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Brown Rudnick Berlack Israels LLP Reflections in plague time: perspectives on the sub-prime crisis
Reflections in plague time:perspectives on the sub-prime crisis Published in 2005 and effective as of January 1 2006, Regulation AB is a comprehensive set of rules and forms adopted by the Securities and Exchange Commission (SEC) to address the registration, disclosure and reporting requirements for publicly offered asset-backed securities (ABS) governed by the Securities Act of 1933 and the Securities Exchange Act of 1934.
Brown Rudnick Berlack
The pre-Regulation AB disclosure and reporting requirements were designed Israels LLP
primarily for corporate issuers and their securities, and consequently did notmandate the provision of information considered important by ABS investors,such as information about the transaction structure, servicing and thecharacteristics and quality of the asset pool. Recognising an increasinglyimportant role of securitisation in the financial markets, the SEC’s guidancewas aimed at clarifying the regulatory requirements for ABS in order toincrease market efficiency and transparency and provide more certainty to theoverall ABS market, investors and other participants.
Fast-forward to early 2008. Despite Regulation AB, the market finds itself in the midst of a severe credit crunch caused by a ‘perfect storm’ of failuresin the sub-prime mortgage securitisation sector. Dozens of sub-primemortgage loan originators have gone bankrupt and a number of big-nameinvestment banks have announced billions of dollars in writedowns as aresult of their direct exposure to the sub-prime mortgage market. More badnews is expected in the future.
Whether there is a real shortage of capital or widespread paranoia and a lack of confidence is yet to be established. A variety of explanations has beenoffered for the existing crisis, the primary reason being a sharp increase in theriskiness of mortgage loans and related financing products offered to sub-prime mortgage borrowers in recent years. Some analysts blame structuredfinance: thanks to a securitisation vehicle, sub-prime lenders were able tooffload sub-prime risk to the purchasers of such loans, and ultimatelyinvestors in mortgage-backed securities (MBS), collateralised debtobligations or structured investment vehicles.
Analysts also believe the lack of transparency to be one of the primary causes of the sub-prime crisis. Blaming Regulation AB for the current debacle is unfair.
However, what is clear is that Regulation AB, with its significantly expandeddisclosure and transparency requirements (eg, the disclosure of historical staticpool information, including frequency and severity of losses), contributed littleto the prevention of the current epidemic of the sub-prime virus.
Ever since its inception in the 1970s as the vehicle for providing liquidity – and its corollary, affordable interest rates – to the US single-familyresidential market, securitisation has been considered a safe and soundvehicle, as both a relatively low-cost funding source (with additional tax andaccounting benefits) for issuers and an attractive investment opportunity forinvestors seeking high yields relative to the actual risk of the securitiesoffered. Far from being a zero sum game, securitisation was perceived asoffering benefits to all sides involved in a transaction. Do the current crisisand the smaller disasters of past years challenge this assumption? Is it now The Americas Restructuring and Insolvency Guide 2008/2009 47 Reflections in plague time: perspectives on the sub-prime crisis Brown Rudnick Berlack Israels LLP
time to reassess the safety and benefits of securitisation structures? Could the problem be embedded in the core premises of securitisation or are the current and past problems the result of the substitution of leases to allow lessees to upgrade their equipment, many financed by technology? If the current situation is the result of prior errors, such as imperfect structures or inattention to asset quality, what measures can be adopted to prevent such abuses or imperfections inthe future without undermining the viability of This was apparently all done with the intention of masking defaults and delinquencies whichwould have put an end to further securitisations. Faulty business model or defective portfolio
When, due to its business shortcomings and financial difficulties, DVI was no longer able to The first logical approach to understanding how a repurchase delinquent leases, the performance of transaction failed should be the ‘helicopter view’ the securitised portfolio deteriorated significantly, analysis: is there something wrong with the early amortisation was delayed by the issuer and underlying business model of the sponsoring entity? the AAA-rated securities were downgraded by the No matter how good assets are or how well they are serviced or distributed, if the business structure itselfis flawed, the transaction is doomed to fail.
