Tuesday, August 28, 2007

Confirmation of My Views on CDOs and Securitization

Yesterday's Wall Street Journal featured an editorial by Ethan Penner, one time Nomura employee in the mortgage banking group. Penner replaced my friend B, who had built the group some years ago.

It was very satisfying to read Penner echoing my own comments from this post, two weeks ago. Specifically, he confirms two of my contentions. First, that the manner in which differing asset types have been combined into CDOs, is far different in purpose, and effect, than the original uses of the securitization vehicles. Second, the ratings agencies played important parts in the debacle, highlighting their conflict of interest.

In one of my posts, I wrote,

"Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used."

In his piece, Penner phrased it this way,

"Of course, it is very important here to distinguish between CDOs that make sense and are a healthy part of the market, and ticking time bombs that should never have been created. As an example of the former, there are those issuers, the NYSE-listed REIT Capital Trust, who utilized the CDO structure to pool their homogeneous real estate credit assets and create a financing that matched up ideally. This sort of CDO is not only sensible but an example of how securitization can help foster a healthy financial system -- creating a liability for the issuer, Capital Trust, that matches exactly the term of the assets.

On the other hand, many CDO issuers bought all sorts of assets and combined them into proverbial "witches brews" that they foisted onto the bond market, sucking out profits and fees at issuance in a game that was ongoing as long as the deals held up. The buyers of these concoctions, reliant upon the rating agencies' models, were unlikely to ever get their arms around the risks that they were asked to underwrite. How a trader would be able to traverse the various markets represented by the diverse collateral underlying these bonds to provide a suitable secondary market bid is beyond me.

My guess is that a healthy CDO market will return, but it will only be available as a source of financing to those few professional risk managers with real expertise and only for homogeneous asset pools. I have pity for bond buyers with the other type of CDOs, as it is difficult to imagine how liquidity will ever return to their holdings."

Penner also reinforces points I made in this post, the following day, regarding how the ratings agencies abetted the mortgage originators/CDO packagers. In my post of a few weeks ago, I wrote,

"Yesterday's Wall Street Journal carried a fascinating article concerning how S&P's and Moodys' rating of so-called 'piggybacked' sub-prime mortgages, in 2000, led to today's credit turmoil.

Amazingly, the ratings agencies first allowed the CDOs backed by these mortgages to be investment grade, then changed their minds last year. It evidently took five or six years for S&P and Moodys to sample and test the payment history of such mortgages, leading them to downgrade them to junk status.

Now, as Wilbur Ross said on CNBC yesterday morning, nobody should simply blame a rating agency for their own bad investment decision. And I agree with that.However, when buyers included institutions which could not buy those CDOs with today's ratings, but could earlier, you have to wonder how much the agencies' appetites for fees led them to inappropriately collaborate with the issuers, and look the other way over an obviously riskier type of home loan."

Penner seconds this by noting in his article,

"However, it's become apparent in these last months that the free market, combined with a complete dependence upon the three main bond rating agencies, may not, in its current format, be the perfect answer either.

Securitization may be the only business in the world where the appraiser is hired by, paid by, and thus works for, the seller rather than the buyer. It would be unthinkable, for example, in a real estate transaction for the seller of a property to expect that the buyer would accept a seller-provided appraisal as the basis of their valuation.

Yet, this is exactly what transpires in the bond market, where the sellers, Wall Street firms that aggregate assets and pool them into carefully "sliced and diced" securities, hires and works carefully with the appraiser, the rating agencies, to maximize their arbitrage. Importantly, appraisers at the rating agencies are paid a small fraction of the pay of the investment bankers they work with, and many aspire to work at one of the firms that they are representing, thereby creating a heightened conflict.

The potential for conflicts and misaligned incentives are more potent over time than even the best of intentions.

So, the first place one may look when tweaking the securitization model would be to re-align the interests of the governing bodies, that is, the rating agencies, more precisely with those they truly represent -- the bond buyers. There are numerous ways that this might be accomplished; suffice it to say here that a change is probably healthy and long overdue."

So true. Finally, we have confirmation from an ex-senior manager of a securitization manufacturer that the process finally went overboard. Rather than allowing the marketing of loans, suitably repackaged, to clarify risks, with concommitant returns, the process became a method for creating opaque securities with respect to risk.

Meanwhile, the ratings agencies- S&P, Moodys, Fitch- stood by and kept quiet, while accepting payment for blessing the evolving practices.

Still, as Wilbur Ross noted, shame on any investor, especially institutional investors, who try to blame the agencies and securitizers, when, as buyers, they bore the ultimate responsibility for knowing what they bought and elected to hold. Some investors will continue to find ways to make bad investment decisions, and blame the markets, regulators, rating agencies, etc. We can't really stop that. But we can at least identify the need for buyers of securities to be intimately knowledgeable about that which they are buying.

No comments: