By Neil Hara and Antony Currie by jennyyingdi


									                                                                              By Neil O’Hara and Antony Currie

          How does a market that is
          carrying the can for the credit
          crisis get back on its feet?
          Improving transparency and
          strengthening standards are
          crucial. That’ll take time.
          But it ought to help restore
          confidence in securitization’s
          ability to reclaim its role as
          a key — and legitimate —
          financing tool for consumers
          and businesses worldwide.

                   ecuritization has become the
                   scapegoat of the credit crisis.
                   Once a word which carried no
          meaning for the general public, it now en-
          joys widespread notoriety and has been
          held up as the ultimate cause of Ameri-
          ca’s five-year credit boom-turned-bubble
          bursting. But just because the crisis first
          took hold in the mortgage-backed securi-
          ties (MBS) market doesn’t mean that we
          can, or should, pin all the market’s cur-                                                                                        Getty
                                                          Sooner or later, one needs to shed excess
          rent troubles to its lapels.
                By now it is clear that the excess leverage built up throughout the financial system was widespread and unsustainable — and
          would have unwound sooner or later, somehow or other. That has not stopped politicians, some regulators and market pundits
          from pointing the finger at financial engineering as a root cause of the crisis.

                It may be a tempting target, especially 18 months or more into a broad credit crunch. But similar jibes were not thrown at the
          equities market after the Internet bubble burst, or at bond and loan markets whenever defaults have hit hard there. Then, it was

          called poor investing, or bad risk management or bad lending. The instruments themselves, though, were never seriously attacked.
                No doubt there was a lot of bad securitizing of bad loans for a couple of years — not least in subprime-backed mortgages bonds
          and collateralized debt obligations (CDOs). But the basic technology has worked as it was supposed to. Scott McMunn, head of
          credit investment at RBS Asset Management, argues that subprime-heavy U.S. residential MBS and asset-backed CDOs ac-

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          count for almost all the losses attributable to structural defects    pean Securitization Forum (ESF) and the Australian Securiti-
          in securitization — two relatively new asset classes for which        zation Forum.
          there was little useful historical data. In contrast, he notes that        What’s more, if you are unsure how a world without se-
          although spreads have blown out for other asset classes — stu-        curitization might look, the same study puts a number on it:
          dent loans, automobile loans and credit cards — the underly-          “banks may fail to meet approximately $2 trillion of demand
          ing credit performance is consistent with historical experience,      for credit origination globally over the next three years in the
          which is based on a much better set of data. Defaults on con-         absence of well-functioning securitization markets.” A Decem-
          sumer credit increase when the economy heads into a recession         ber 2008 research report by a group of Citigroup analysts led by
          regardless of whether the loans are securitized. Even collateral-     Darrell Wheeler takes an even broader view: some $8.7 trillion
                                                                                of assets globally are currently funded by securitization. Put in
                                                                                context that’s more than half the amount of assets in the entire
           “Everybody involved, including investors,                            U.S. banking system. Clearly securitization has a lead role to
              shares some blame in the systemic                                 play in financing the economy.

