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Is A British Court About To Decide The Future Of Securitization?
While momentum chasers in America quarrel over worthless data points and whether some trading desk bought an additional 20 PCs with Intel's brand spanking new i7 CPU to reduce latency by yet another 1 nanosecond, imagine hypothetical green shoots, and storm the futures in hopes of getting other momentum chasers to get behind them, a much more relevant development is currently unfolding which could potentially have a terminal effect on the future of securitization. Creditflux reported last week that the lawyers of bankrupt Lehman Brothers recently filed in English courts a request to overturn the concept of bankruptcy-remoteness for special purpose vehicles (SPVs). If granted, this request could spell the end of securitization as a once-upon-a-time multi-trillion credit product, regardless of how many PPIP or TALF revisions the administration throws into the CRE fire.
According to available reports, and an analysis by CreditSights, Australian investors in a synthetic CDO issued by the Dante Multi Issuer Secured Obligation Program (a Lehman SPV) are attempting to collect the SPV collateral following the bank's bankruptcy.Furthermore, the bank's US lawyers are now suggesting that principle of bankruptcy-remoteness goes against bankruptcy law, arguing that collateral should first pay off in the money swaps before paying off investors. To make things even more complicated, lawyers are now trying to move the case to New York claiming UK courts do not have jurisdiction, because since the swap counterparty is American (even though the documentation is based in England), it should be decided in an American venue. It is odd that the lawyers believe this issue will have i) not only a heightened standing domestically but ii) an increasing probability of success here despite what will likely be vocal opposition by such entities as the CMSA, and by implication, the administration.
Some background info from a recent report by Credit Sights:
The principle of bankruptcy-remoteness of SPVs forms the bedrock of securitization. It is vital to achieve a full separation between the assets and the originator of those assets. One key element of this separation is the so called “true” sale of assets, that ensures that no creditors of the originator have any claims against the sold assets, and those assets cannot be consolidated in the bankruptcy estate in case of insolvency proceedings against the originator. As a result, the transaction can be highly-rated (AAA or AA) even though the originator may have a much lower rating. In funded synthetic transactions, also known generally as credit linked notes (or CLNs), bankruptcy-remoteness of the SPV translates into a claim on the underlying collateral. According to industry standards, the swap counterparty’s claims are subordinated to those of the investors post the counterparty’s default, thus allowing rating agencies to ignore the (usually lower) ratings of the default swap counterparty when assigning a rating to the transaction.
The chart below shows a typical CLN transaction where the swap counterparty is generally a dealer. The issuance proceeds from the investor are used by the SPV to purchase pre-agreed collateral to fund the exposure of the default swap. The SPV simultaneously enters into a default swap with a swap counterparty whereby it sells credit protection in return for an ongoing premium. The collateral coupon and swap premium are then passed on to the investor. The SPV is usually a trust designed to enter into certain limited transactions to enable it to issue debt customized to a specific payout profile or suitable to investors. Each SPV issue is collateralized separately and has recourse only to a defined pool of assets. So while the same SPV can issue any number of notes, no two issues will impact each other. An appointed and independent trustee ensures the interests of all parties to the SPV (the investor and swap counterparty) are considered and maintained. The SPV can be situated in a number of jurisdictions, providing tax benefits. The issued CLN can also be rated and/or listed as required.
It is indeed not an exaggeration that a ruling in favor of the plaintiffs would have major ramifications on securitization. As Credit Sights concludes:
A ruling against the investors would be hugely negative for the credit markets as the concept of bankruptcy-remoteness will most likely not be valid for any transactions where the swap counterparty has a U.S. connection. The immediate outcome will be potential ratings downgrades of funded synthetic transactions, as rating agencies factor in the lower ratings of swap counterparties (provided they have a U.S. connection). In some instances, this could lead to forced unwinds by ratings-sensitive investors, resulting in significant upward pressure on spreads. In the medium to longer-term, this outcome could present a huge hurdle in restarting the securitization market especially as most traditional investors, who are also ratings-sensitive, are unable to participate in the market.
While the case has not generated much traction yet in the legal system, once investors realize the potential ramifications it is likely that this could become the most followed legal development whose adverse repercussions could throw a major wrench in the administration's wheels, which as everyone is aware, are fully focused on doing all that is necessary to not only restart securitization but to bring leverage to the same dizzying heights that brought the system to a grounding halt the first time around.
Data from: Credit Sights.
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Same with GGP in the US courts. The remoteness of these entities is what makes the securitization possible, otherwise the de facto substantive consolidation renders this entire industry moot.
actually the ESH bankruptcy filing and NY state court lawsuit describe even more trouble for structured finance than does GGP because the senior certificate holders including Cerebrus are alleged to have conspired with the borrower Lichtenstein to circumvent to trust agreement which governs the securitization structure for mutual benefit against the interests of the junior certificateholders...that spells the end of securitization
You're talking about the FACTS trumping the POLICE STATE. I doubt it will happen.
No, this is a bigger issue and involves a lot more than most realise.
The Australians, as to the British will force this through.
