“You won’t know who to trust.” (from Sneakers)

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.