                   lowering of standards.”                                      Uneconomical funding
                        Richard D’Albert, Seer Capital                          The trouble is, the credit crisis has rendered securitization un-
                                                                                economical as a funding tool as spreads have widened to record
          ized loan obligations have performed as expected in times of          levels. Bank lending currently offers much more competitive
          stress. “The accusation that securitization is flawed is wrong,”      rates for the issuer. But as Wheeler and his team point out:
          McMunn says. “The flaws came from two asset classes that              “Given the magnitude of the funding requirement and the scope
          evolved very quickly in a short period of time.”                      of credit risk, we see this balance sheet approach as simply im-
               The broader securitization industry has had a longer and         possible without assistance from the existing securitized mar-
          much more successful history. It has helped consumers finance         kets infrastructure that is available.”
          homes, automobiles, college tuition and credit card purchases              But investors are running shy. Staying firmly on the side-
          for around a quarter century. It is rare for these asset-backed       lines, for now, are leveraged investors like banks that generally
          bonds to be downgraded, let alone post losses.                        look for carry trades that pay a margin over their funding cost.
               Properly structured and executed securitization benefits         In their liquidity portfolios they typically manage excess cash
          everybody involved. From an issuer’s perspective, securitiza-         and thus need an active market so they can get out at any time.
          tion can be either a cheap funding source if it retains the lower     That liquidity does not currently exist. Richard Watson, man-
          tiers of the capital structure, or a risk transfer mechanism if it    aging director of the ESF, explains that banks that used to buy
          sells the entire capital structure — or even a mix of the two. An     triple-A MBS tranches at 50 basis points (bp) over LIBOR
          issuer that sells a pool of mortgages in a securitization trans-      can’t or won’t buy them today at a spread of 200bp or wider,
          action frees up cash it can recycle either to support additional      even though the annualized rate of return would be 25% based
          mortgage lending or to reinvest in other assets. An originator        on a capital requirement of 8% against the position. “We need
          may be able to realize economies of scale by expanding loan           to recapitalize the banks to get carry investors back into securi-
          volume beyond what its regulatory capital can support, too.           tizations that provide cash to the real economy,” says Watson.
               That in turn has a positive impact on the consumer. Studies
          have found that securitization both increases the availability of     “CDOs could come back in a simpler form,
          credit and lowers the cost. Meanwhile, the flexibility inherent in
          structured debt allows issuers to tailor products so that differ-       with fewer tranches, higher attachment
          ent investors can better match the duration of their assets and
          liabilities. And securitized debt offers a proportionate interest
                                                                                         points and more equity.”
          in a dedicated pool of assets housed in a separate legal entity,                   Tricia Hazelwood, Credit Suisse
          which removes any credit risk from the potential bankruptcy
          of the issuer. “Investors get the exact asset each one needs to            Banks have been bolstering their weakened balance sheets
          match their liability mix,” says Tom Hamilton, managing direc-        for over a year now — and in Switzerland, the UK and U.S.
          tor and head of securitized products at Barclays Capital.             have even received infusions from the state. But write-downs
               U.S. financial institutions securitized just under half the      have often followed, thus undermining the confidence to ex-

          credit they originated between 2005 and 2007, while up to             ecute such trades. Citigroup’s Wheeler goes one step further
          55% of gross mortgage lending in Europe was funded using              than Watson, suggesting that governments that have invested
          mortgage-backed securities or covered bonds between 2000              in their banks “use moral suasion. They should encourage these

          and 2006, according to a McKinsey analysis undertaken for the         institutions to use some portion of those funds to buy existing
          Global Joint Initiative to Restore Confidence in the Securitiza-      and new securitized issuance.”
          tion Markets (GJI) — a collaboration between the Securities                The picture’s pretty clear: securitization is a crucial source
          and Financial Markets Association (Sifma), the ASF, the Euro-         of capital. But issuers can’t afford it, too many investors are wary