National Century Financial Enterprises, Inc
DVI, Inc
The problems faced by National Century FinancialEnterprises, Inc (NCFE) are known as a classic case Incorporated as Diagnostic Ventures, Inc (and later of a fraud situation, but are also a good example of renamed DVI, Inc), this company, along with its a faulty business model leading to one of the worst subsidiaries, provided lease and loan financing to cases of ABS market defaults. Ohio-based NCFE healthcare providers for high-end medical purchased medical accounts receivable from US diagnostic equipment. It also provided working healthcare providers. Through its subsidiaries, capital loans backed by healthcare receivables. DVI NCFE would purchase accounts receivable from would later securitise its lease payments: between hospitals, nursing homes and other healthcare 1994 and 2003, it sponsored 16 transactions, issuing providers and medical institutions, and securitise securities backed by medical equipment leases. these accounts by privately placing the issued DVI was considered a safe and sound company securities with large institutional investors.
until it declared bankruptcy on August 26 2003. In However, the company did not adequately value its the course of the bankruptcy proceedings, the assets and therefore significantly overestimated the court-appointed examiner produced a 188-page expected collections on some receivables, thus report citing an overly aggressive expansion plan creating a mismatch with securitisation cash flows. and an ill-advised strategy of international Another issue in this debacle resulted from expansion as the core causes of DVI’s problems. In addition to an assortment of improprieties, receivables sales agreements, which did not accounting irregularities and other fraudulent provide the clients with the ability to terminate activities, the report accused DVI of “over reliance those contracts (even after default, cash payments on securitizations, a principal source of income for from unsold receivables were directed into the companies, based on the higher level of interest accounts controlled by the special purpose entity on the underlying loans and leases over the interest rather than the providers), which resulted in level of the securities issued”. According to the providers essentially becoming lenders to NCFE. In report, DVI was “addicted to securitizations” addition, NCFE’s situation also highlighted which the company did not adequately collateralise problems associated with due diligence conducted (double pledging assets was one of the many issues on transactions backed by revolving pools of assets: cited in the report). Without cash generated by new due diligence performed prior to the closing date securitisations, DVI could not have continued its cannot guarantee the existence and quality of the operations. Among the securitisation-related collateral that revolves into the underlying pool after the closing date. The lesson here, as noted in 48 The Americas Restructuring and Insolvency Guide 2008/2009 Brown Rudnick Berlack Israels LLP Reflections in plague time: perspectives on the sub-prime crisis
the report produced by Nomura Fixed Income pioneers in issuing consumer credit online. The Research group, is that revolving deals should have company securitised its credit card receivables in strict ongoing oversight and audits by independent 2000 and 2001. NextCard’s faulty business model third parties. NCFE filed for bankruptcy in was highlighted later in 2001: after the regulators November 2002 and was liquidated in 2004. The forced NextCard to reclassify some of its ‘fraud investor losses exceeded $2.6 billion and losses’ as ‘credit losses’, the company became approximately 275 healthcare providers found undercapitalised and the Office of the Comptroller themselves in bankruptcy protection.
of the Currency ultimately closed the company andappointed the Federal Deposit Insurance BioPharma Royalty Trust
Corporation (FDIC) as its receiver. The FDIC couldnot find a buyer for NextCard’s portfolio (partially Asset diversification is another important due to underpriced servicing fees), and at the same component that should not be overlooked when time refused to honour an early amortisation structuring a securitisation. The case of Royalty trigger, noting that “early amortization based solely Pharma AG presents a good lesson not only for on the insolvency or the appointment of the FDIC securitisation of intellectual property, but also for as receiver is not enforceable against the FDIC”.
