S&P Pullout Blindsides Dealers, Investors

S&P wasn’t the only one hurt by its unprecedented decision to pull its ratings from a virtually completed securitization.

The rating agency’s abrupt move is likely to result in large losses for the blindsided bookrunners, Goldman Sachs and Citigroup, which were forced to scuttle the $1.5 billion offering.

It also created a logistical and public-relations disaster for the dealers — one that some rivals assert was partially self-inflicted. Goldman and Citi now have to decide what to do with the giant loan pool. And a host of their customers ended up not getting bonds they had expected and incurred unnecessary hedging costs.

Citing a discrepancy in its ratings methodology, S&P withdrew its ratings late Wednesday, five days after Goldman and Citi placed the bonds and on the eve of the scheduled settlement. “It’s the only thing that anyone is talking about,” said one sellsider yesterday. “In my 25 years in this market, I’ve never seen anything like it.”

Sellsiders said S&P’s decision will cost Goldman and Citi millions of dollars in additional hedging expenses, wasted legal fees and compensation to investors. For example, according to one analyst, the dealers might have to pay “hundreds of thousands of dollars” to cover due-diligence expenses incurred by Torchlight Investors, which had committed to buy the transaction’s B-piece.

Likewise, the snafu caused havoc with hedges for the transaction. “Goldman had priced all their bonds, so they would have taken their hedges off,” said one veteran issuer. “They had $1.5 billion of collateral, so you can guess they would have had about $1.5 billion of hedges. When they took their hedges off, the investors buying the bonds were putting their hedges on — that’s another $1.5 billion. And if this deal comes back to market in the future, the whole process will be repeated, so that’s $6 billion of hedging taking place because S&P took this course of action.” Whether the dealers or investors lost money on the hedges depends on movements in interest rates and spreads. Goldman and Citi now have to incur the risk of holding the loans longer, as well as the additional hedging costs.

The dealers had to notify investors yesterday that the planned bond sales were being unwound. Although the investors committed to buy the bonds last Friday, they weren’t required to wire payment until yesterday. In the meantime, some of those investors had flipped bonds in the secondary market. Those transactions also had to be unwound. In other words, none of them actually took place. Goldman and Citi likely provided compensation to some of the original investors, especially their best customers, rival dealers said.

“In the real world, you can’t just say to your investors, ‘Sorry — better luck next time,’” said one CMBS veteran. “You have to compensate them for their time and trouble. If they were buying the triple-Bs, they might have even sent guys out to look at the properties. So Goldman probably said to them, ‘If the 10-year Treasury was at 3.05% when we priced it, and now it’s at 2.96%, we’ll pay you the 9 bp difference to make it up to you.’ ”

Executives at Goldman and Citi either didn’t return calls seeking comment or declined to comment.

Many market players were sympathetic to the plight of Goldman and Citi. “The banks were blindsided by S&P,” said one market player. “S&P looks like a complete idiot, and they have done much damage to their franchise.”

“I don’t think Goldman or Citi had any idea this was happening until Wednesday night,” said one rival issuer. “It came at them totally out of the blue.”

A few market veterans sounded a contrarian note, asserting that Goldman and Citi should share some of the blame for the deal going off the tracks. They said the dealers should have anticipated that the 14.5% triple-A subordination level awarded by S&P and Morningstar — which was well below the prevailing level — would have invited the investor pushback that resulted. Goldman and Citi restructured the triple-A bonds with a senior-junior structure to appease bond buyers, but still had to widen the spreads significantly — a fate made worse by simultaneous deterioration in the general market.

“They should have known better than to put only S&P and Morningstar on this deal with 14.5% credit enhancement,” said one CMBS lender. “Goldman and Citi are not newcomers to this market. They should have known that the S&P subordination level did not make sense, and that investors would push back.”

While many CMBS players said “good riddance” when asked about the possibility that the backlash would keep S&P out of the sector indefinitely, others said that wouldn’t be a positive development for the sector.

“It’s bad for CMBS to lose one of the major rating agencies,” said one issuer. “It damages the credibility of the whole market.”

But it was hard to find anyone defending how S&P handled the episode. “If they discovered a glitch at the last minute, they could have said, we will study how bad this is and monitor this deal more closely, instead of blowing it up and wreaking havoc,” said one CMBS lender. S&P declined to comment.

Goldman and Citi now have to figure out how to proceed. The offering might be reconstituted in the future, with different rating agencies signing off on the collateral. Or they might shift some of the collateral out of the pool and replace it with other loans in their pipelines, making the deal slightly different.

“They could find there is a bit of a stigma on this collateral, just because it was part of this deal,” said one CMBS lender. “So they might want to change the pool enough to make it noticeably different.”

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