about it. This includes everything from the consolidation to the mark-to-market of the contracts,” says Deborah Shire, AXA’s head of structuring securitization and structured credit in the firm’s structured and alternative investment management division in Paris.

Few players are as up to speed as players like AXA, who are both investor and collateral manager. However, even the more sophisticated firms miss overlaps and gaps of the credit-related operational risks. “A lot of investors just do not have the guts to get things rewritten in the management agreement. For example, when you are getting married you do not want to write up some clause that is going to end up in divorce,” Tavakoli says.

The problem, she adds, is that so many players feel that ISDA is the language. If it is over-the-counter, then it is private and can be negotiated, she explains. “Arrangers try to make out that the language they use is ISDA standard even though it is not always the case. Most investors are completely unaware of the disadvantages so it is easy for arrangers to hide behind the ISDA mantle and get naïve investors to accept whatever language they want.”

According to consultants, investors often ask about the fee structures and what they mean. But is not easy breaking it down. Tavakoli says investors have to watch out for the “documentation arbitrage” that banks play.

She says banks add in fees at different times even after they have already taken out extra basis points. “The bank shows the investor an all-in average spread on the portfolio that is lower than the actual average bid side spread of the portfolio. That way then can capture extra basis points without the investor knowing it.”

Single tranche deals have been particularly lucrative for banks this past year, so it is often difficult to get information about the fee structures for them. “The bank does not want an investor that is going to invest in a huge mezzanine tranche to know that they are actually driving the deal,” she adds.


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Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008).

Janet Tavakoli's book on the global financial meltdown is Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley 2009).

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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