structured finance at large. Royalty Pharma is in the However, weak performance of the assets and the business of purchasing royalty interests in subsequent violation of certain transaction triggers still resulted in performance-based early pharmaceutical companies and investors. One such amortisation. After the FDIC terminated a large biopharmaceutical was Zerit, a HIV drug licensed number of credit card accounts, thus converting the by Yale to Bristol-Myers Squibb. In June 2000 securitisation assets from a revolving pool to an Royalty Pharma, through the BioPharma Royalty amortising pool and further diluting the quality of Trust, securitised Yale University’s patent for Zerit the portfolio, ratings were further downgraded. by issuing $115 million in debt and equitysecurities. The transaction was rated “A” by Servicing, trustee and rating agency issues
Standard & Poor’s, based on projections of Zeritsales and Yale University’s and Bristol-Myers In the current market crisis much commentary has focused on the oversight provided by neutral third- The deal initially performed well and was party participants in securitisation transaction, thought of as a “model for future deals going such as servicers, trustees and rating agencies. One forward”. However, in 2001, due to lower than of the expected byproducts of the current crisis is a projected cash flows generated by Zerit, the better definition of the role of third-party transaction violated certain financial covenants for participants in analysing legal structures, running three consecutive reporting periods and went into stress cases and simulations, monitoring various early amortisation in 2002. The problem was caused features of a securitisation and uncovering fraud.
by Bristol-Myers Squibb’s sale of its entire Zerit Successor servicing and collection practices are portfolio at a discount to wholesalers in 2001.
an essential ingredient of a well-structured Moreover, according to other specialists the securitisation. With respect to servicing issues, two valuation methods originally used to calculate the main problems may arise in a structured finance projected revenues from the sales of the drug were context: pricing of servicing fees and servicing faulty. The primary lesson learned from this transaction was that it is too risky for asecuritisation to depend on revenues from a single Conseco
asset, no matter how profitable or secure it mayappear on the closing date. Incidentally, Royalty To make securitisations more attractive to investors, Pharma learned this lesson well and the next the sponsors or issuers are often tempted to securitisation it sponsored included a portfolio of underprice servicing fees (thus increasing the amount of cash flow available to bondholders) andmake such fees subordinate to certain classes of NextCard
issued securities. This problem is especiallyapparent where the servicer is related to or is the NextCard, Inc, founded in 1996, operated as an entity sponsoring a securitisation. In such case, if the online issuer of Visa credit cards and was one of the sponsor or the special purpose vehicle (SPV) should The Americas Restructuring and Insolvency Guide 2008/2009 49 Reflections in plague time: perspectives on the sub-prime crisis Brown Rudnick Berlack Israels LLP
find itself in bankruptcy and no longer willing or of default under transaction documents; and able to service the portfolio, it may become near- managing or arranging for servicing transfers if impossible to find a replacement bona fide servicer to the securitisation servicer is no longer willing maximise the return on the remaining assets. This scenario played out in the case of Conseco, Inc,which serviced pools of manufactured-housing loans securitised by one of its subsidiaries. After organisations; they are generally not set up to Conseco filed for bankruptcy and the securitisation conduct the daily servicing activities for large asset performed badly, the servicing fee (already pools and would be unwilling to play larger roles underpriced at a rate of 50 basis points) further without being adequately compensated, if at all – declined because of its subordination in the something that may not play well with the current waterfall. After the company threatened to walk economics of a securitisation transaction. Even away and stop servicing the collateral, the where there is a mechanism in the documentation bankruptcy court restructured the servicing fee by for replacement of the sponsor (as servicer) or other increasing it to 115 to 125 basis points and moving it original servicers with a named back-up servicer, if to the top of the waterfall (which is rarely done by the original servicer refuses to cooperate in the bankruptcy courts). This resulted in reduced levels transition installing the back up might require convincing a court to issue an injunction or other downgrades of the more junior tranches.
Another question arises as to the role of the Heilig-Meyers
rating agencies in structured finance transactions. Ithas long been recognised by US courts that rating A good illustration of how asset performance is agencies act as independent evaluators of the linked to idiosyncratic servicing and collection creditworthiness of specific debt issues, not as practices can be found in the case of Heilig-Meyers advisers to the issuer of such debt. However, in Company, a Virginia-based chain of furniture light of current developments questions have stores. Two years after securitising its instalment arisen as to how independent rating agencies really sale receivables, the company closed its stores and are. Under the current system, rating agencies are declared bankruptcy in August 2000. Following its paid by the entities whose products they rate.