The US Courts have to be very careful as to how this is handled and ensure that on all the facts presented the correct precedent is set. To snub these colonies may result in a lot more problems than just dumping Guanto prisoners on british soil without approval.
please refrain from making fun of the i7; it is a wonderfull chipset and makes curve fitting much much faster - things that were taking 15 minutes on the quad core now takes about 45 secs with distributive processing (using all 8 threads) at 3.2 ghz. Pretty awesome.
When are people going to realize that securitization was the greatest achievement of modern finance. The idea of tranching and distributing risk is a brilliant one. The problem was not the instrument but the brokers who underwrote the securities who would also lend prime brokerage clients money at 20 to 40x leverage to buy these instruments. It's kind of like a guy driving into a brick wall at 170mph - this does not make the car useless; it makes the driver an ass hole.
i may be old fashioned but what was wrong with debt - low risk, equity - high risk
I'm all for a normal capital structure and am a huge huge believer in proper underwriting. I just think that securitizations are a great way to get the right product to the right counter-party therefore creating more liquidity (or really currency). I just think that the leverage given to clients by banks was out of control. There is nothing wrong with buying a Z tranche of a properly underwritten pool of real mortgages, just dont lever 40x. In the end, there is nothing wrong with the instruments, what is wrong all the players. Hell, Tyler, I could have bought straight Chrysler bonds at 40x leverage and I still would be screwed. The same applies for CDS's, unless you have the paper you should not be able to buy the CDS or at least limit the speculative position size. I mean can you imagine if I could buy property and casualty insurance on your house; what's to stop me from burning it down. The system is just so broken because of the players. I know this is long winded and not so much too the point but I will still say that securitizations are good and the mortgage market will not come back until the market is fixed - this includes the rights of security holders. But for me, I started my wall street career trading emerging market debt (I am also from Argentina) so non of this is strange to me. We live in a developed emerging market.
Yes in theory advanced financial engineering could allocate capital and risk more efficiently thus facilitating progress - but the unfortunate reality is most people who are selling / buying / handling these products do not have proper respect for their complexity. The academics who engineered them are very smart people, but the sellers, pushers and traders don't seem to have humility in regards to input / assumption sensitivity of complex systems (or they simply don't care). The complexity of properly pricing the underlying debt or equity is staggering itself. The reason a pilot doesn't have to understand every nuance of building a plane is because the laws of physics do not change and once a physical system is engineered and tested it performs reliably. There are no Laws to flight test this type of engineering before putting actual risk on the line.
"We live in a developed emerging market." (from above)
Great post! Don't hate the game, hate the playa!
Your post is so true, but I'd revise your last statement:
"We (Americans) live in a delveraging, equinaminous market".
All dollar assets are fragile and suspect. Current fiscal "worries" will soon translate to, and beyond, scary, if monetary nightmares like Tyler's latest become remotely realistic.
We are way too close to the edge, going way too fast. Hopefully somebody rolls the rig into the borrow ditch on the uphill side before we go airboirne yelling "Geronimo!"
Wilderman
But don't let the hedgie off the hook if he assumed 20-40x leverage was appropriate risk for his investors. He did whatever he needed to get paid that 2 and 20, but the guy paying the 2 and 20 was expecting his hedgies to be smarter than that. Responsibility and culpability lies at every level of the trade, but don't blame securitization technology. And it really wouldn't be constructive to shoot the SPV concept in the head either, as its use extends well beyond securitization. Lots of simple financing applications that have zip to do with what that court is going after.
Well of course securitization is brilliant. If you're one of the securitizers. It's the only way anyone would be able to polish turds for a fee.
Right, but that polished turd is worth something to someone and the guy who was smart enough to know that on a big pay-off you bet little, you did ok. Z tranches should be used as a form of yield enhancement, not returns. The same could be said for equities and many other risky instruments.
Now, not doing your underwriting properly and creating fraudulent securities, which everyone did, should be illegal and the ramifications should have been much bigger. Shit, you probably need an institutional investor protection act, but it still does not make the concept of securitization bad.
You're still not getting it, quant-this. We're not talking about what, in theory, would seem to be a 'brilliant' idea. We're talking about a procedure which, in actual reality, is rife with fraudulent practices that are inherent to the profitability of securitization in the first place.
That is, in order to accurately rate these securities one has to re-underwrite the underlying obligations, as we've learned, since using mathematical models of default rates has proven to be wildly, dramatically inaccurate. But the costs of re-underwriting the underlying obligations would be very high, orders of magnitude higher than applying some mathematical model. These costs -- the costs of securitizing in a way that is not fraudulent or opaque -- are enough to make securitization unprofitable from the outset.
So the point is, if you or your firm is profiting from securitization, you are clearly cutting a number of very important corners. The whole process of securitization -- in practice, not in theory -- tends toward fraud. Doing it honestly and transparently wipes out the profit. There's just no way around this, there's no way to regulate it, and there's no way to enforce such regulations anyway.
EDIT: Let me add that I'm not saying securitization should be outlawed. I'm saying any security that hasn't gone through the process of re-underwriting the underlying obligations should never be certified as investment grade. In such cases nobody knows what the rating should be, so it should be treated as junk.
