15 Mar Rope-a-Dope Securitization Economics
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.