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Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge
June 22, 2009

Back to Basis for Securitization: Interview With Ann Rutledge

"Proving yet again that it has become a puppet of its sell-side parent SIFMA, the American Securitization Forum has just released a 241-page study that it commissioned from National Economic Research Associates, Inc. (here) to prove that securitization increases the amount and lowers the cost of consumer credit. It is as though the White Star Line commissioned a book on the RMS Titanic in which the author was told to extol the power of Titanic's engines, the elegance of the china in its dining rooms, and the verve of its dance bands, while strictly ignoring its shortage of lifeboats. There is only one question worth asking about securitization: why did securitization become the seedbed of the broadest and costliest epidemic of fraud in history? Until we face that question squarely and answer it honestly, securitization will remain in its coma. Unfortunately, the Obama Administration missed a chance to address that question in its plan to regulate the securitization market. ASF's sponsorship of the NERA report is more insidious. By a combination of forbidding mathematics and emollient prose ("Recent experience appears to demonstrate readily that securitization is not inherently 'good' or 'bad.'"), ASF tries to whisk us past that looming question and past the one measure that will best restore confidence in securitization: effective redress for investors against those that turned securitization from a useful financial tool into an orgy of misconduct."

David Grais
"ASF and NERA Rearrange the Deck Chairs"
www.absinvestoradvocate.com

Last week, we got a lot of responses about our missive regarding Larry Summers' economic rescure plan and the guest commentary by Joe Mason on securitization. One reader in particular thought we were too hard on Summers, but most of the comments actually suggest we went not far enough. It seems our friend John Dizard of the Financial Times is having a similar problem with credit default swaps ("Letís take the right path on credit default swaps" June 21, 2009).

Well, if you think we were tough on Larry Summers last week, then be sitting in the Senate Banking Committee's hearing room later today when we remind the members that it was Larry Summers, Alan Greenspan and Robert Rubin who smeared the reputation of then-CFTC Chairman Brooksley Born and the other members of the Commission a decade ago to prevent federal oversight of OTC derivatives.

We wrote about this issue last year in The IRA: "The Subprime Three -- Rubin, Summers & Greenspan', April 28, 2008" It is high time that the Congress compelled a public explanation from these three men, all of whom were in public service at the time, for their actions regarding OTC derivatives. We're not looking for sanctions or prosecution, you understand, just to complete the public record.

Click here to read the written testimony by IRA co-founder Christopher Whalen for the hearings today before the Senate Banking Committee on the subject of "Over-the-Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks."

One comment regarding last week's missive by Joe Mason was telling, namely that the whole purpose of representations and warranties in the securitization market is not to enforce same, but to force the sponsor to cure the defects. Thus if a securitization experiences a default, the sponsor is supposed to substitute a new loan for the defaulted credit to maintain the fiction of the securitization, even if the act of substitution eviscerates the legal claim of separateness between the sponsor and the DE trust that is the actual issuer of the securities.

The commenter noted further that the whole securitization model was created from the world of auto and credit card receivables, relatively short-term paper that does not carry nearly the same degree of legal complexity as a mortgage securitization. Such legal nuances regarding the servicing of a securitization are sublime, however, compared to the larger issues surrounding the securitization market, namely the economic basis for the pricing of these securities during the offering to investors. While many people may think that "mark-to-model" is just a joke, for many investors and trial lawyers, the issue of whether the Street really exercised due care with respect to the pricing and description of complex structured assets is a deadly serious issue and one that will consume enormous resources in the months and years ahead.

To get some further insight into the world of securitization and cash flows, we spoke last week to Ann Rutledge of RR Consulting. A University of Chicago M.B.A., Ann has over twenty-three years of experience in financial valuation and risk analysis, and special expertise in the microstructure of exchange-traded and OTC dynamic markets. She worked at Moody's in the golden era of structured finance, but left the agency when it became clear that models where being substituted for cash flow analysis at the behest of the Sell Side dealers. Ann is frequently retained as an expert witness in prominent securities litigations in the United States and Europe. And yes, Ann is the wife of Sylvain Raynes, the other half of "RR" Consulting. We know them both thanks to our mutual friend Josh Rosner.