of it and banks are not in a position to replace it. If securitiza- specializing in buying distressed debt. “Each link in the chain
tion does not reclaim its place as a safe and successful funding relied on the diligent practices of the participant before them.
tool the economy will suffer a deeper credit crisis in the short Everybody involved, including investors, shares some blame in
term, and stunted economic growth in the longer term. The the systemic lowering of standards,” says D’Albert.
question is: how do we make it happen?
     The securitization industry has launched several initiatives Classic signs
in an attempt to breathe new life into the market, including These are classic signs of a credit bubble, not the failure of a
Project RESTART, an ASF program designed to restore inves- funding mechanism like securitization. This time round, though,
tor confidence in MBS and ABS.                                                     participants in the asset-backed market finally got caught up in
     More recently, the GJI of Sifma and three major securitiza- the hype and paid insufficient attention to the risks they were
tion forums has taken the lead in laying down the basics needed taking. That is what allowed overall exposure to subprime
to bolster confidence in                                                                                                       mortgages to mushroom
the integrity of the mar-                                                                                                      out of control. If it were
kets. Its eight-point plan,                                                                                                    just loans in the system
announced in a joint we-                                                                                                       going into default and
binar in December, calls                                                                                                       foreclosure, the fallout
for greater transparency;                                                                                                      would have been painful
clarity and standardiza-                                                                                                       but manageable.
tion of due diligence dis-                                                                                                          But the real bugbear
closure, representations                                                                                                       was the rapid growth
and warranties, and                                                                                                            in credit default swaps
servicing; expanded and                                                                                                        on subprime mortgage
improved third-party                                                                                                           bonds which facilitated
sources of valuation and                                                                                                       the creation of synthetic
valuation infrastructure;                                                                                                      asset-backed       CDOs
greater transparency in                                                                                                        (ABS CDOs). How
ratings; more education;                                                                                                       much this multiplied
and the establishment of                                                                                                       exposure to the market
a global securitization                                                                                                        is anyone’s guess: this
markets group to report                                                                                                        derivatives market was
publicly on the state of                                                                                                       two, five, 10, or even 20
the market and changes                                                                                                         times the size of the cash
in market practices.        Lehman’s collapse reignited the credit markets crisis with a vengeance            Associated Press market, depending on

     Regardless of the various private sector efforts, regulators who you ask. And it was mostly a private market, so few knew
are bound to weigh in at some point, though how they will who held the risk, either.
throw their weight around at this stage remains unclear (see                             Hamilton at Barclays Capital says CDOs were nothing
page 56).                                                                          more than a ratings arbitrage game anyway; they not only failed
     What will define the success of any of these securitiza- to redistribute risk but actually concentrated it when the con-
tion rescue packages will be a profound understanding of what stituent credits depended on the same class of collateral. “The
caused the crisis, and where overall standards fell short. For industry tried to do the same thing twice,” he says. “The ratings
good or ill, the market has already identified most of they key agencies will never rate that kind of structure again. And I don’t
problems. The most obvious was allowing bad collateral into think they should.” Hamilton believes investors won’t be in any
the structure — or more precisely, riskier collateral than in the hurry to look at CDOs of any hue again, either.
past, whose expected performance relied more on rosy assump-                             Others are not so sure. Tricia Hazelwood, a managing di-
tions than on historical data that reflected a complete credit rector and global head of asset finance at Credit Suisse in New
cycle. But asset-backed experts weren’t alone in that. The belief York, sees no future for ABS CDOs or CDO-squareds. But
that house prices wouldn’t fall, however foolish, was rife. Lend- she says the CDO structure could still play a role in repack-
ers felt they could lower credit standards and rely on higher aging credit into diversified pools that would allow investors

prices to cushion any losses. In addition they tolerated higher with limited resources to buy multiple risk exposures through a
debt loads relative to borrower income, accepted higher loan- single instrument: “It’s not something we will see overnight. But
to-value ratios and in some cases failed to verify borrowers’ in- CDOs could come back in a simpler form, with fewer tranches,

come and asset declarations.                                                       higher attachment points and more equity.”
      “Poor underwriting tracked through the system,” says Rich-                         Of course, most if not all of these products were rated, and
ard D’Albert, the former head of structured credit business at critics have vilified the ratings agencies for assigning high rat-
Deutsche Bank who is no co-CIO at Seer Capital, a hedge fund ings on what too often turned out to be slop. But credit analysts,

