05 Apr Rope-A-Dope Securitization Economics ll

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.

Defaultand 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 whosecredit and investment (C&I) policydoesn’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 Valuegames 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.