The IRA: Thanks for taking the time to speak to us. Where in the world are you today?

Rutledge: I'm in London this week teaching a class on securitization. The course goes for a full week, which is not a bad way to handle it. A week is enough time to really go on an excursion through the details of the method, which is both an adventure and a great leveling experience for experienced practitioners and newcomers. I do two courses a year on securitization sponsored by Euromoney and we always get a very interesting group from around the world.

The IRA: We wanted to follow up with you after the presentation at the PRMIA event last week. Your talk was very provocative, but we really did not have time to get into the meat of the issue, thus our request. We think we got the punch line, though, which is that credit default swaps and collateralized debt obligations or "CDOs" share a common flaw, namely the lack of a cash basis for these derivatives.

Rutledge: Yes you did. And you asked a devastating question, namely whether OTC derivative markets that do not have a visible cash basis are legitimate or should even be allowed to exist. I have taught classes on securitization for years and don't often get people asking this basic question.

The IRA: Well, we started out on Wall Street with a Series 3 license from what was then called the National Futures Association. All of the contracts we knew at the time had very visible, easily observed cash markets upon which the derivative were based, thus the term "basis." The difference between a futures contract for T-bonds and a credit default swap is that the former is a real contract for a real deliverable, whereas the CDS trades against what people think is the cash basis, but there is no cash market price to discipline and validate that derivative market.

Rutledge: Well obviously the answer is that no, a contract or structure without a cash basis should not be allowed at all. You cannot have a derivative that is honest and fair to all market participants without a true cash basis.

The IRA: So to play devil's advocate for a moment, even if it were possible to synthetically create the equivalent of a basis and allow a trader to borrow the non-existent collateral for a single-name CDS contract, that would not address the problem? Is there any way to fix CDS contracts and other structures for which there is simply no cash basis market?

Rutledge: That is an interesting theoretical discussion, but the fact is that if you don't have a community of interest with the exposure and with the value at risk in a given name to really make it a market and believe in it, then who is to say whether the synthetic market works? That is always the classic problem with new markets. Communities of users or what The Chicago School calls "the market" that create a new vehicle don't want to come in under any kind of standardization or regulation. They exist to capture abnormal returns.

The IRA: Correct. But with CDS we have a community of dealers, not really a market, and everyone else is a second class citizen standing in the street. There is no true cash market where there is a deep community of traders, investors and locals who create true price discovery and make the pricing meaningful.

Rutledge: The way you state the problem really begs the question. When traders start to think of themselves as a community then by definition they start to be willing to come under some type of jurisdiction and accept some standardization. But here it is extremely important to say that Chicago has it wrong: people don't put on trades unless they can make money. If they can make money by the trades in the market that doesn't have a basis (I'm not speaking of earning spread for carrying positions-this is what is missing), then the traded price clearly does not represent fair value. If you can make money in such a market, then it is because somebody made a mistake.

The IRA: Or as your spouse Sylvain has said to us many times, price is not value.

Rutledge: Right, price is not value today, though if the market is rational and people are carrying positions that are marked to market, then in a long term sense it will be. The more commodity that you have to carry on your books, the less interested you are in abnormal returns and the more interested you are in carrying the goods at a rational cost of capital.

The IRA: Yes. This is why we believe that derivatives markets such as CDS and CDOs that have no cash basis tend to magnify speculative excesses, while derivative markets where there is a visible cash basis market to discipline investor behavior seem less unstable in terms of systemic risk. Is it fair to say that the point made in your presentation is that CDS and complex structured assets that do not have a cash basis should be banned by regulators?

Rutledge: You can say that. The first issue for me is that CDS and CDOs are an unexamined market. The fact is that the cash side is unexamined in these markets, because the cash analysis is owned by the rating agencies and they don't share all the vital details needed for pricing. An example of a vital detail would be how the cash flow analysis yields a number - a default rate or an implied price - that maps to a rating. Yet, the cash is the best indicator of what synthetic value really is. If the cash market were visible and could be examined by all participants, then it would give away the ability of the dealer banks to tax participants in the market and extract these abnormal returns.

