While certainly not the first cataclysm for securitization, the sewage leak at National Century Financial Enterprise will, at the very least, pollute the integrity of the entire market, particularly from the outside looking in. At this point, the worst case is becoming increasingly more plausible: that the receivables themselves, to some extent, were fabricated and manipulated.

Though the NCFE blowup will make it more difficult for esoterics and small leveraged companies to come to market, vanilla ABS has arguably not seen meaningful spread widening associated with NCFE, noted Alex Roever, head of ABS research at Banc One Capital Markets. In fact, current conditions are more reflective of events that happened this summer, such as the negative headlines surrounding Capital One Financial Corp. - which announced a memorandum of understanding with the federal regulators - and The Metris Companies, currently under strict direction from the regulators.

That the general market is less spread sensitive to NCFE - despite the debacle securing prime real estate in several non financial publications - indicates that primary investors make a clear distinction between off-the-run deals like NCFE and the greater market.

Assumptions are key

to structure

At some level, the NCFE implosion demonstrates the frailty of ratings in situations of fraud.

The structure and collateral, as purported by NCFE, may have been sound, but was it a house of cards all along, or was there systematic breakdown and deceit after the initial structures were set up, perhaps several quarters out? The Wall Street Journal reported last week that NCFE had been transferring funds between securitizations to make up for shortfalls. This deception was, in fact, part of its business strategy.

According to one former Prudential Securities banker, the firm dropped NCFE as a client in the mid-1990s for several reasons, some of which are based on Pru's skepticism of the company's integrity.

One of the major discrepancies focused on by investors in late October was NCFE's need for so much cash in the first place - enough to motivate management into the deal reserves. If the company was servicing a $3.3 billion portfolio of receivables that was turning over every two months, three months, or even six months, the transactions should have been flush with funds, and NCFE should not have been reliant on the term market to fulfill existing purchase agreements. The company's cash shortfall could have been tied to new portfolio growth, or it could have been that the existing portfolio was not what it should have been.

Last week, following NCFE's widely publicized Chapter 11 filing, several national newspapers were reporting on the federal testimonies associated with parties to NCFE, in some instances concerning financial transactions the company was involved in during ex-Chairman & CEO Lance Poulsen's final days at the helm. It was revealed that Poulsen was instructing healthcare providers, with which he was personally affiliated, to retain funds that would have otherwise passed into the ABS trusts. These providers were also receiving unsecured loans from NCFE.

The idea is that he was feeding his own companies with bondholder cash, benefiting from the equity in his various investments as well as receiving commission on the loans.

Also last week, the Washington Post reported that NCFE was aggressively building its loan portfolio in preparation for an initial public stock offering. The IPO motivation was the downfall of several securitizers in the mid-to-late 1990s, particularly on in the subprime auto and subprime home equity arenas.

It has been said that scandal-laden franchise issuer Enterprise Mortgage Acceptance Co. was aggressively and haphazardly growing its loan portfolio in hopes of a stock offering. In fact, with EMAC, plaintiffs suing the company allege it was feeding cash into its existing book of loans (by propping existing borrowers) so that the portfolio would seem less risky, allowing it to continue securitizing and to eventually IPO. Also similar to NCFE, EMAC was allegedly lending to its affiliates, certainly a red flag for securitization, where risk analysis is understood to be the key underwriting factor for lending.

Walsh went pass through?

If NCFE is found to have engaged in fraud, it's unclear how the securitizations and/or the investors will be ultimately impacted. Several firms with positions in NCFE securitizations have already written down their exposures. Ambac, for example, wrote down about $80 million or 70% of its combined investment in both NPF VI and NPF XII, the two issuance vehicles of NCFE.

One investor with a legal background indicated that home equity securitizations from Walsh Acceptance Corp. turned pari parsu - such that the senior and subordinate note holder were placed on equal footing - after it was ruled that the company had engaged in fraud. In 1996, the investigation into Walsh's lending practice began, as the company was accused of manipulating the value of the properties it lent against.

Other instances of fraud associated with ABS lenders include Commercial Financial Services (CFS), First National Bank of Keystone, and, lo and behold, a healthcare receivables factoring company named Towers Funding. Bondholders in CFS apparently suffered substantial losses, recovering about 5% of the $1.6 billion outstanding, according to research titled "Bullet Proof Structures Revisited" by Moody's Investors Service.

With First National Bank of Keystone, where fraud cost the Federal Deposit Insurance Corp. about $800 million, the ABS credit story is fairly non existent, meaning that, according to sources, investors came away unscathed. Basically the bank was securitizing assets but not removing them from its books, inflating its value. Though the deals kept performing, the regulatory backlash from Keystone is a larger story, as the value of home equity residuals - which the regulators associated with Keystone's failure - has become an enforcement target.

ABS in bankruptcy

There have been several bankruptcies in ABS over the past five years, some of which have affirmed the ABS structure. As Moody's notes, when Pacific Gas & Electric Co. filed for bankruptcy in 2001, the structural integrity of its triple-A rated stranded cost ABS was affirmed, while its corporate debt holders suffered losses

A few tragic examples, however, have brought servicer linkage to the forefront of concerns for credit analysts and investors.

One of the most notable servicing breakdowns resulted when department store franchise Heilig-Meyers collapsed into bankruptcy in fall 2000. Because the borrowers paid on location - in most cases at their local Heilig-Meyers - when the retail locations collectively closed their doors, the borrowers could not pay even if they wanted to. The stores reopened under court order while a servicing transfer was taking place, and, at the time, the borrowers were "trained" to pay by mail.

The ABS outlook

"Any time you have a company that gets in the headlines and it's a securitizer, it can make things difficult for similar companies," said Banc One's Roever. "In this case, any monoline finance company would be considered a similar type of company."

Perhaps indicative of the current market, just two weeks ago the senior class of a timeshare securitization for Marriott International widened 20 basis points from initial talk after a mild, mid-marketing restructuring, sources said. Credit Suisse First Boston was lead manager. According to a source, two years earlier CSFB took back the senior tranche of a Marriott deal and sat on it until the bid improved. "Underwriters are going to be less willing to do things like that," the source said. "Deals are clearing where they're supposed to clear."

As fraud is now on the radar screen, certain provisions will probably be written into deals, especially those from smaller players, such as regular SPE audits and increased disclosure.

As for the healthcare receivables sector in general, it is unclear how or if investors will receive new deals in the future. "NCFE is really an aberration, but it's unfortunately a big aberration," said a healthcare industry source. "But their problems are not indicative of an industry problem. It's contained and solely related to them and what they were doing."

"The hysteria seen in the ABS market is frightening, like nothing I've ever seen," said a securitization consultant. "People are way too quick to pull the trigger. Cap One was an example of a company that got hurt but didn't need to get hurt. It was just an agreement. On the equity side, their market [capitalization] fell in the billions."

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