          however qualified, cannot make reliable calls unless the infor- dead for the foreseeable future. It’s not a securitization tool, but
          mation on which they base their analysis is sound. As struc- rather a business model: monoline lenders which relied as much
          tured securities became more complex neither the ratings agen- on the fees from selling loans into securitization as they did on
          cies nor investors had empirical data to support the prospective fees for originating the loans in the first place — if not more so.
          credit performance touted by issuers and underwriters. Ralph This was the originate-to-distribute model taken to its extreme,
          Daloisio, a managing director in the New York-based struc- which needed to generate fees yet often paid little regard to the
          tured finance group at Natixis, notes that the ratings agencies quality of the underlying collateral. Investors fueled the frenzy,
          placed what was tantamount to a                                                                                particularly those who relied on
          seal of approval on the integrity                                                                              the ratings agencies’ opinions
          of the data fed into their models,                                                                             and did not conduct their own
          which was often supplied by un-                                                                                credit analysis — a practice no
          derwriters who had not verified                                                                                corporate bond manager worth
          the information fed to them by                                                                                 his salt would ever contemplate.
          originators.                                                                                                       Observers disenchanted with
                “The chink in the armor of                                                                              the originate-to-distribute bank-
          securitization has always been                                                                                ing model have suggested that
          its reliance on sponsor-produced                                                                              issuers should keep some skin
          information,” says Daloisio,                                                                                  in the game in securitizations.
          “We need either a financially                                                                                 European regulators have put
          sound sponsor to vouch for the                                                                                forward a specific proposal that
          data, or an independent system                                                                                would force issuers to retain 5%
          to check and validate the core                                                                                of the “net economic interest” in
          data elements required to model                                                                               each deal, an idea that has raised
          expected performance.” He ac-                                                                                 hackles in the securitization in-
          knowledges that neither solution                                                                              dustry. Daloisio dismisses it as
          is perfect, however.                                                                                          unnecessary — he says the mar-
                No doubt the ratings agen-                                                                              ket already demands a higher re-
          cies bear their share of responsi-                                                                            tention rate in most cases — and
          bility for the crisis, but attempts                                                                           insufficient because it regulates
          to blame the entire fiasco on                                                                                 an outcome rather than a process.
          their failings ignore the role that                                                                           “If we target the desired outcome,
          regulators and investors played.                                                                              we demote the process,” he says.
          “People have to do their home-                                                                                “Any means becomes justified
          work,” says Sanjeev Handa,                                                                                    provided the specific regulations
          head of global public markets                                                                                 are satisfied, which can produce
          at TIAA-CREF and an ASF                                                                                       a horrendous result. The current
          board member. “Origination and Another Titan forced to carry the weight of the world on its shoulders         crisis is a prime example.”
          investing standards slipped during the long bull market in this                It’s worth noting that some products already do involve risk
          asset class. There was a sense that things could not go wrong retention — U.S. credit card ABS, for instance, where securiti-
          — but they can. TIAA-CREF runs its own analysis, including zation is a pure funding tool and banks retain the first loss piece.
          stress tests on every bond it buys.” It keeps a close eye on the Wheeler at Citigroup is not averse to extending that to other
          bonds after purchase, too; Handa insists that portfolio surveil- products, though does add the “significant question here is: how
          lance is just as important as buying the right assets in the first much is enough to align interests, and how much is too much
          place.                                                                   that would render securitization uneconomical.”
                Investors need to ensure that portfolio managers have the                Seer Capital’s D’Albert notes that nobody expects under-
          appropriate safeguards in place. At TIAA-CREF, Handa runs writers of conventional corporate bonds or equities to keep part
          the investment team, which works closely with colleagues in an of the deal on their book. “How is that different?” he asks. “I am
          independent risk management group, which in turn gets pric- not sure retention achieves the intent — to keep people vigilant

          ing data from a valuations unit that is also independent from at each step of the way — and it will have unintended conse-
          investments. “We have a three-legged stool,” says Handa. “It is quences.” A mandatory retention requirement could threaten
          not just my people who look at an investment and decide what the economic benefits of securitization, too. If an issuer has to

          it is worth and how much we should hold.”                                retain a significant equity interest, it retains the risk as well and
                                                                                   although a securitization will free up cash the issuer will get no
          To retain or not to retain?                                              capital relief on that portion of the deal.
          There is another structure that, like ABS CDOs, is probably                    The central premise behind forcing firms to retain a stake