The IRA: Correct. One of the things that has infuriated us over the past year or more is that all of the steps taken by Tim Geithner, starting at the Fed and now as Treasury Secretary, have only served to reinforce the monopoly of a few dealers in these markets. In the name of limiting systemic risk, investors who trade CDS are now forced to trade directly with dealers instead of amongst themselves as they can on a public futures exchange. Why should a large energy companies such as ExxonMobil (NYSE:XO) or Shell, which have far more capital and financial stability that JPM or any money center bank, be prohibited from trading energy swaps directly with other participants?

Rutledge: No they cannot. You see the thing that is really unique about structured risk -- I am not talking now about CDOs, just ABS and RMBS - is that where it is backed by an amortizing pool, it does have a theoretical profile where the performance of the security can easily be predicted and benchmarked against. This is the point of my presentation at the PRMIA event on June 10. The risk of making things like CDOs and CDS truly transparent is that the banks will be permanently disenfranchised: if the secret of how to price risky credit becomes democratized, and banks lose their special purchase on underwriting, then what will be their role?

The IRA: As you said during your presentation, the analysis of cash flows involves arithmetic, whereas the model culture used by the OTC dealers to obscure the true nature of instruments such as CDS and CDOs is about deliberately making markets less efficient. Is this fair?

Rutledge: Yes, that's right. Here's the issue. What we are really talking about is microbiology whereas the world is still thinking in terms of biology. In the case of a security with an observable basis, we are looking at the DNA of its risk and we can transform the risk profile via re-engineering. It is a matter of guesswork for securities that do not have this observable, tangible cash basis, where all that we see is the structure -- the outside of the package. Pricing ABS is about arithmetic, not ad hoc models or structures.

The IRA: So if you have a CDO that is comprised entirely of credit derivatives, for example, that is replicating one of your transparent, easily valued ABS deals, how do you feel about that?

Rutledge: That is OK so long as the structure tracks the cash basis; right now, it does not. As you know, structure is a function of the target credit quality, and target credit quality is a benchmark for the pricing. The amortization of ABS CDS/CDO and cash ABS risk follows essentially different processes: one is based on default write-downs, the other on actual cash distributions. Effectively, these two processes of amortization never converge, not even in the simplest of ABS transactions.

The IRA: So you do not object to a derivative so long as it tracks the cash basis. After all, if and when such a deal diverges from the cash market basis, that would put the risk back to the derivative's sponsor, who would be sued by the investors for fraud!

Rutledge: That's the way markets should work. Think about what is different between a dealer market, where you take an outright exposure but you can get out of it by passing it on to somebody else, and an ABS structure where the guarantee is built into the security.

The IRA: Correct, the ABS is self liquidating -- assuming that the underlying assets perform within the bounds of the assumptions in the structure.

Rutledge: Yes and because it is self liquidating the investors in the securitization have economic capital against the risk. The real essence of the ABS problem, or opportunity, is that the risk is going to expire before the economic capital in the structure expires. If you've correctly analyzed the risk, most ABS deals will converge on a "AAA" rating regardless of the initial rating of the security. And so any synthetic or derivative that tracks a cash ABS as its basis must understand and replicate the insurance component of the ABS. These deals are all self insured as well as being self liquidating. That is why the creation of structured securities that lack a cash basis is such an abomination for traditional investors in ABS, who are among the most risk averse investors.

The IRA: There are clearly some striking examples of this disparity. You compared the performance of an ABS from Ford (NYSE:F), which performs precisely as advertised in the offering to investors, with a late-production securitization from Countrywide, which never even came close to converging on "AAA," suggesting that the Countrywide deal was a fraud. You even suggested that F has been overpaying for its ABS deals to the tune of tens of millions of dollars a year. Explain that for our readers.

