The developments at National Century Financial Enterprise that began surfacing last week could have striking consequences for the market, particularly for esoteric assets, which have already had to struggle for love in ABS land over the past several quarters.
As of press time, it was unclear whether or not a waiver had been granted by investors to allow NPF XII to continue revolving, or if the deal will begin amortizing.
According to sources, even in the best case scenario - such as replenished reserve accounts, a waived rapid-AM trigger, and a cash injection - the event still calls into question seller/servicer "integrity risk," an emerging facet of securitization risk analysis that was discussed in depth at the fall conferences. Specifically, seller integrity has come into question in situations involving smaller, unrated companies that are faced with financial viability issues, as was the case with NCFE over the past months.
The company was unable to successfully complete a third quarter securitization, sources said, which left it in dire need of liquidity.
"If all they did was raid reserve fund money, it's fixable," said Mark Adelson, head of ABS research at Nomura Securities. "If there's a problem with the receivables, and they did something worse, than it could be the death knell for healthcare securitizations."
At this point, it is not clear to the parties involved - which includes rating agencies, investors, law firms, and trustees - whether or not the violations stem further than the misappropriation funds out of the reserve accounts, though investors and independent directors of NCFE have sent in teams of auditors to verify, among other things, that the receivables are actually there, and match up substantively to what is represented in the servicing reports. Recall that in May 2000, Asset Sales Report (ASR's predecessor) ran a controversial story regarding NCFE and allegations of fraud, which was a contributing factor to the ABS market shunning the company for nearly a year. The subsequent investigation, conducted by Fitch Ratings (then Fitch), declared the allegations to be unsubstantiated.
According to sources at Moody's Investors Service, over the course of last week the agency learned that NCFE had been siphoning from the reserve accounts of both the NPF VI and NPF XII trusts, which have $3.3 billion in combined ABS outstanding. While the reserve account for the NPF VI trust was in compliance for the September reporting period, trustee J.P. Morgan Chase informed Moody's that NCFE had been removing funds from the account and replacing them with amortizing receivables earlier in the year, and stopped doing so when J.P. Morgan asked for deal documentation supporting these withdrawals. Banc One Corporate Trust Services, trustee on NPF XII, took no such measures, nor does it feel that it was obligated to question NCFE's cashflow directions, sources said. A investor relations contact at Banc One did not return phone calls as of press time.
According to Fitch, which removed its ratings from all NCFE securitizations last Monday, the agency had received no information from either NCFE or the trustees prior to midnight Oct. 25 (technically Oct. 26, a Saturday morning), at which point Banc One alerted Fitch that there had been a servicer default. As of press time, despite efforts to contact both NCFE and the trustee, Fitch had received no further documents or information.
"The only contact we've had was when Lance Poulsen (NCFE's Chairman and CEO) answered the phone when we called," said Kevin Duignan, a managing director at Fitch. "He said it was their intention to communicate with Fitch, but we have not received any further information or contact from NCFE. We have been completely boxed out."
In a prepared statement, NCFE said it is working to resolve concerns with the rating agencies and investors. A spokesman for the company declined further comment.
The big picture
At this point in the game, investors and the agencies are willing to assume the worst until solid information emerges proving the contrary. Last Thursday, Moody's Investors Service sent several senior ABS staff members, including Andrew Silver, a group managing director, to Dublin, Ohio for onsite interviews with NCFE and the trustees.
In the grander scope, investors are concerned about initial rating agency operational reviews, and whether or not the agencies are doing enough in the way of "background checks" on the sellers, and, to go further, whether or not the agencies should be seeking proof backing the information provided to them by the sellers.
The agencies make a legal distinction between a credit opinion and due diligence, which is the role of the auditors and law firms, and to an extent, the underwriters, to ascertain the "realness" of a company. While rating agencies do conduct onsite operational reviews, their function, said Michael Kanef, speaking on behalf of Moody's, is to "provide investors with an indication of the credit risk evidenced by defined pools of assets within specified structures."
