Let us acknowledge the end of securitization as we have known it. As what began as a "subprime" problem metastasized into, first, a credit market collapse and, ultimately, a worldwide economic crisis, those of us who lived and worked and profited from securitization should do some deep soul-searching. What we now see, with the benefit of hindsight, is not just a series of bad judgments and unintended consequences but instead a wholesale systemic failure of gargantuan proportions. The original securitization paradigm became so corrupted over time by those participating in the MBS/CDO sector that it is pointless to debate whether good technology got into the wrong hands or the technology was itself flawed. It is impossible to distinguish "the dancer from the dance," and the market is, without mercy, sweeping both away.
The Pre-Meltdown View of The Financial System
In the pre-meltdown view of the market, the orgy of leveraging which securitization technology was fueling was going to be kept within safe bounds by an interlocking system of checkpoints with built-in redundancies. The checkpoints were:
Asset-Up Due Diligence - The assets being securitized would be thoroughly understood and carefully selected to assure minimum standards of asset and/or credit quality and, where portfolios were involved, non-correlated characteristics.
Robust Bond Models - The cash flows from the assets being securitized would be modeled through highly-sophisticated computer programs which would facilitate rigorous sensitivity analyses.
Bankruptcy-Remote Structures - The assets would be isolated from the bankruptcy risk of the sponsor by being transferred via "true sales" into special-purpose bankruptcy-remote vehicles which would be immune from consolidation with the bankruptcy estate of the sponsor.
Legal Documentation, Disclosure and Due Diligence - The legal documentation under which the assets were securitized would be written with exactitude, using standardized forms of indentures; the securities would be sold under carefully crafted disclosure documents to assure that all risks were identified and that all material facts were disclosed; and exhaustive due diligence would be performed.
Rating Agency Review - The securities would be subjected to rigorous stress analysis by the rating agencies in determining required enhancement levels for the desired ratings.
Monoline Wraps - Where monoline wraps were used, the monolines would perform their own independent analysis of the assets and the legal structure before wrapping the securities with their financial guarantee policies.
Bank Risk Management - The securities underwriting, distribution and trading functions would be subject to a stringent internal risk management system within the banks to assure that the risk to which their capital was exposed was kept within tolerable levels.
Investor Scrutiny - The final safeguard would be the investors themselves, who would perform their own independent analysis of the securities before committing capital to their purchase.
The Reality: A System Short-Circuited
What was assumed to be an interlocking system of checkpoints was in reality an interlocking series of malfunctions, as a post-meltdown review of these putative checkpoints makes clear:
Asset-Up Due Diligence - As the demand for MBS and CDOs intensified, the assets became secondary to meeting the demand of the buy side, and the assets themselves became obscured under multiple tiers of ownership within the CDO structures and in many cases were replaced by proxies in the form of credit default swaps.
Robust Bond Models - The usefulness of the bond models as a risk management tool was undermined by their uses, especially in decisions about input ranges and distributions.
Bankruptcy-Remote Structures - Bankruptcy-remoteness was never intended to be a remedy for bad credit underwriting; as asset quality became irrelevant to the process, the use of bankruptcy-remote vehicles also became irrelevant: crap inside a ring-fence is still crap.
Legal Documentation, Due Diligence and Disclosure - The law firms became assembly lines for MBS and CDO transactions, cranking out transactions in one-to three-week intervals, using fill-in-the-blanks documents and offering materials, with limited due diligence.
Rating Agencies - The rating agencies succumbed to competitive pressure as they incrementally reduced their standards for rating mortgage-backed securities and CDOs. Not until late in the game did they recalibrate their stress cases and Monte Carlo simulations to reflect the risk of large-scale, nationwide devaluation in the real estate sector.
Monoline Wraps - The monolines, like the rating agencies, were overwhelmed by volume and by the push for profits, with seasoned mortgage professionals being replaced by CDO managers ill-equipped to evaluate the risks of large residential mortgage pools.
Underwriter Risk Management - The bankers were incentivized only to take big risks, in order to maximize profits, and thereby maximize bonuses, with inadequate personal skin in the game if huge losses occurred. The risk management function was further subverted by the opaqueness of the risks to which the banks were exposed.
Investor Scrutiny - Many investors relied solely upon the ratings and the monoline wraps and paid little if any attention to the actual securities they were buying or the assets backing those securities - or to the disclosure prepared by the law firms.
What Will Life Be Like?
It would be folly to presume to predict how structured debt will be issued after the current crisis subsides. The predictions which follow are based in part on proposals which have surfaced to date and in part upon the authors' own views of what should be the market's and the government's responses to the abuses of the past.
Compensation Reform - The U.S. Treasury Bail-Out Act which became law on Oct. 3 imposes new limits on golden parachutes and compensation packages for institutions which sell troubled assets to the Treasury. These standards are expected to be applied more broadly, to mandate that compensation plans create better alignment with longer-term interests of the institutions and their shareholders.
Role of the Rating Agencies - The rating agencies, having been discredited by their work in rating MBS and CDO transactions, will be much less relied upon as a proxy for the regulators; and it is likely that a greater share of structured debt will be sold without a rating. The most effective way to restore the proper alignment to the rating agencies' work is to adopt a regime under which a rating agency's revenue does not depend on whether it is selected by bankers to rate particular deals.
Role of the Monolines - All but two of the monolines have been downgraded below 'AAA' and the remaining two with 'AAA' ratings are under review for possible downgrade. The upshot is that fewer securitizations will be issued with financial guarantees.
Back to Basics - The deals of the future will return to the basic principles which drove the early growth of the securitization market: Know your assets. Know the structure. Know the underlying credits. Ironically, in the post-meltdown world it may turn out that the safest structured finance investments are in fact the so-called "exotics" - the deals backed by non-traditional assets, which do not involve large pools of consumer loans but which instead are built around discrete businesses and assets which can be diligenced and understood.
Borod (rborod@brownrudnick.com) heads the Structured Finance Group and the Structured Resolution Group at Brown Rudnick, LLP, an international law firm.
Macy (stephen.macy@churchstreetadvisors.com) is a Managing Partner of Church Street Advisors.
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