bankruptcy declaration, Heilig-Meyers wanted to Moreover, the revenues of the rating agencies resign as a servicer of the securitised assets. The depend on the volume of securities they rate. As trustee objected and a new back-up servicer was illustrated by the sub-prime mortgage crisis, rating appointed for the portfolio. Additional problems agencies play a crucial role in securitisation were created by the fact that collections were transactions and their failure, for whatever reason, typically performed at Heilig-Meyers’s stores, can have a destabilising effect on the entire system.
which were no longer in operation. Accountclosures led to a declining pool in early amortisation. After the back-up servicer took over,it discovered further problems with the portfolio.
Transaction failures can rarely be attributed to a As a result, Standard & Poor’s had to downgrade single problem. Most case studies mentioned in any section of this chapter could easily be moved to One significant lesson learned from the Heilig- other sections, since the failure was usually the Meyers situation is the importance of having a named back-up servicer and a mechanismproviding for a smooth back-up servicer transition Spiegel
and specifying its role in preserving the assetportfolio. In this regard, some parties have From this perspective, the case of The Spiegel advocated for bond trustees to assume greater Group (Spiegel, Inc) and First Consumers National responsibility in managing securitisations.
Bank (Spiegel) is the War and Peace of problematic Typically, the trustee’s role has been limited to: securitisations. Founded in 1865 in downtown holding cash flows in segregated trust accounts Chicago, Spiegel was a seller and catalogue supplier of furniture in the United States. In 1989 notifying investors, rating agencies, insurers Spiegel acquired First Consumers National Bank and other parties of certain breaches and events (FCNB) and made it Spiegel’s finance subsidiary.
50 The Americas Restructuring and Insolvency Guide 2008/2009 Brown Rudnick Berlack Israels LLP Reflections in plague time: perspectives on the sub-prime crisis
manipulation of triggers and early amortisation securitisations of credit card receivables, with MBIA Insurance Corp providing a guarantee on the reclassification of ‘fraud losses’ as ‘credit issued securities. In early 2001 the asset performance started to decline. Through various servicer misappropriation of collections; and mechanisms (eg, allowing its merchants to charge FCNB marketing charges) and in order to avoidhitting an early amortisation trigger, Spiegel was NCFE
able to achieve a higher excess spread in itssecuritisation SPVs. However, this did not result in In addition to the Spiegel case, the experience of any long-term gains and continuing charge-offs led NCFE (described above) provides a good example to the decreasing excess spread. Similarly to of fraud and misappropriation being major NextCard, Spiegel characterised first payment obstacles to a successful securitisation. Shortly defaults as fraud losses instead of credit losses, before the bankruptcy filing (which in turn was which led MBIA to declare ‘pay-out events’ on the preceded by a Federal Bureau of Investigation raid deals that it had insured (the issue was later settled on its headquarters), NCFE and its principals were between MBIA and Spiegel). Shortly thereafter the accused of fraud in connection with NCFE’s rating agencies started downgrading the non- securitisations and claims that the securitisation insured securities. After trying unsuccessfully to collateral either was ineligible or did not exist.
sell its credit card business, Spiegel was forced by Enabling this fraud was the revolving nature of the the Office of the Comptroller of the Currency to collateral and the lack of third-party oversight. In liquidate the FCNB credit card portfolio and in 2003 addition, improper transfers of reserve funds Spiegel filed for bankruptcy protection, thus between the two major securitisation SPVs were triggering early amortisation events under the made without authorisation. As well as claims against the principals, the investors filed lawsuits Around the time of bankruptcy declaration, the against the placement agent, the trustee and other Securities and Exchange Commission began an parties. Three top executives of the company investigation into Siegel’s compliance with federal pleaded guilty and were sentenced to prison terms, securities laws. In September 2003 an independent while five others began trial in February 2008.
examiner’s report revealed that Spigel had made One of the lessons learned from these and other material misstatements and omissions with respect prior securitisation transactions is that corporate to the collateral used in FCNB’s securitisations, fraud infecting structured finance issuances is not manipulated interchange rates and misreported the an uncommon phenomenon in structured debt performance of securitisation transactions to avoid transactions. With stronger compliance rules and better management and supervision (both external Similar to other deals described above, the and internal), the results might have been different.
