I am reminded of the first paragraph in the CFA manual under the header, Ethics in the Investment Profession—

Ethical practices by investment professionals benefit all market participants and stakeholders, and lead to increased investor confidence in global capital markets. Clients are reassured that the investment professionals they hire have the clients’ best interest in mind and investment professionals benefit from the “reputational capital” such integrity generates. Ethical practices instill a public trust in the fair-mindedness of markets, allowing them to function efficiently. In short, good ethics is a fundamental requirement of the investment profession.

—and I wonder why. And who—who wrote these words? These are the people I want to do business with.

- Ann Rutledge

There are markets, and there is the Market. Markets are networks of people who come together to exchange one thing for another. The Market is the cornerstone of a belief system whose biggest proponent has been the University of Chicago. Chicago: Hog Butcher for the World, according to Carl Sandburg in 1912, whose economy was revitalized in the 1970s by the City’s commodity exchanges and their esoteric flacks in Hyde Park.

Market value theory is to economics what “universal grammar” is to Chomskian linguistics: a hypothesis that the human brain wants to trade in organized markets, where the syntax of our behavior generates a fair valuation of the resources and goods that we are trading, which we call “price.”

This view has considerable romantic appeal, but it does not explain an inalienable dimension of market behavior: cheating. The stunning barrage of evidence that the Market is being willfully and systematically dismantled–the rigging of mutual fund pricing, credit ratings and now LIBOR–is positive if it causes us to reflect critically on our false belief in the power of the Market to protect us from ourselves.

In Rope-A-Dope 101, we said there are five ways to mask the credit quality of a structured bond, that it is done by manipulating an “invisible” boundary where the consequences of being on one side or the other are not symmetrical, and that the boundary is only invisible to the investor. In Rope-A-Dope 201-205, we will go through each of the five in more detail to show how the cheating takes place, beginning with: Recognize a bad (credit) event late.

Default and delinquency are bad credit events. The meaning of delinquency is strictly financial. It represents the point in time when the borrower’s payments begin to lag the contractually due amounts. Default on the other hand is a political event. It signifies that the lender has lost faith that the borrower will repay and starts proceedings to try to recover the capital. The right time to declare a default is a judgment call, made in light of the borrower, the loan purpose, the type of collateral and the due amount. Give the borrower too little time and he will not be able to repay you. Give the borrower too much time and he will not want to repay you but will divert funds originally intended for you to other uses. Despite the judgmental aspect of when to set the cutoff, however, good credit policies always have an arm’s-length cutoff, which good credit managers consistently enforce.

The simplest game is to securitize receivables whose credit and investment (C&I) policy doesn’t define default in days-delinquent terms. Information about loan status disappears upon sale or transfer, because the clock is reset to “zero days delinquent.”

What happens? If the cutoff is not in the definition of default for purposes of setting eligibility criteria, the receivable will always be “current” even after it stops paying. That loophole allows it to be securitized again, and again as if it still had full value, because the buyer can never discover what the seller knows, namely that the receivable is worthless.

Is it legal? The Uniform Retail Credit Classification and Account Management Policy has clear cutoffs for consumer loans. The default definition for wholesale lending under the U.S. Basel NPR (September 2006) is well-intended but has no teeth. It is also out-of-synch with regulatory guidelines elsewhere that have a clear cutoff.

Another common game, mainly in ABCP conduits, makes use of a double-standard: the original cutoff for the transferor, and a more lenient cutoff for the SPE.

What happens? Say the cutoff of the original receivable is 90 days and the cutoff for the conduit that buys the receivable is 120 days. An 89-day delinquent receivable may be sold out of portfolio and funded in the conduit for another 119 days. And new notes can be issued against it, even though it is still unpaid at 208 days, because it is still “current.” (For a thorough discussion of calendar tricks, see Sam Pilcer’s Understanding Structured Liquidity Facilities in Asset-Backed Commercial Paper Programs, ABCP Commercial Paper Market Review, First Quarter 1997.)