"Due diligence implies legal consequences, and we do not perform that function," Kanef said. "Moody's does conduct operational reviews, but our ability is not such that we are able to provide conclusive protection from fraud, nor do we have the resources to do so."
Said one investor last week, "Am I to understand that [rating agencies] never touch and feel the receivables, but just take the CEO's word on it?"
If the market had been more receptive to esoterics over the summer months, perhaps NCFE would not have been cash-strapped to the point where misappropriating funds from deal reserves seemed like a good idea. Can this incident be considered the missing "seller integrity" stress test, a characteristic previously presumed? When rating deals, should the agencies ask sellers questions like, "If such and such was happening to your business, what would you do? Would you be inclined to cheat and steal?" Should lie detectors be incorporated into the operational review process?
According to sources, the NPF XII trust should hold about 17% of its total value in the reserve account, which would be in the neighborhood of $340 million. In the September trustee report, this figure was more like $15 million, out of compliance by a wide margin, approximately $325 million.
On Oct. 25, Moody's downgraded all ratings on NPF XII and VI, reflecting the agency's concern about NCFE's financial stability, its ability to continue servicing, and its role in directing cashflows out of the reserve accounts, rating agency officials said.
The withdrawn funds came from the offset reserve and the seller credit reserve. The offset reserve is intended to secure the obligation of the servicer to repurchase receivables that are rejected by the insurance providers. NCFE said it was using these reserves to purchase new receivables.
Banc One as trustee said it did not delve into the reasons for the reserve account withdrawals by NPF XII, because it did not believe it was obligated to do so under the transactions documents. NCFE was providing payment directions to both trustees on a daily basis.
Also, there has been contradicting information regarding the average term of the receivables. During the summer, NCFE was reporting that the pool of receivables average term was 60 days, although last week the company informed Moody's the average term was closer to 180 days.
According to sources, as per the offering memorandum, an accounting firm was required to audit NCFE receivables and its operation every two quarters, which was to be sent to the rating agencies. Moody's said that none of the information it had received prior to these developments indicated these discrepancies existed, or that cashflows were being misappropriated.
Other factors at play
According to one source in trading, any conduit owning the NCFE paper will likely be forced to unload, particularly if Moody's takes further action on A classes, as the receivables in conduits need to be at certain rating tiers.
"A lot of the NPF bonds were sold into conduits," the source said. "The conduits will have to sell them at any level." The source suggested that, at the appropriate discount, there might be opportunity even in the event of a servicing transfer.
According to a rating agency official, NCFE appears in just two multi-seller facilities, and the facilities are fully wrapped by liquidity banks, which pay CP investors irrespective of asset quality. The official said there is no arbitrage conduit exposure. The assets would likely be funded out and onto the banks' balance sheet.
A structured finance CDO collateral manager speculated that a modest amount of CDOs are likely holding NCFE, as they fit the profile. Also, Credit Suisse First Boston, the top-ranked firm in CDOs, was NCFE's exclusive ABS underwriter over the past two years.
In pure speculation, should fraud prove to be an element in this situation, the deal could be deemed pass-through, which could eliminate the waterfalls and put both senior noteholders and subordinate noteholders on equal footing in a workout, said one source, noting a past instance of this happening in a securitization.
In July, Fitch downgraded several NCFE transactions citing seller over-concentration and, in retrospect perhaps ironic, an unsatisfactory flow of information between the company and the rating agency.
On Aug. 1, Moody's affirmed the two NCFE trusts responding to investor concern over the deals, presumably resulting from Fitch's downgrade.
"The affirmation was based on the continued positive performance of the receivables as reflected in the monthly reports provided by the servicer," said Jay Eisbruck, senior vice president at the rating agency, during an investor conference call. "The parameters that Moody's analyzed included the aging of the receivables, payer and provider concentration, and the percentage of defaulted receivables."
Further, at least one investment bank was recommending investors purchase NCFE ABS following Fitch's July downgrade, arguing that a Fitch-induced cheapening represented a buy opportunity.