Sunday, February 24, 2008

Reinventing securitization

(Andrew Davidson) ...the current senior/subordinated structure should be revised, simplified or, perhaps, even abandoned. The beauty of the senior/subordinated structure is that the credit quality of the senior classes is based on the quality of the underlying assets, not on the guaranty of any third party. In principle, the diversity of loans in a pool should create a better quality guaranty than even a highly rated corporate guarantor.

The structure works by locking the subordinate investments in place until the senior classes are assured of full payment. To increase the value of the subordinate investments, structures have been devised that allow payments to subordinate investors when that subordination is no longer needed. Herein lies the problem. Issuers, investment bankers, and investors in subordinate classes are always seeking to reduce the amount of credit enhancement and increase the early cash flow to subordinate classes. This has lead to complex overcollateralization targets, multiple triggers, and early step‐down dates. These structures are designed to meet specific rating agency scenarios and may not provide the desired protection in real world scenarios. In addition, the ratings process has lead to the creation of very “thin” classes of subordinate bonds. Some bonds may make up only a small percentage of the total collateral, so when losses rise they can face a complete loss of principal over a very small range of performance change. This makes these bonds extremely difficult to analyze as they may be worth near par or near zero.

The securitization market would function more smoothly if these classes were less complex and were not so finely divided. The “gaming” of rating agency models by underwriters needs to be eliminated. Perhaps it is time to consider whether newer financial tools, such as credit default swaps, could be used to design a more transparent and financially efficient structure.

[Also,] investor capacity to perform independent investment analysis [should be increased]. While there may not be a way to force investors not to rely ratings in making investment decisions, it may be possible to increase the amount of information available to investors to improve the quality of their decision‐making. Over the past few years, too many bonds were sold with insufficient information for investors to form independent views on performance. Ratings should not be a safe harbor against independent analysis. Without detailed loan level information, clear underwriting criteria, and assurances against fraud, it is nearly impossible to form an independent view of a security. The investor’s motto should be: If you can’t assess, then don’t invest.

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