Rutledge: It is expensive for F in real risk-adjusted returns. At the beginning of the decade, we estimated that in issuing ABS, F may be paying $50 million more in annual interest costs than they would need on an apples-to-apples comparison with the benchmarks; but that excess protection is not, strictly speaking, why investors buy the paper. Investors can't measure the excess protection they receive; they are simply buying the F ABS because it tracks the cash basis and is entirely predictable. The markets always think in terms of "structure," but it is more than that; it is about numbers.

The IRA: So, again, to be the Devil's advocate, given the economic environment, the already record default rates in most asset classed, and the continuing pressure on consumers, how much variability from the norm do you expect to see in cash flows from conventional ABS? Is the variation in the loss experience in ABS deals from F and other traditional issuers going to break the admittedly conservative assumptions in terms of cash flow over the next several years?

Rutledge: Well, I think you are going to see a lot of variability. Look at the banks, who have been watching their internal cash flows falling for months now. For them there is no surprise. Hence their reluctance to disclose it. There really are two ways to answer your question. First is the subjective way, which is how different are the real cash flows going to be from what the armchair observer might think. The answer is quite a bit different. The armchair observer is thinking in market-average terms, while the actual experience of the structure from deal to deal could be very different, much higher or much lower. So the Ford deals are all trading above par on a theoretical basis. Nobody is pricing them at such a huge premium, but that is what they are worth in an economic sense.

The IRA: Your point about the cash flows at the banks is important. We have been observing a steady decline in the gross yield at many banks, which is a simple calculation of cash flow vs. outstanding loans and leases. As default rates rise and recovery rates fall, the total cash flow coming to the banks must continue to drop, probably through 2010 and beyond based on what we see in the channel now. What is the second method of pricing?

Rutledge: Now, the other way to answer the question is to ask: How stable has the performance been of the subordinate tranches of the more problematic structured deals, what people call toxic waste, been over the past 24-36 months? Paradoxically, because the underlying collateral experienced such high rates of default and prepayments early on, the risky tranches now tend to be very stable because they were only really ever worth 20 cents on the dollar when the deals went out! Conversely, it's the senior tranches that are highly uncertain. Will the collateral really ever throw off enough cash to make them repay in full?

The IRA: The investors who bought these toxic deals in the primary market will no doubt find great comfort in that fact.

Rutledge: The fact is that the performance of many toxic deals has been remarkably stable, but that does not change the fact that the deals were badly mispriced at inception. It is not even a question of marking these deals to market. If they had been valued properly at origination, they would not have been done in the first place. But, once in the market, the marks may also be wide of fair value. Jerry Fons, the former author of Moody's bond default studies, just published a paper examining how the ABX.HE 06-01, a synthetic ABS product, tracks the underlying cash ABS on a DCF basis. ABS.HE 06-01 is an index product developed and owned by Markit, a consortium of dealers. There are five sub-indices (AAA, AA, A, BBB and BBB-) made up of tranches taken from 20 large cash ABS deals (5% each) backed by vintages of late 2005 or early 2006 home equity loans. Obviously, the AAA index is composed of AAA-rated tranches from each deal, the AA index composed of AA-rated tranches, etc. It was designed for banks to hedge their long exposures and hedge funds to speculate on pricing anomalies. For benchmarks on the intrinsic cash flow value of the ABS tranches, Jerry used our secondary market re-rating metric, which reverse-engineers the transaction structure and follows the migration in value over time from origination to amortization. His paper shows that the trading on the ABX really did not reflect a movement away from par until early 2007: February 07, to be precise. Pricing these securities at par meant the market believed that each sub-index was appropriately discounted, given the risk. But, in fact, if you did the DCF analysis on the underlying collateral, you could have known that many of these deals deserved to be heavily discounted vs. the current market. Even the raw collateral data showed deterioration. But the ABX did not reflect this information.

The IRA: So the ABX is not a good indicator of changes in the performance of the underlying ABS market? Whatever will our friends at CNBC, Bloomberg and the investor community who swear by the ABX do when they read this interview!