Spiegel securitisation had no back-up servicingarrangements. The servicing fees were not high Legal issues
enough to encourage FCNB to continue servicingthe asset portfolio or to find a bona fide servicer to A fundamental principle of structured finance (and replace FCNB. Ultimately, the Office of the its distinction from a secured financing) is Comptroller of the Currency directed FCNB to find bankruptcy based: it involves a true sale of the another servicer and at the same time ordered collateral to a bankruptcy-remote SPV, which is Spiegel to raise the servicing fees to market rates to structured so as to prevent it from being avoid the further deterioration of the portfolio that substantively consolidated with the sponsor if the would result if a substitute servicer were unwilling sponsor becomes a bankruptcy debtor. Investors to step in. According to Nomura’s “ABS Credit must look solely to the collateral portfolio and any Migrations 2004” report, Spiegel’s series of credit enhancements to provide the expected cash securitisations was the most instructive of all flows. Moreover, a high rating is supposed to be indicative not only of a high probability of ultimate problems with the servicing of assets and repayment to investors, but also of timely payment when due without delay due to the automatic stay in bankruptcy. Thus, it is essential to structure an SPV in a way that minimises the prospect that it will The Americas Restructuring and Insolvency Guide 2008/2009 51 Reflections in plague time: perspectives on the sub-prime crisis Brown Rudnick Berlack Israels LLP
become a debtor in bankruptcy and to reduce the typical of many other securitisations. When LTV practical possibility that its bankruptcy remoteness Steel, one of the largest steel manufacturers in the will be challenged in a bankruptcy court. At best, United States, faced a liquidity problem and filed however, proper structuring can make the risks of for Chapter 11 relief in December 2000, the an SPV bankruptcy more remote; as is seen below, it company itself filed an emergency motion with the bankruptcy court in Ohio requesting the interimuse of cash collateral used in prior securitisations LTV Steel/Days Inn
and claiming that those securitisation transactionswere not true sales, but disguised financings. The Until recently, it appeared that securitisation arguments and points that LTV Steel used were not finance rested on secure legal grounds. Then came atypical of those used in other similar bankruptcy the LTV Steel case which challenged (without definitively resolving) the very foundations of failure to maintain corporate formalities; structured finance, with the case successfully LTV Steel’s retention of risk if the value of the entrenching itself in all true sale opinions given by the amount of control LTV Steel exercised over bankruptcy of Days Inn in the late 1980s. In the $155 million securitisation of the trademark franchiseassets of Days Inn, the sponsor entity which ran its The collateral in question was securitised and franchised hotel business operations declared the securities sold to a consortium of banks led by bankruptcy and, despite the fact that the Abbey National. The bankruptcy court went along securitisation itself was performing as scheduled, at and approved the emergency motion as part of LTV the request of the sponsor the bankruptcy court Steel’s first-day pleadings, thereby allowing the entered an order granting a motion for substantive debtor the use of the securitisation proceeds on an consolidation of Days Inn and its SPV which held interim basis in return for providing the securitised the trade name and received franchise fees. The parties with adequate protection in the form of a ruling (which was subsequently withdrawn) relied continuing lien on LTV Steel’s new receivables and heavily on the ‘core assets’ analysis: the monetised trademarks were determined to be core assets of the debtor and therefore necessary for the successful sale securities noteholders appeared at the final hearing and reorganisation of the entire Days Inn business on the matter and challenged the bankruptcy court’s operation in bankruptcy for the mutual benefit of jurisdiction to enter an order extending the creditors of the sponsor and SPV. The bankruptcy automatic stay to inventory and receivables sold to filing by the SPV resulted in the occurrence of a LTV Steel’s special purpose entities prior to the filing termination event under the transaction documents on the grounds that such assets were no longer the property of its bankruptcy estate because they had economically. What was instructive about the Days been transferred to the SPV in a true sale. The court Inn case was that it demonstrated that it is not in effect treated their objection as a request for a always sufficient to structure and document a temporary restraining order against the debtor’s use securitisation properly if the legal requirements are of the securitised assets, which it refused to grant not observed following the closing date. What the without the benefit