I discovered Apple was attracting - employing – young people from all walks of life (even Wall Street dropouts) who wanted to share their knowledge with customers and be part of a positive phenomenon.

I watched how customers came in droves to fondle these beautiful objects with their eyes, and sometimes their wallets, many of them completely oblivious to (and certainly none intimidated by) the complexity of the technology inside.

Could structured finance achieve a transformation like this? Become something whose inside is as beautiful as its outside? Be adopted by young people as a tool to support their values and ideas financially, through collaboration and crafting the right incentives?

not right+not wrong=not science

A lot of nonsense has been written in the name of finance, and a lot is being written today about the causes and cures of the subprime crisis. Much of the latter is politically motivated, designed to deflect blame and promote the broader application of self-serving pet theories. The distraction value of these debates is very high. That is why Richard Alford’s focus on science in his discussion of the open letter “Economics is hard. Don’t let bloggers tell you otherwise” is a refreshing direction for the dialogue to move.

two assets backing the same liability

The other interesting Tweet on Yves Smith’s 8/13 feed is about rehypothecation. In the context of revolving portfolio finance (aka corporate finance) this goes by the name of leverage, but in non-recourse receivables-backed finance (aka securitization) it goes by another name, one that Dr. Pauli would understand. It is fraud. Asset-liability parity is a precondition for all securities to go to market. Unless 100 cents of real asset value backs the 100 cents of liabilities issued, the lender will lose money with 100% certainty while the borrower and financial arranger make out like bandits.

two sides of the same intellectual coin

These two points are actually related–not only in Dr. Pauli’s mind but also in financial system governance and engineering.

A simpler way of approaching Richard Alford’s posting is to think about the rating process as a rehypothecation of company business receivables at different rates; these rates are based on the “gold-like” certainty of repayment, with AAA suffering an average level of impairment so low as to be beyond human intuition, AA slightly riskier, etc. Carried to the limit, this process of rehypothecation is the valve of leverage getting into the macro-economy. And, in a world where the traditional role of banks has been superseded by debt capital markets, think about the assignment of structured ratings as a de facto replacement for the Fed window.

A structured rating process that has integrity is also the control mechanism for balancing leverage with fundamental working capital demand. When business is brisk, clients pay on time and business receivables can be pooled to perform to a AAA standard, the borrower can borrow cheaply based on current receivable performance. When business slows, it costs more and the leverage in the system goes down.

But structured finance, like economics, isn’t easy. It isn’t intuitive, can’t be learned from cyberbabble. It requires rigor, which means mathematical training; and consistency, which means financial training. The good news is that it can be learned. And, it can empower an economy to transform itself towards doing more good than harm. That’s a scary – but inspiring – thought.

Elements of Structured Finance

Rutledge calls for “an exchange-like setting to provide the sort of standardization and rules that help trading of stocks and options,” and operational revamps to produce more accurate and dynamic ratings that reflect the changing performance of securitized loans.

Read the full article: “Shadow-Banking System Next Up for De-Stressing,” David Reilly, Bloomberg, May 8, 2009.

Like the SEC reform proposal released about the same time, the FER statement inspired no comments of passion or controversy. That is a shame, because unlike the SEC proposal, the FER statement comes close to the heart of the matter and deserves a thoughtful response, or at the very least some controversy. So, from the practitioner’s view, let me play devil’s advocate.

FER’s key conclusions are that they—

1. …support strategies designed to improve SRO incentives by increasing the transparency of their modeling practices and holding their managements accountable for negligent ratings errors.
2. …challenge the wisdom of incorporating SRO ratings in securities and banking regulations issued by governmental entities.
3. …recommend SROs publish an express margin for error in their ratings for every tranche of securitized instruments, to acknowledge differences in the degree of leverage that is imbedded in different issues of securitized debt.

My reading of these points is as follows—

(1) implies that merely looking at SRO models and approaches would tell us what went wrong. That’s unlikely to be true. In the past (more than now) rating agencies historically disclosed a lot about their models, and there were flaws, but self-correction did not arise from the disclosure. Rather, the market believed in their magic all the more fervently because they saw how the power of the SRO could overrule logic.