Rutledge: No, the ABX did not reflect the true loss and prepayment experience of the underlying collateral at all. The actuals, the cash basis, suggested that these securities really deserved to be heavily discounted to par. For example, fair value of the AA tranche at closing was only about 40 cents. And now, if you compare the volatility of the ABX traded prices with the volatility of the cash market, "fair value" price, the cash price is much more stable.

The IRA: Ha! Why do we suddenly have this image of chimpanzees sitting on trading desks and responding to artificial stimulus dispensed by the large dealer banks? What proportion of people who trade ABX do you think understand what you just described? Is our supposition that most market participants trade these deals vs. bond yield spreads and not with an eye on actual cash flow performance correct?

Rutledge: Yes, that's right. You wake up in the morning and say "How do I feel about the market?" But that is not really the intrinsic value of an ABS or any structured asset.

The IRA: No and the Big Media never bothers to ask whether dealer-sponsored indices like the ABX have any connection to the actual cash basis. Do we perceive a pattern here? Is it just basic human weakness that keeps bringing all of us back to valuation shortcuts that all look like Merton models? Or is it that the deals, the rating agencies and the media have conditioned the markets to believe that such methods are effective?

Rutledge: It's a complex problem, in fact. It does seem to be basic human weakness to prefer religion to science or sociology. Modern financial theory is a religion; we believe that markets meld data into truth, but that the truth of markets is beyond the ability of any one person to comprehend, except some very special wizards who have the right recipes to decode it. One after another, the wizards are discredited, but our slavery to false ideas about markets continues. Part of the reason for this is the lock that The Chicago School of finance has had on financial thinking. A little objectivity would show that much of what we think is, in fact, a set of myths -- but myths that favor certain parties in the market at the expense of everybody else.

The IRA: Why is it that the media, even our friends at Bloomberg, never question these assumptions about market valuations? Is it laziness or that they just don't get it?

Rutledge: I am not too critical of the media. To start, I am not sure most of them understand the difference between subjectivity and objectivity. So they are just not ready for that message.

The IRA: They are not, alas, but that is one reason why we publish The IRA. So in the proposal from the Obama Administration to reform the securitization markets, it is proposed that banks retain a 5% "exposure" in all securitizations. Do you find this as amusing as we do given your work for investors involved in litigation against the sponsors of securitizations? The FASB is now telling the banks to bring 100% or the risk exposure back on balance sheet, but the Fed and Treasury are saying 5% risk exposure. And meanwhile investors are suing the sponsors of deals based on 100% of the exposure.

Rutledge: FASB in some sense has no choice. They never got the rules regarding securitization right and the IFRS was even further away from reality when it comes to securitization. If you go back to the original FAS 140 discussion paper, you can see where the debate came down in terms of on-balance sheet and off-balance sheet treatment. My position and Sylvain's too is that if you are going to the trouble of analyzing the intrinsic risk of a pool of receivables and you are putting capital against that risk, then all that matters is the integrity of the analysis of the structure. It does not matter on whose balance sheet the structure resides so long as the analysis of the cash flows is performed correctly. In that sense, GAAP was kind of far from a radical treatment of OBS treatment, but it was certainly closer than IFRS. Now that the market has fallen apart and given the pressures to harmonize IFRS with GAAP, which really has little credibility left, I expect to see the US move to a more European style of accounting for OBS vehicles. But a European standard, implemented in an Anglo-Saxon financial regime, is an invitation to abuse the standard.

The IRA: Give us some examples? Where is the next area of regulatory arbitrage for the major dealer banks?

Rutledge: Look at the proposals for using covered bonds to rebuild securitization. There is a great difference between how banks use covered bonds in an Anglo-Saxon market vs. the European model. In Europe, there is some attempt to size the risk and maintain a level of responsible leverage.