of a full evidentiary review. On bankruptcy court found during the proceedings (eg, the basis of the limited record before it, the court was commingling of bank accounts, expense payments unwilling to rule that LTV Steel had no interest in from a joint account, interrelationships among the these assets or that such assets were not the property debtors and other violations of the separateness of LTV Steel’s bankruptcy estate subject to the covenants) was enough for the court to determine automatic stay, and left its original ruling intact, that grounds existed for substantive consolidation of permitting use of these assets to stand pending a full the SPV with the bankruptcy debtor, especially trial on the merits. However, the LTV Steel court’s where the benefits (a higher sale price for the entire ruling was only an interim one; it made no final findings on the true sale issues. Ultimately, Abbey securitisation investors which ultimately were paid National reached a settlement with LTV Steel involving new debtor-in-possession financing The structure employed in LTV Steel was also arrangements with higher fees; in return, LTV Steel 52 The Americas Restructuring and Insolvency Guide 2008/2009 Brown Rudnick Berlack Israels LLP Reflections in plague time: perspectives on the sub-prime crisis
acknowledged that the securitisations were in fact causes of the collapse and what lessons can be true sales of the collateral. The bankruptcy court learned to avoid similar fiascos in the future? The current sub-prime mortgage crisis can trace Due to the settlement, the bankruptcy court did its origins to the latter part of 2006, which saw a not get a chance to answer the question of whether moderate drop in housing prices, combined with LTV Steel’s transfer was in fact a true sale. The main rising interest rates. Sub-prime mortgages are lesson learned from this case was that significant mortgages taken out by individuals with a less- risk exists where the securitised collateral consists than-perfect credit profile, often under significantly of the sponsor’s working capital assets which relaxed documentation requirements. However, generate substantially all of its cash flow (without instead of looking at the borrower as the source of which the sponsor would be unable to obtain repayments and the property as security for such debtor-in-possession financing or remain in repayments, more often than not lenders paid more operation following a filing). In short, the true sale attention to the property. With the booming real findings requested by the securitisation parties estate market, the sub-prime borrower’s worst-case would have meant a quick end to the bankruptcy scenario appeared to be refinancing or selling the case and would have left LTV Steel with little or no funds with which to operate. This explains the This system continued to be profitable for a while, leading to easy access to mortgage credit and As LTV Steel indicates, there is no bright-line test to determine whether a transfer amounts to a true sale of assets, as is demonstrated by the myriad growth and the decline in home prices, combined with the rising interest-rate environment, disclaimers found in true sale opinions. Issuers and refinancing or even selling the property was no sponsors can try to minimise the risk of a longer an option. Default and foreclosure activity bankruptcy court applying the doctrine of intensified and neither the borrower nor the substantive consolidation (ie, disregarding the property itself could now support the amount of separate legal status of two or more legal entities and pooling their assets and liabilities). To achieve This chapter takes a brief look at the causes of this, it is important that the issuer in a securitisation the current crisis from a structured finance be prohibited from engaging in activities other than perspective and attempts to determine whether owning and managing the securitisation assets and they are different from or similar to the issues from behaving as a mere alter ego of its parent previously discussed in this chapter.
company. Sponsors and SPVs employing differentand independent officers and/or directors, having System and structure failure
separate offices, paying their own operationalexpenses, not assuming each other’s liabilities and Most analysts have concentrated on the poor obligations and otherwise obeying typical quality of the collateral, relaxed underwriting corporate formalities can all be used to prove the criteria and the condition of the real estate market SPV’s independence and to defend against efforts and the US economy as a whole. However, the to invoke substantive consolidation. Similarly, the failure of the current market may be an actual SPV can have an independent director whose reflection on the failure of structured finance as a consent is required to approve a voluntary means of providing capital markets liquidity. In his bankruptcy filing, but who is subject to the same defence of the sub-prime mortgage market, former state law fiduciary duties as any other director.
