When you receive your brand new credit card in the mail, you also receive a sheet with the terms and conditions of the arrangement you have established with the issuing bank. These terms govern how the bank views and manages its relationship with you. Typically these terms and conditions are variable in the sense that the issuing bank can revise and modify the terms without regard for you, the consumer. It’s a contract with you where you don’t have the benefit of legal representation, or even a voice in the process. Moreover, these term sheets tend to be very fine print, dense and written with a lawyer’s attention to comma placement and nuances the average reader would overlook. The last one I reviewed was about eight pages of 6 point type (Except of course for the Schumer box.)

What happens is, of course, that the consumer never reads the fine print. They read the box and the APR, but typically gloss over the billing cycle period, the ‘adjustments’ to the interest rate as a function of your payment behavior, grace period exceptions to cash advances, cash advance fees, late fee charges, overlimit fee charges, and the like.

Apparently financial institutions pull the same tricks with each other although I suspect that the fine print extends to 50 or so pages. Take, for example, a collateralized mortgage obligation (CMO) where the servicing agreement permits the servicer (the organization which actually accepts your mortgage payments and sends you notices, etc.) to advance payments on behalf of defaulted homeowners (essentially additional loans at 12% or more interest). These ‘servicer advances‘ go back into the trust and terms may be written so that these funds go to the junior security holders. That is to say the mezzanine tranche or lower quality segments of the portfolio.

For those unfamiliar with how asset-backed securities are offered, there are usually three segments or tranches: the senior or low risk, the middle or mezzanine, and the retained or equity tranche which is usually high risk. The equity and mezzanine tranches are subordinated to the senior tranche in that all senior obligations are paid out prior to any payment to the other tranches.

In the event of a foreclosure, the servicer advance funds are paid out first to these junior securities, even before the holders of the senior AAA rated securities receive any payment. Consequently, the foreclosed home sale may produce no proceeds to the AAA holder and may in fact generate a liability. If the servicer owns the junior security, then there is no incentive whatsoever to resolve defaults. The subordination of senior debt to the servicer advances makes the AAA rating of these senior securities a myth.

Additionally, terms in some securities permit borrowers to sell collateral and reinvest the proceeds in other assets, including ‘junk’ bonds. Most permit unlimited amounts of swaps obligations with debt that is senior to or equal to the original priority of repayment. Because the terms do not specify an acceptable risk level for these assets, the collateral backing the debt is compromised. Thus an AAA rating is meaningless — by the time the swap obligations are satisfied, or if the repurchased asset becomes valueless, nothing is left to payout the original debt.

So given the complexity of these arrangements, traders who participate in these markets are likely to look at a security and view its price, its predicted paper return and its rating and leave it at that. No one reads into the fine print, and even if they do, they are faced with much the same choice as the credit card consumer. The security is written and offered as-is. Optimistic traders (especially ones who never have experienced a down market) purchase the security confident in its value, until that is, the underlying asset defaults and sets off a chain of events which leaves the ‘investment grade security’ well below grade. These traders are like consumers who run up credit card debt trusting in low rates and generous payment terms, and who miss a payment, and subsequently find that a great deal becomes a terrible deal with little or no warning.

And now we have a liquidity crisis. No one wants to borrow or loan against securities that have been found out to be riddled with loopholes. While politicians wring their hands in anguish over the poor defaulted homeowner, the real Aegean stable is the financial industry. Until the term sheets are rationalized and simplified to the point where a trader knows his asset’s value, the confusion and resultant liquidity lock will remain. Alt-A packages are likely engineered in the same manner and they haven’t been touched yet. Look for another round of grief as these securities are reassessed.

So in the last segment we reviewed the securitization of our portofolio with the following results:

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 4% 6-8%
Risk Low Medium High
Joe’s Rating AAA BBa ‘junk’

In any industry, there are clever little engineers that can make interesting things. The finance industry is no exception, except for a couple of salient facts. Most of these engineers are young (after all their products didn’t exist as much as 10 years ago), and most have never lived through a significant down market. So a certain set of eternally optimistic financial engineers looked at the mezzanine tranche (the Loans to Used Car Salesmen), and asked whether they could do something to strengthen the sales of this group.

One thing that they came up with was to apply a bit of insurance theory. Develop a product that could spread the risk even further than securitization. Take the pool of loans from the used-car salesmen and insure that pool against loan loss. That is to say, if any of those loans went south, the insurer (Guido) would cover the face value of the loan and the person who actually invested in (read bought) that tranche, would be guaranteed his principal back. Of course nothing is free so the person who was packaging the loans, me in this case, would pay a premium for that insurance just like I do on my house or car. However, in return for the insurance, the credit rating of the used-car-salesmen offer would improve as the risk would decrease. Joe would rate it higher — maybe A or AA. This means that since the risk was lower I would give only 2.5% or maybe 3% interest on the package to the investor.

The ABS package wouldn’t be AAA but it would be higher than BBa. And even though I had to pay Guido some cash for his protection, I ended up with a larger spread in rates. 6% – 2.5% is 3.5% for me verses the 6% – 4% or 2% I would normally get for unenhanced used-car-salesmen loans.

And Guido, even though he was betting my used car salesmen were a good risk and pricing my premiums as such, would spread his risk by protecting a large pool of such loans. Hey! It works for insurance with only minor glitches like Hurricane Hugo and Katerina.

So my new offerings look like this.

  Loans to Cashmere Coats Loans to Used-Car Salesmen Loans to Bums
  Securitized Loan to Cashmere Coat Securitized Loan to Used-Car Salesman Securitized Loan to Bum
Rate 2% 2.5% 6-8%
Risk Low Low-Med High
Joe’s Rating AAA AA ‘junk’

 

Thus with this piece of financial ingenuity we have created a new market. The companies in this market include ACA, AMBAC, FSA, and MBIA.

ACA recently saw its stock plummet 57% due to downgrades on its holdings. MBIA’s trillion dollar portfolio is under stress from $2.4 billion in debt obligations related to subprime mortgages as well as AMBAC. FSA has taken a $215 billion dollar hit. Fitch, a rating agency (Joe’s friend), has downgraded obligations of several banks, including Barclays.

The problem here is that the risk was incorrectly estimated — i.e., the people offering the securitized holdings were optimistic to just plain wrong. Spreading your exposure over a pool of equally bad obligations does not increase the quality, so the insurers did, in fact, not reduce their exposure to defaults. This is similar to major insurance companies issuing policies over a wide geographic area, noting that tornados, hurricanes and fires are localized events, only to have an asteroid strike the earth.

 

Next installment: Adding more structure.