The IRA: Well, look at Denmark. We've spent a lot of time speaking to Alan Boyce about this issue. In the Danish mortgage market, the banks aggregate the risk into large trusts that have excess economic capital. The bond market manages the interest rate and market risk, instead of pushing these risk onto the consumer. So whereas a home owner in Denmark can effectively repurchase their mortgage at a discount in a rising interest rate environment, in the Anglo-Saxon world the home owner bears all of these risks. The Danes have essentially banned bad behavior by the banks and have created the most stable market for home finance in the world. You, the consumer/home owner, can examine the current market price of your mortgage every day in the newspaper because all of the Danish mortgage bonds trade on an affiliate of the NASDAQ/OMX. Wonder how long it will take our friends at the Fed and Treasury to figure out that we have a solution to the crisis affecting the US residential mortgage sector that is already extant and trading on the NASDAQ every day?

Rutledge: Yes, the Germans are shocked to see that there is gambling going on in the US mortgage market. Last year I was asked to look at a handful of prospectuses in the Canadian and US covered bond markets last year on behalf of a client, and none of them come to market with asset-liability parity. That means, none of them were set up to pay the investors off in full without recourse to the bank doing the securitization. Unlike Demark, most covered bond deals in the US and Canada come to market with liabilities in excess of asset values. This illustrates how the Anglo-Saxon interpretation of a seemingly safe and sound model like covered bonds can create opportunities for regulatory arbitrage -- if the authorities do not insist on tight underwriting standards and enforce same. In the Canadian and US covered bond deals, it is clear that there will be recourse to the lender since the NPV of the liabilities exceed that of the assets. So in this example, the "safe" model for a covered bond becomes an excuse to excessive leverage on-balance sheet!

The IRA: But are covered bonds, even with this notable defect, a more conservative model that what we have seen in the US? Are we close to God or is this just another ruse by the large dealer banks to hide unsafe and unsound practices?

Rutledge: Maybe. There is no panacea. There is enormous potential for abuse in covered bonds. The constituency behind the adoption of covered bonds by US regulators was pushed by Countrywide and WaMu. The proposal was adopted in 2007. All that a covered bond does is make legitimate what used to be illegal, but that banks were doing anyway, namely the substitution of collateral in securitizations and other undocumented transactions between the sponsor and the supposedly separate DE securitization trust. The invisible and illicit forms of recourse such as substitution and servicer cash advances by the sponsor that were never reimbursed are all now legitimatized by the covered bond model. The practice of bringing securitization deals to market that have an imbalance between the NPV of assets and liabilities is unsafe and unsound, but now it's legal!

The IRA: So you believe that all of the deliberate mispricing of securitization deals and the substitution of collateral that occurs today under the table could simply get worse in a covered bond model - at least one implemented by avaricious gringos who don't have to operate under the authoritarian political environment of Northern Europe? We have a lot of respect for the discipline of the Danes, but these are societies where individual choice is largely pre-empted by the state. We hear that the positive liberty crowd that surrounds President Obama are big fans of the European model. So give us you take on reform of the securitization markets. What should the US do to make these markets more transparent and fair to investors?

Rutledge: My answer is really boring and not very sexy. The first key issue is that we need to do to reform our markets is to have a standard vocabulary for the definition of what is a delinquency, a default, and loss. That is really boring, but that fact is that I can show you transaction documents for one deal after another where the bad acts are committed because these very definitions can be gamed. The accounting firms are so obsessed with liability and who takes responsibility when things do go wrong, that they never bother to ask why things go wrong with securitizations. But, we understand that the accounting framework was set up for corporate finance, so it is understandable that they would think about the "biology" of the problem - the whole company solution - rather than focusing on the appropriate level, the "microbiology" of these structures, where risk is measured at the pool or even loan level.

The IRA: No, we know the problem well. The audit firms rightly complain that they cannot bear the liability of these transactions, so they spend most of their time trying to ensure that somebody else bears the risk - instead of trying to identify and eliminate the sources of the risk. If you were the managing partner of PwC or Deloitte and you were working for a group of greedy, irrational banks that only care about next quarter earnings and have literally bought everyone in the political and regulatory worlds, what would you do?