Federal Reserve Chairman Alan Greenspan argued These mechanics can make the chances of the SPV’s that the securitisation of sub-prime mortgages, and filing for bankruptcy more remote, but to say that not the loans themselves, was to blame for the they bankruptcy-proof the SPV is a misnomer.
Before the widespread use of securitisations, Sub-prime crisis
mortgage originators typically retained theirmortgage loans until they were paid down or refinanced. As a result, they were much more coincided with the later stages of the real estate concerned about the credit quality of both the boom, then the downturn and ultimately the borrower and the collateral. However, with the meltdown of the sub-prime market. What were the The Americas Restructuring and Insolvency Guide 2008/2009 53 Reflections in plague time: perspectives on the sub-prime crisis Brown Rudnick Berlack Israels LLP
securitisations of sub-prime mortgage loans, and problem and are now faced with issuing multiple- later collateralised debt obligations, the link notch downgrades on billions of dollars’ worth of between the lender and the borrower was severed: bonds which they rated AAA/Aaa just a year or with the mortgage loans securitised or sold at a profit to unrelated third parties, the originator’swellbeing was no longer dependent on the quality Third-party oversight
of the collateral. Many lenders decided to reduceunderwriting standards and to resort to automatic One of the problems often cited with respect to the software-enabled underwriting. Even then, under rating agencies is that while the market relies on the reduced documentation standards many loan their independent valuation of the issued securities, applications included fraudulent misrepresentations, they are not disinterested evaluators as their fees leading one economics professor to refer to the are paid by the issuers or related entities whose phenomenon as “predatory borrowing”.
securities they rate. The more deals that the rating Therefore, there was an apparent disconnect: agencies help to structure and ultimately rate, the lenders had the power to decide whether to higher their earnings. This conflict of interest is underwrite mortgage loans and on what terms, but often cited by sceptics who do not believe that in most cases had no stake in their performance.
faulty ratings were purely the result of mistaken Moreover, following a securitisation any losses associated with sub-prime mortgage loans can be Regardless of whether this failure was the allocated to a multitude of investors, therefore result of wilful representations or honest mistakes, spreading the risk of owning a sub-prime portfolio.
there was certainly a model failure on the part of Is the system itself to blame for the sub-prime the rating agencies. To assign a rating to a MBS crisis? Unlike the micro analysis (eg, fixing the security, the rating agency needs to be able to problems of deficient pools, stricter origination predict its performance over a certain period of guidelines), this would be a macro approach to the time. One level of analysis involves reviewing and problem. If the system itself is flawed, is there a analysing historical data on similarly situated pools of mortgage loans. The second level of analysis involves an examination or prediction of how the structural weaknesses within the system. The first current pool would perform under a variety of plausible economic circumstances. It appears that collateral. Aside from the elephant in the room – the the problem with the second level of analysis was sub-prime nature of the assets as discussed above – that the scenarios envisioned by the rating agencies the current crisis also underscored the fallacy of the were typically too close to the average values and portfolio effect. One of the problems faced by the did not contemplate a housing meltdown of the sub-prime mortgage-backed securities (MBS) is the current proportions. Some Congressional leaders lack of real diversification. The supposed have called for an investigation of the rating agencies and their role in the sub-prime crisis.
notwithstanding, most of the sub-prime MBS Clearly, an overhaul of the rating system is required transactions were based on homogeneous collateral and the rating agencies are aware of this. which did not perform well under the negative Therefore, it is no wonder that as a reaction to market conditions, and most critically proved to be the market’s criticism Moody’s has recently correlated rather than non-correlated in a declining announced that it is contemplating a change in how real estate cycle. Thus, the comfort of the ‘portfolio it assigns ratings to MBS securities and other effect’, the ‘law of large numbers’, the Monte Carlo structured products. Other rating agencies are simulations and other stress analyses performed by likely to follow. For now, one lesson to be learned is the rating agencies in rating these securities proved that ratings assigned by the agencies are not absolute truths or unconditional guarantees of performance; they are opinions (presumably securitisations is their complexity. The MBS educated) by some of the market participants based structures, with multiple variations, tranches and largely on data which the sponsors and other credit support arrangements, have become difficult participants provide to the rating agencies, and to value and it is even harder to predict their should be viewed accordingly. The few reported performance over a long-term period. The rating cases in which attempts have been made to sue the agencies failed miserably in addressing this rating agencies for faulty ratings have stressed this 54 The Americas Restructuring and Insolvency Guide 2008/2009 Brown Rudnick Berlack Israels LLP Reflections in plague time: perspectives on the sub-prime crisis
point in typically refusing to hold the agencies challenge to the true-sale concept, this is not likely.
