Dave Jefferds, co-founder and COO of DealVector, examines how noteholder communication could help heal the Trups CDO sector

Five long years ago, the global financial crisis hit. Many deals imploded almost immediately, like ABS deals that blew through their event of default triggers. That capital was more or less destroyed.

Other deals, like CLOs, were stretched but did not break at all. Their resilience allowed the structures to recover and that sector is now booming again.

But there are some deals that lived in between - zombie deals, neither living nor dying, the capital tied up and slowly wasting away. Some hedge funds are zombies: they were gated in 2008 and remain gated even today, still charging fees to investors. In structured credit, it turns out that a 'small' backwater (with US$60bn in total issuance) called Trups CDOs (or should we say ZDOs) also is full of zombies.

How can this be, after so long? How do markets heal and what stops them from healing?

Well, of course, the deals themselves matter. But there is a deeper problem. That problem lies at the heart of the financial system and it stops markets from healing efficiently.

The problem for investors is the one described in the movie Cool Hand Luke: "What we have here is failure to communicate." Let's compare the cases of the 'good' structured debt (CLOs) and the Zombie structured debt (Trups). As we will see, despite their differing fates, both would have (and would still) benefit from improved communication pipes in our financial infrastructure.

Let's look first at the ZDO situation. Trups CDOs were structures that took 'trust preferred' securities - usually issued by regional banks - and bundled them into CDOs, which were then tranched and sold. Most of these trust preferreds were issued by small un-rated banks.

The CDO underwriters kept the names of the banks secret (!) from the investors in the CDOs. Ostensibly this was to protect the banking relationship that existed between the big underwriter and the small regional, but it probably (I mean, for sure) also served to disguise the risks in the pool.

In this type of 'blind pool' structure, it turns out that many of the investors that were most comfortable with Trups were those that were most familiar with regional bank risk: the regional banks themselves. So, in the end, many Trups CDOs that held regional bank risk were themselves held by regional banks. Risk was not dispersed; it was concentrated.

When the crisis hit, these structures went south along with the banks. Without getting into too much detail, the structures had a forbearance period of about five years and this window suited policymakers just fine as they attempted to stop a banking collapse.

So far, so bad: this trade was a tragic one. Regional banks have been in a sort of limbo existence, reducing their balance sheets and doing relatively little lending. Holders of the CDO risk have also been in a limbo, with payments cut-off while they hoped for some restructuring or market recovery.

Healing the un-dead, or how do you talk to a zombie?
Still, in capitalism, when prices go down, new investors should appear at the right price. Why hasn't that happened in Trups? The answer is that new actors have indeed entered the market, but they have suffered from a failure of communication.

We are aware that CDO noteholders have reached out to banks with the idea of working constructively towards a more beneficial workout. But in the main these paper-written inquiries have generated no response.

Conversely, some commercial bank issuers have been reaching out to CDO noteholders because they want to repurchase their own Trups out of the CDO. Such repurchases could facilitate the recapitalisation of the bank in question.

The bank has sent notices through the trustee system and DTC. But they have not been able to locate the holders of their liabilities.

So this is a strange situation. Motivated parties on both sides seem to want to find each other but can't. Messages through the trustee system seem to go into a black hole.

Such messages are forwarded to custodial banks, who then forward it to beneficial owners or their representatives. Perhaps such messages are read. Perhaps they sit on a desk unread. Perhaps they are never actually delivered.

The stakes are not small. The potential transactions in question - recapitalisations of regional banks - could reach into the US$100m range or higher. Failure to communicate; in the Google age, it seems crazy.

The Trups market is still truly impaired. But even rebounding markets like CLOs could have recovered more quickly if the central communication system of the financial world were more dynamic.

During the bottom of the crisis, certain buyers of CLO equity perceived that the there was significant value in assets that were trading below liquidation prices. They attempted to find and purchase such assets.

But really only two entities knew where to find them. The first was the trustee. But the trustee is boxed in: if it moves proactively to help in connecting particular affiliates of a deal, it has little upside and potential downside.

The other entity that would know who the holders were is the underwriter. But the underwriter is conflicted because it trades on its own behalf and so any buying inquiry depends on a trust relationship that is fraught because one party holds all the knowledge.

As a result, any interested buyer of assets has to take certain protective steps in this information vacuum. The buyer can't vet the recipients of any notices they send ahead of time, so they may begin with a more conservative proposal than they are really willing to undertake. The risk of this approach is that it makes the sender appear unserious, when in fact it is more in the nature of an opening bid to start a conversation.

The recipient of such notices, in turn, may be reluctant to disclose their identity by responding to an inquiry (especially if it is overly vague or 'low-ball'). Even in the case where both parties want to communicate, the slow turn-around time of such messaging is problematic.

Anecdotally from several sources, the consequence can be a missed vote, or lack of time to truly evaluate a proposal effectively. Such votes are often a reason to send messages through trustees.

The threshold percentage of votes that is desired, depending on the asset class, might be 25%, 33%, 50%, 67% or even 75% of the total votes outstanding. The clunkiness of messaging means that there is a fatal inability to develop the critical mass for such blocks, even when the economic incentives are clear.

So, as the economy continues fighting World War ZDO, perhaps policymakers should focus on the low-hanging fruit. Rather than focusing on top-down legislative reforms, they could simply encourage the development of platforms that make bottom-up communications easier among investor groups and interested participants. That would be the easiest way to wake the undead.