Is it legal? Calendar tricks are acceptable in fully-supported conduits, where the conduit administrator provides a credit backstop. By rating agency and market custom, they are not permissible in partially-supported conduits where receivables should be funded at fair value. However, since loan-level information is never disclosed in ABCP conduits, this trick is utterly beyond the capacity of investors to discover, unless or until it is too late.

A third game is to “fix” the delinquency clock so the cutoff is never reached. The most common version of this trick is to keep track of delinquencies using recency rather than contractual accounting.

What happens? With recency, the clock is reset to zero and the borrower is deemed current, regardless of whether or not the contractual amount has been paid. The consequences are the same as above: only the seller can see that the loan is not worth what the buyer pays for it.

Is it legal? Bank regulators frown upon and discourage it. Under the Revised Uniform Retail Credit Classification and Account Management Policy in 2000, the FFIEC highlighted the abuses of the recency method and articulated a preference for the contractual method. The revision imposed a limit on institutions using the contractual method, who would not be allowed automatically to change to recency without seeking and obtaining permission.

Finally, Market Value games are based on the use of traded price as a proxy for fair value when price formation becomes disconnected from valuation. Market value games are the rationale for Market Value CDOs. They also led to the August 2007 U.S. ABCP liquidity crisis.

What happened? Demand for prime mortgages in the late 1990s was strong. It was common for delinquent loans to be bid at par in dealer markets. That is why rating agencies came to accept market value swaps (MVS) in extendible notes (SLNs) issued by single-seller mortgage conduits. MVSs came to be viewed, incorrectly, as a credit protection. Their role in these extendibles continued long after the original rationale was forgotten and the mortgage collateral was no longer prime.

Is it legal? So long as the swap is documented and the counterparties are not proscribed in their own rules from making the trade, it is perfectly legal. But it is not credit protection.

The high road of securitization is forward-looking. It promotes economic growth and rewards superior asset quality. Securitization is alive and doing well in grass-roots economies. But maybe you have not come to our blog to read about the high road of securitization. Maybe you have come looking for a map to lead you off the low road of securitization because it’s a dead end, and you’re out of a job.

Your first step is to take a good long look at the pot-holed reality of the low road you’ve been on. All the signs of fast money and questionable business practices were in public view for five or ten years. (The annual conference in Las Vegas—what did you think that was? WYSIWYG) But, this blog is not meant as a litany of cheap shots. It’s meant to be a guide to what needs to be confronted and changed. You see, the low road of securitization is actually much worse than people imagine.

The low road of securitization is a series of pseudo-processes embedded in a special market where anything goes so long as it can be vetted by one or more rating agencies. Call them de facto regulators of a rogue financial system placed effectively beyond the control of the SEC, the Fed and Congress, and below the radar screen of FASB. Call these pseudo-processes Rope-A-Dope 101. Call the American public – you, and me too – who are being handed a sentence of lifetime of debt service for the financial system’s five year credit orgy, the dopes.

In Rope-A-Dope 101, there are five preferred (often inter-related) ways to mask the true credit condition of a structured bond. Each entails the manipulation of an “invisible” boundary where the consequences of being on one side or the other are asymmetrical. The boundary is not really invisible; it is transparent to the rating agency MDs and certain parties inside the arranging banks who know how to play. But most of the market does not, and in some cases, cannot see it. That’s the beauty of Rope-A-Dope.

Here are the rules:

(1) Recognize a bad event late. In credit, the “bad event” is generally taken to mean default, but delinquency numbers can also be jiggered.

(2) Recognize a good event early. Receipt of cash flows is a “good event,” hence recoveries are good although they result from defaults. To minimize the optical loss, delay the recognition of defaults and accelerate the recognition of recoveries. Push the envelope as far as it will go.

(3) Hide a particularly toxic loan or security inside a portfolio and publish only aggregated (which is to say average) risk measures that paint an unduly rosy picture of risk-adjusted returns. This is a favorite Rope-A-Dope tactic in ABCP conduits and CDOs, where collateral is generally heterogeneous.