Rutledge: The thing is that when you look at as many deals as I have and see that over and over again, the same issues cause deals to go wrong because you counted the loans at full face value or you counted loans that were not really contributed to the securitization, these are basic flaws. The basic rules of securitization, going back to the simple example of the F ABS deal, do work if people follow the rules - but this assumes that we have a government, auditors and regulators that will enforce the rules.

The IRA: So wait, are you saying that adopting and enforcing basic definitions as you have described would eliminate a lot of what's wrong with structured finance?

Rutledge: If everybody is playing by the same set of rules, whether you are talking about loan origination or securitization, then it becomes very hard to game the system. The lack of definitions is a huge problem. Here's the problem. At the very first step, when Citibank or another large bank buys loans from Countrywide or Associates or whomever, they don't believe the representations that the seller is making, and they don't have to because they can put the bad loans back to the seller. However, this is hidden recourse. The seller is not a highly rated company, yet the AAA investor in the deal Citi structures is ultimately relying on the seller's ability to substitute assets or buy them back at par. So therefore, within the supply chain, as the "capital" moves through the system in the form of the funded loan, it is ultimately a recourse problem back to the originator. So either you rely on the strength of the loan to guarantee the investment, or you dismiss the representations about the loans entirely and simply rely upon putting the loans back to Citibank or whoever is the sponsor in the event the deal goes wrong. In the former situation, you have a bona fide structured finance market; in the latter, you have plain vanilla corporate finance. If you choose the former, you need the measures in place to evaluate the strength of the loan. If you choose the latter, but you allow hidden leverage to build up on the bank's balance sheet that can't be measured -- because you are not operating in a granular structured finance world with pool or loan-level measures -- then you have an essentially unstable financial system.

The IRA: So how do you assess the decision by Advanta to accelerate one of their credit card securitizations. As we understand it, the losses on the securitization became so large that Advanta simply decided to buy-in the bonds at par to avoid precisely the sort of recourse claim and perhaps also litigation that you just described.

Rutledge: Funny that you ask about Advanta. We talked before about resizing the economic capital of a securitization as the pool of risk shrinks. The first time we ever did an analysis on a deal was on a transaction from Advanta's mortgage portfolio, which they had sold to JPM. Later, JPM turned around and sued Advanta in 2003, I believe, for making servicer advances to the securitization trust that were never reimbursed and that created an illusion of credit quality that was not real. We had identified the problem in the Advanta portfolio in 2001. In those days, according to our research, the servicer advancing problem was not widespread. But after 2001, it became more widespread, until you could say it was a problem for most of the market. To come full circle on the earlier point about covered bonds, servicer advancing is wrong only if you disallow recourse. If you allow it, by promoting covered bonds, you are simply legitimizing the deceptive practices that developed in the last decade. But, without an ability to track current credit quality in the ABS or MBS, you will not be able to detect the magnitude of the problem until it is too late.

The IRA: So how do we fix the problem without creating more opportunities for gaming the system? How do we make the buyers do the diligence? Can you fix this by merely creating consistent definitions?

Rutledge: These originators play this game over and over again and they don't get caught, in part because we do not have a common, standardized set of definitions for governing the most basic aspects of the securitization process. The buyers don't do the work and the accounting framework is a counterparty-oriented framework, not one that is focused on the underlying assets. So banks like Countrywide and WaMu originated and sold some truly hideous structures during the bubble, but the buyers only diligence was reliance upon recourse to these banks. It costs maybe 50bp for a buyer to get the data and grind the numbers to really diligence a securitization based on cash flows, even a complex CDO. But the cost to the buyer and the system of not doing the diligence is an order or magnitude bigger. If the Congress, the SEC and the FASB, and the financial regulators only do one thing this year when it comes to reforming the world of structured credit, then it should be to impose by law and regulation common standards for the definitions used in the marketplace.

The IRA: Thanks Ann. We'll definitely come back to you in the future to revisit this issue.

Questions? Comments? info@institutionalriskanalytics.com


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