Such challenges have previously arisen in Multiple conflicts of interest can also be found transactions involving a company’s core working with the existing structure. Far from uncommon capital assets, not discrete pools of financial assets were structures where the originator, the sponsor, the depositor, the underwriter and/or the servicerwere affiliated entities, often represented by the Conclusion
same counsel in a securitisation transaction. Asidefrom a potential failure of the system of checks and Returning to the original question of this chapter, is balances in structuring securitisations, there is also the current sub-prime mortgage crisis proof of a a question of financial incentives as certain fatal defect in the structured debt paradigm or is it functions (eg, origination, underwriting or servicing) are valuable in and of themselves and are securitisation technology? Are the problems likely to continue to be profitable even if the currently faced by the structured finance market transaction itself does not perform well. inherent in the securitisation model or do they Finally, many observers believe that the lack of constitute a ‘black swan’ event? In The Black Swan: governmental oversight is one of the reasons for the The Impact of the Highly Improbable Nassim Nicholas market’s collapse. Conversely, some claim that the Taleb defines a ‘black swan’ event as an occurrence government’s role in strongly encouraging lenders of high impact which was not predicted based on to extend sub-prime mortgages to uncreditworthy prior experience, but which in retrospect could have been foreseen if erroneous conclusions had Reinvestment Act is one of the reasons for the not been drawn from such experience. Could the expansion of the sub-prime market. Others claim sub-prime crisis have been predicted based on prior that, despite a multitude of federal and state laws governing disclosure limitations with respect to securitisations? If the problems are of the same high-cost loans, the government has not done nature, why were the necessary measures not taken enough to discourage predatory lending and prevent the growth of a secondary market in It would be easy to think that the problems of predatory loans. At present, there is no shortage of previous years were resolved and remedied and proposed legislation to deal with the existing crisis; that the current crisis is a new phenomenon caused it will soon be seen what remedies, if any, the by a different set of issues. This is not the case. The government will adopt to respond to the current only difference between the failed transactions crisis and to prevent its recurrences. However, one described in the first half of this chapter and the word of caution is that there is a fine line between sub-prime mortgage crisis is the magnitude of the excessive government regulation and the stifling of problem and, due to the nature of the collateral, the effect that it has on a large number of investors andhomeowners. On the one hand, there were True sale issues
individual cases which concerned only a handful ofinvestors and securitisation analysts; now the same With the amount of litigation generated by the sub- issues and problems are magnified by a substantial prime meltdown and the multiple theories and factor. However, the nature of the issues facing causes of action involved, the true sale issue will structured finance remains the same: defective undoubtedly resurface again as one of structured collateral, deficient structure or business model, finance’s black holes. As noted earlier, while the fraud, mismanagement of assets, lack of third-party entire concept of structured finance is based on a oversight and shaky legal grounds. What changed true sale to the SPV, the issue, as applied to was the scale and the effect these problems are securitisations, has never been definitively settled in a court of law. The true-sale analysis rests on a As to the question of whether securitisations few bankruptcy cases arising in contexts very cause more good than harm, it is appropriate to different from a securitisation. There is no reported paraphrase Winston Churchill: securitisation is the decision upholding a securitisation true sale. Is worst form of finance, except for all the others that there a risk that the sub-prime debacle may actually unwind the true-sale concept? While there is a riskthat the sub-prime debacle may lead to a frontal The Americas Restructuring and Insolvency Guide 2008/2009 55


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