(4) Massage the capital structure until the security in question (part of the capital structure) is on the right side of a rating boundary. The classic maneuver is to make the security a very weak BBB-/Baa3 and not a very strong BB+/Ba1, because of the pricing or capital regulatory impact of carrying a NIG (non-investment grade) rather than an IG (investment grade) risk.

(5) Stuff the pool with small portions of ineligible or non-existent collateral. If the transaction pays anyway, make the portions bigger the next time.

In early 2004, we were asked to join a professional support team to help a new equipment lessor get financing through the structured market. The premise of the deal, the team, and our role in it, were not new. The endgame, to get a monoline insurance company to wrap the senior tranches so as to obtain the cheapest possible working capital, was not new. The path, as we re-tell it here, was not new. But what may be new to you is an untold story. It is one we expect to be retold in our market over the next 20 months and change.

First, the team.

The client (let’s call it Equilox) was a company formed by a disgruntled managing partner of a well-branded equipment lessor. Equilox had adopted their same systems and same basic underwriting approach. Equilox understood securitization. They knew the static pool, not the portfolio, was the unit of measurement. They knew that credit scores could be used to discern relative value between deals with similar partial loss curves. Equilox had a contract with a credit scoring firm (let’s call it Scorex) for the equipment lease sector. Scorex had a modeler from a well-branded credit scoring firm. Equilox had also lined up a monoline insurance company to wrap the senior notes, and an investment bank to underwrite the transaction. What the monoline’s endgame was, is now topic du jour. The investment bank had no stake in any outcome other than a sale. R&R’s role, as usual, was to build the transaction model to find the cheapest cost of capital consistent with robustness using Scorex inputs to modulate cash flows, and then offer that analysis to the bank and the monoline as a negotiating tool, for a fee.

Now the dilemma.

Credit scores cannot be used in a securitization as raw scores. They first must be mapped to the distribution. It may have changed. If it has changed, they must be revalidated. This mapping exercise showed something much worse. Scorex had no predictive value. Furthermore, the modeling exercise using pure static pool data showed the target ratings were wrong, given the structure. It is amply evident today that ratings (like credit scores) must also be validated by relating them to a distribution of risk. But since, at the time, the monoline did not understand the relationship between the rating and the risk distribution, our analysis was rejected in favor of the investment bank’s counsel.

Now comes the punch line. How many Equilox tranches do you think are out there in today’s market. Some are much better than you think. Some are much worse than you think. You won’t know which to trust.

So, structured ratings are not good indicators of secondary market value, and market prices are not working their usual magic. Why are we surprised?

More importantly, how do we want the sector-wide securitization crisis of confidence to turn out? Do we secretly desire a return to financial feudalism? Because, unless we step up and take ownership of the securitization market, that is what we will get.

Financial feudalism equates to asking the large banking institutions to bail us out—with our own money. Financial feudalism means putting capital, the gasoline that fuels our economy, in the hands of a handful of institutions who are going to use it to fuel their own engines. It also means handing over the reins to some of the same people who botched it in the first place. And, you don’t need an R&R Consulting to tell you that this is true.

The alternative to financial feudalism is financial democracy:

Financial democracy means borrowing at the risk premium that matches the intrinsic riskiness of your loan assets. Financial democracy means that firms whose earning assets outperform their market-determined credit benchmarks can use some of that latent capital for growth now. It means you don’t have to have brand, or come from an OECD country, to borrow capital at an equitable cost. You don’t even have to be a commercial entity. You just need to be economically viable.

Financial democracy, the antithesis of bully capitalism, is epitomized by the securitization market in its original design: the one that worked well for borrowers and lenders in the first twenty-five years of its existence.

What happened? Quite simply, we let it get away from us by pretending it could run itself. Rather than implement process controls, disseminate knowledge of risk measurement conventions and adapt them to new products as they emerged, we all worked against the health of the market by suppressing knowledge. By slipping in a few substandard assets, here and there. And by chiseling away bits of capital here and there, for ourselves and our friends. Until it collapsed.

The all-wise, all-knowing Market is a myth. We are the Market–the Market is Us. And so once more, the question: why are we so afraid of ownership, and so quick to accept feudalism?

- Ann Rutledge