assumes that otherwise they have no skin in the game. That’s sary to evaluate a deal in which an issuer seeks to sell its entire
misguided, as hundreds of subprime lender bankruptcies can economic interest — to relieve capital constraints, or otherwise
testify to. Such firms had plenty at stake in a down market: in- — and decide whether it meets their risk profile. Issuers that
vestors could throw back at them, at par, any fraudulent loans do not need capital relief often prefer to retain equity residuals
and mortgages suffering early payment defaults. That’s what anyway; they are expensive to sell and deliver high returns if the
sent most of them under. True, they ignored that risk. But it underlying origination is high quality. For example, Hazelwood
was there — and few lenders are likely to forget that in a hurry, expects most issuers will hold on to residuals for loans origi-
especially as the recommen-                                                                           nated in 2008. “Origination
dations of the Global Joint                                                                           standards have increased
Initiative include strength-
                                     “The chink in the armor of securitization                        dramatically,” she says, “I
ening and standardizing                      has always been its reliance on                          think the performance is
representations and war-                                                                              going to be better than any-
ranties and repurchase pro-                 sponsor-produced information.”                            thing we have seen since
cedures for bonds backed                            Ralph Daloisio, Natixis                           the early 2000s. But if the
by residential mortgages.                                                                             issuer does decide to sell
     What’s more, retaining an interest is no guarantee of better that piece it should be able to.”
underwriting or risk controls. Among the largest casualties in         Industry participants argue that heightened due diligence,
the credit crisis are Washington Mutual, which went into re- better disclosure and greater transparency will enable investors
ceivership and was bought by JPMorgan Chase, and Wachovia, to police underwriting quality without the need for risk reten-
which sold at a discount to Wells Fargo. Both banks were laid tion. Hazelwood expects the market to demand more informa-
low in part by their large exposures to option adjustable-rate tion about how collateral was originated, including the right
mortgages which they originated themselves, from brokers or, to review loan files to check documentation and income veri-
in Wachovia’s case, bought with Golden West in 2006 and kept fication procedures, how servicers collect payments when due
on their balance sheets. That’s good old-fashioned bad lending. and what happens when borrowers fall delinquent. She says
     Credit Suisse’s Hazelwood sees no place for mandatory re- investors may insist on modifications that will better protect
tention in a market peopled by sophisticated players who can the interests of senior tranches, too. One example is sequential
look after themselves. Investors should have the skills neces- pay structures that give triple-A investors their entire principal


Banks’ capacity for supplementing or even replacing securitization is even more strained than a year ago
          back before the subordinated bonds get paid, rather than pro- market that consists of millions of securities, most of which
          portionate redemptions that ripple down the capital structure. trade seldom if ever. Last trade reporting has little value when it
          That would likely change the economics, of course — triple-A may be weeks or months out of date, and it’s an open secret that
          spreads would be tighter as a result of the increased protection the mark a dealer gives an investor for portfolio valuation pur-
          but wider further down the structure to compensate for tying poses may be higher — and sometimes much higher — than
          the investment up longer.                                            the price a dealer would pay to buy that same security. The GJI
               The trouble is, most of this is longer-term planning — identified reliable valuations as a critical component in restoring
          which is necessary, but doesn’t kick-start the market now. So investor confidence, but although it encouraged efforts to solve
          far, nothing has: the longer the crisis has continued, the more the thorny problem it was unable to propose a clear solution
          obstacles have been thrown in the way. As the risks of recession either.
          have risen, investors have grown increasingly wary of buying             Mayer Brown’s Kravitt says revised accounting regulations
          any consumer debt — so credit card and auto ABS spreads have will make it harder for banks to shift transactions off their bal-
          widened and issuance has slowed to the point where in recent ance sheets and reforms to the risk-based capital regime have
          months it virtually halted for weeks at a time. Meanwhile the killed off most capital arbitrage opportunities. That leaves fi-
          failure to bail out Lehman Brothers and the about-face on how nancing as the main driver for securitization in the future,
          to use funds in the $700 billion Troubled Asset Relief Program which Kravitt sees as its “highest and best use” anyway.
          (Tarp) has caused confusion                                                                                    With private markets
          about the role Treasury and                                                                             seemingly going round in
          the Federal Reserve are willing           “People have to do their homework.                            circles on this, it comes down,
          to play (see page 40).
               The upshot? The hard-
                                                  There was a sense that things could not it seems,Wheeler’s exhortation
                                                                                                                              to government inter-

          to-value, illiquid, mostly sub-                  go wrong — but they can.”                              that governments lean on their
          prime-related loans and secu-                      Sanjeev Handa, TIAA-CREF                             banks to buy securitized debt
          rities that sparked the crisis                                                                          may be a long shot. But in the
          remain on many banks’ balance                                                                           U.S. many still hold out hope
          sheets, weighing them down. The hope was that vulture inves- that the government will revert to Tarp’s original intended pur-
          tors specializing in buying distressed assets would help provide pose of buying troubled assets.
          a pricing floor and eventually set clearing prices to help shift         Longer-term, governments may want to consider reviving
          them. Jason Kravitt, a partner at Mayer Brown in New York, private sector mortgage securitization by encouraging support
          believes there is perhaps as much as $1 trillion of such mon- for triple-A securities through purchase or guarantee programs,
          ey, though others put that number at just $100 billion. While a policy already under consideration in Australia and other
          some have been active, many have remained on the sidelines countries. “We need tighter spreads on the triple-A securities
          during the turmoil.                                                  or wider spreads on mortgage loans to make the mathematics
               Their tepid activity makes other investors reluctant to jump of securitization work again,” says Watson. Resurrecting secu-
          in until they know that whatever price they pay today will still ritization assumes even greater importance in Europe and oth-
          be good tomorrow. Nobody wants to buy a bond only to find er countries outside the U.S., which do not have government
          that a distressed seller has waded in and pushed the price down sponsored enterprises like Fannie Mae and Freddie Mac to keep
          20% or more overnight. In many cases, bid-offer spreads are so the supply of mortgage credit flowing.
          wide that investors, many of whom pay the offer but must value           That’s a way off in the U.S. at least. Shorter-term measures
          the position at the bid, take a significant hit on day one even if are needed. And financial institutions must rebuild their capital
          the middle market price has not changed. Kravitt says mark-to- bases, dispose of or get comfortable with their troublesome as-
          market accounting has contributed to the problem and clearly sets and cut back leverage, a painful process that is under way
          made it worse because it creates a downward spiral of forced but by no means over. Once the banks regain their footing, the
          selling and lower prices that feeds on itself. “It is intensely pro- more robust infrastructure being mapped out by market partic-
          cyclical and it creates self-fulfilling prophecies,” he says. “We ipants ought to restore and underpin investor confidence. Then
          need a better price discovery mechanism.”                            securitization will be poised to resume its rightful role in pro-
               Not everyone agrees, but even those who see themselves viding credit, the lifeblood on which economic growth depends.
          as proponents of mark-to-market accounting are now calling

          for greater clarity at least. As Citigroup’s Wheeler and his team
          wrote: “We would caution that we are not saying that market             Neil O’Hara is a freelance writer based in Lincoln, Mass.
          value accounting should be suspended. Rather, we are suggest-           He is a contributing editor to FTSE Global Markets and

          ing that auditors and companies be encouraged to carefully              writes for a variety of other publications including On Wall
          consider FASB’s guidance for valuation of assets in illiquid sec-       Street, Wealth Manager and Alpha.
          tors.” Even this, they continue, is “an imperfect solution.”
               Valuation questions have long bedeviled a securitized debt


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