R&R focuses the problem differently. The lack of opportunity to study structured ratings in a formal setting contributes to the problem more subtly and profoundly than any other single factor. What is primarily needed is not more transparency but basic structured finance literacy.

To be blunt, none of the 27 FER signatories are affiliated with universities where structured finance/ securitization is taught, or taught in a way that remotely corresponds to market practice. Nor is there an attempt to integrate such content into courses dealing with (i) money and banking, (ii) traditional corporate finance, (iii) portfolio analysis, or (iv) options. My remark in regards to (iv) may sound excessively harsh, since many of the affiliated universities offer credit derivatives in their curriculum as an extension of option theory. Nevertheless, there is no opportunity for formal study and critique of the underlying cash analytic framework that gives rise to ratings on structured tranches in the first place. The reason, quite simply, is the lack of academic expertise in this area. My comments, which relate to the finance curriculum in business schools, also apply to accounting.

How can we talk about elevating the standards of analysis and raising the accountability of SROs when we do not enable our MBAs to understand and follow the paradigm shifts taking place right under our noses?

(In the interest of full disclosure, fewer than ten people in the world teach real-world securitization. Sylvain Raynes and I are at least one-fifth of that population. Does my comment signify preaching for my own parish? Or does it make me somewhat uniquely qualified to raise these points?)

(2) is a good idea. Like most market professionals, R&R principals are skeptical about government-mandated solutions for the market — most of all when they are government-mandated commercial solutions. For point (2), however, separating SROs from a quasi-regulatory role implies a capacity for self-regulation. Taking self-regulation to the limit, recommendations (1) and (3) would no longer be relevant, because the SROs would no longer matter much. The underpinnings of self-regulation lead us back to the primacy of education and training raised above (1).

But, more needs to be said about reversing the role of an institution (the SRO) that has been around for 2008-1936 = 72 years. That was two decades prior to the rise of modern accounting in the 1950s. Securitization accounting is another instance of a failed system. The frank discussion of obstacles to creating a reporting language for structured finance/securitization activities without undermining the tenets of the accounting paradigm in FASB 140, Appendix B makes for enlightening reading.*

Taking the idea of disclosure-based regulation to the limit, is America prepared to become the information society we would need to become in order to free ourselves from relying on designated authorities who tell us what to think? Are we prepared to shoulder responsibility for the decisions we make for ourselves, psychologically? financially? Yet, if finance is not prepared to become bold or knowledgeable enough to govern itself, why should it deserve a free market?

(3) is where the proverbial rubber meets the road in financial theory. Credit volatility is a property of the underlying cash flows that form the credit structure of structured securities. With the passage of time, this volatility changes in a pattern that is time- and structure-dependent. Quantifying how the credit exposure improves or deteriorates is the essence of the valuation problem.

In one sense, calling credit volatility an error term shows an essential misconception about the value proposition of structured securities. But in another sense, the FER are due an enormous amount of credit for having hit the nail on the head, albeit from the canon of corporate securities valuation and stochastic calculus. Because credit volatility is real and not a result of modeling error, imposing the assumption of constant returns (static ratings) on structured securities introduces pricing errors precisely by imposing an exogenous (and incorrect) assumption about the distribution of structured risk.

Once again, in the interest of full disclosure, the commercial premise of R&R Consulting is the need for dynamic risk analysis in structured finance/securitization. We were pioneers in describing the non-stationary nature of structured risk and modeling it for the cash market.** Does that mean we’re “selling snake oil”? Or does it make us unusually well qualified to identify the central valuation arguments and debate them?

Other comments about the role and function of rating agencies in structured finance that can be found in the paper are important and worthy of counter-comment. I leave those for a follow-on blog.

– Ann Rutledge

*Yet, despite its shortcomings, GAAP is much closer to practical reality than IFRS. As we contemplate abandoning GAAP in favor of the European system, should we not reflect on the adverse consequences that shift would have on reviving the securitization market?

**Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford University Press, 2003, pp. 101-103.