No, I do get it and I agree with you 100%. What I'm saying is that the idea and use of securitization in the beginning was good and usefull; this is when underwriting was properly done and issuers where acting responsibly. But like everything Wall Street, we cooked the goose. It still does not make securitization bad and I believe that we can not return to a healthy market until this product comes back. But in order for it to come back, there is a ton of regulation and oversight that needs to happen, such as making issuers ultimately liable for misleading investors. So if you issue a tranche that you call triple A and it defaults six months later, the issuer should be sued and make up the losses. If the issuer calls this junk and forewarns investors, then the pricing reflects the risk.
Personally I think what has gone on in the securitization business is out right illegal and many many people should be in jail. But securitization is a good way to transfer risk and pricing is less fallible than say modern options theory (umm.fischer black scholes) which is soooo wrong when it comes to pricing risk (especially at the tails).
So I do get it; I think that unfortunately securitizations have been used to take advantage by mis pricing risk, but I will still say that it has been the greatest innovation of modern finance. Most early vintage MBS's have performed well and as designed. But when you get fraudsters involved things change. Again, just because everyone is using cars to run illegal goods, it does not make the car bad.
But I agree with you that wall street, as always ruined it. PS, proper pricing and risk management is really only critical with hyper leverage where a 1% higher default rate would kill you. I dont price that way or use leverage, I price things with my worst case scenario in mind and take it from there, but that is why I am still alive and kicking.
Securitization is fraud to begin with.
What's so brilliant about taking on too much risk and then handing it off to other people? That this doesn't further responsible behavior should be clear to everyone paying attention.
The models you are using are simply wrong, reality disproves them again and again.Every crisis can only be solved by giving the securitizers even more money than in the crisis before.
The only brilliant thing in securitization is the marketing and PR, which pulls the wool over the eyes of the general public and hides real pyramid-like nature of this 'financial innovation'.
No securitizations are not fraud; calling a crappy investment tripple A and then lending money to buyers at absorberant levels of leverage to make fees to sell crappy product is fraud. Dont mistake the two.
But the securitization structure is brilliant, especially the handling of extension and contraction risk. When you split risk, you are not amplifying it but getting risk to the proper individuals.
The problem is excess leverage, so never in a million years should someone be allowed to buy $100 of notional value of a Z tranche for $5 because there is a very good chance you will loose $50.
Again the fraud was in the underwriting and excess lending not the instrument itself.
Baaaaaahaaaaaaaaaaaa!!!
Maybe in ten years when this finally gets settled, we'll know what the future of securitization is....
Meh, the Obama corporatist cabal has already made a joke of the US legal system. Hell, I thought the Patriot Act was the worst thing that ever happened to America. . .
Not gonna happen. There is simply too much at stake, including basic consepts of corporate separateness. If you make the walls of an SPV permeable in every which direction as a general rule, we may as well go to the good old days of sole proprietorships and partnerships as the dominant business model. So while the plaintiffs may prevail in this case if there are facts that support a "no true-sale" conclusion or if there are factual grounds for veil piercing, the general landscape is not going to change. The headline here is a pile of sensationalist nonsense.
I sincerely hope you are correct. Corporate contracts are only as good as the language therein; the court's impartiality notwhithstanding. Trust one or the other; neither is certain.
The new normal.. A done deal isn't done at all... Just a concept looking to be smoked in some jurisdiction or other.. Shuffle and deal 'em...
Judge Gropper in GGP made it clear that the contracts governing securitization were as much a subject of the bankruptcy court's equitable jurisdiction as any other pre-petition debt agreement.
Can someone explain this article to a neophyte such as myself? It appears to have serious ramifications but I am not sophisticated enough to follow. Thank you in advance
Lehman went belly up in Oz. Technically any company has limited liability in this situation refer
http://en.wikipedia.org/wiki/Bankruptcy_remote
Now all things being equal when one sells something toxic, they try and wash their hands of that product, that is no strings attached.
"A ruling against the investors would be hugely negative for the credit markets, as the concept of bankruptcy-remoteness will most likely *not be valid* for any transactions where the swap counterparty has a U.S. connection.
Think about this for a minute, the immediate outcome will be potential ratings downgrades of funded synthetic transactions, as rating agencies factor in the lower ratings of swap counterparties (provided they have a U.S. connection).
In some instances, this could lead to forced unwinds by ratings-sensitive investors, resulting in significant upward pressure on spreads. In the medium to longer-term, this outcome could present a huge hurdle in restarting the securitization market especially as most traditional investors, who are also ratings-sensitive, are unable to participate in the market ...
Boom Boom ,,,
aussie aussie aussie ,,, oi ,, oi ,,, oi
Well we will win the ashes.
The Banks may get their knickers in a knot over this Court case though.
I'm not terribly sophisticated, so please bare with me...
No one seems to acknowledge that the reason Lehman Bro went insolvent had nothing to do with securitization. Bear and Lehman (and almost Morgan Stanley) ate it b/c Hedge funds used credit dervis along with spreading rumors to drive credit spreads through the roof. With all the short sales and HFs longing protection, they were able to cause panic and scare investor to pull their cash.
It was a systemic attack on these banks and the hedge funds won.
Thoughts?