As has been discussed at industry gatherings over the past two years, navigating the challenges of corporate fraud in the asset-backed market have proven particularly difficult, thanks in part to the industry's nature - it's the route less traveled by the mainstream. At last week's Asset Based Lending Symposium presented by Financial Research Associates, Daniel Alpert, managing director and co-founder of Westwood Capital examined the issues of why and how fraud can be committed in the receivables and asset-based lending industries, while discussing warning signs that may lead to such practices.

Most of the fraudulent behavior seen to date may lie in the challenges presented by the assets themselves, which are, in the structural and servicing sense, very unique. And servicers face a particularly heinous curve in an industry still void of guardrails, years after the National Century Financial Enterprises and Enron scandals.

Building a guidebook:

Seven steps toward fraud

In his panel, Alpert discussed seven methods in particular towards committing fraud in the ABS market. The first was the easiest of the seven to spot: inventing loans that simply do not exist and entering into a securitization. Following this is the creation of collateral for loans that do not exist.

The repurchase or substitution of loans and from securitization pools immediately before they become delinquent is a third common fraud. Although this is permissible, it is in the volume of these repurchases and what one does with loans after they are repurchased where the devil resides, said Alpert.

The fourth most common method of fraud is "structured repayments," or the writing of a new loan to avoid repurchase right limitations.

The commonly used practices of loan kiting, when loans are removed from one pool, restructured and dropped into another pool, has typically occurred when one lender acts as servicer for several pools, each with different investors. Fund kiting, meanwhile is the practice of transferring interest and credit reserve funds from one securitization to another.

Other instances of fraud have stemmed from the round tripping of advances from one borrower facility to make payments on another. The final fraudulent strategy is the restructuring of loans by lenders which have obtained the ability to control equity stakes in their borrowers in exchange for restructuring and stretching out loans, added Alpert.

"Of course," he added, "None of this would have been possible if investment bankers, the rating agencies and the buyside itself had not been willing to forego oversight and permitted leverage to grow to the levels it did prior to the last cyclical downturn."

Warning signs for such practices include a hard-driving entrepreneurial founder or controlling shareholder, a passive board of directors and audit committee, credit policies and procedures which permit certain credit decisions to be taken outside of conventional channels, audited loan-loss levels that seem too good to be true and companies operating at abnormally high leverage with any of the above characteristics.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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