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Sad episodes of Global securitisation:
[We make a repertoire of some of the sour experiences in the short history of global securitisation. Have you burnt fingers in any securitisation transaction? Or are you are aware of any such incidents/ cases, do let me know]
Here are some sad episodes from the mortgage and non-mortgage market. Some of these relate to wrong investments or speculation in mortgage instruments. Yet, as they relate to securitisation, we list them
The list is in no particular order.
NextCard, Inc., at one time claiming to be the leading issuer of consumer credit online, proposed to capitalizes on the power of the Internet to deliver unique services to the online consumer. The company was the first to offer instant online credit card approval and provide consumers with a choice of customized offers based on their unique credit profile.
The Company had done a securitization of card transactions originated on the Net, in NextCard Credit Card Securitization Master Trust.
With the failure of the business model, the transactions went into a toss. NextBank was ordered to be closed by the Office of Comptroller of Currency in early 2002. FDIC was appointed as a receiver.
Using its statutory powers, FDIC decided not to honour the early amortization clause in the master trust deed. If the early amortization had been effected, the noteholders would have been paid on accelerated basis.
Securitisation deals are based on transformation of the role of the originator into a servicer, and quite often, this transformation is unrealistic. Where it becomes a true separation of the two roles, some unique difficulties may arise, as was revealed by the Conseco Finance case.
Conseco Finance, the beleagured finance company, filed for bankruptcy. Conseco was responsible for several securitisation deals in the past, which it was still servicing. The service fees being charged in these deals was 50 bps. The bankruptcy court considered the servicing fee to be inadequate, and ordered for the increase thereof to 115-125 bps.
The result was a compression of the excess spread, which reduced the levels of credit enhancement, resulting into downgrades of several of its subordinated tranches.
The Conseco case establishes that the splitting of the excess spread between service fees and excess service fees is not merely an accounting notion: the service fees have to be commercially acceptable. If not, on migration of the servicing in such extremeties as in Conseco's case, the whole hierrarchy of rating assumptions might crumble.
National Century Financial Enterprises (National Century) filed for bankruptcy in Nov 2002 and brought to the fore some uinque risks of mishanding of securitisation funds.National Century specialised in health care funding and used to buy health care receivables from several health homes in the USA. These receivables were securitised.
Shortly before the bankruptcy filing, it was revealed that the company was misusing the funds collected on behalf of its securitisation clients. Investigations revealed frauds by the company's top bosses, resulting into filing of the bankruptcy petition. Approximately USD 3.5 billion worth asset backed securities were defaulted.
Investors have sued the trustees as well as the placement agencies.
The case has been reported in the news section of our website - search the news.
The case of Superior Bank easily highlights the risks inherent in securitisation. The bank was virtually romancing with subprime lending behind the securitisation facade. In 1993, it began to originate and securitize subprime home mortgages in large volumes and later, finding that there were investors who buy up what a banker itself would hate to keep on balance sheet, it expanded its activities to include subprime automobile loans as well. As would be usual, the bank was supporting its securitisation business with residual interests and over-collateralisation.
Superior 's residual interests represented approximately 100 percent of tier 1 capital on June 30, 1995. By June 30, 2000, residual interest represented 348 percent of tier 1 capital, which, put simply, would mean that that the risk on the asset side was 3 1/2 times the risk on the liability side. After all, the first loss risk retained by the originator in a securitisation transaction is comparable to equity in a corporation. If Tier 1 capital is the first loss support to the bank, the equity holders in Superior Bank agreed to absorb first loss risk of $1, and correspondingly, the bank went out in the market to bear first loss risk to the extent of $ 3.48. To a lay man, it would mean, I have $ 1 in my pocket and go to the casino and put a bet of $ 3.48 - however, the regulators did not see this for quite sometime.
Not only did the bank's financials hide this risk, it, on the contrary, continued to book profits on sale of subprime loans which is both allowed and required under US accounting standards. "Superior's practice of targeting subprime borrowers increased its risk. By targeting borrowers with low credit quality, Superior was able to originate loans with interest rates that were higher than market averages. The high interest rates reflected, at least in part, the relatively high credit risk associated with these loans. When these loans were then pooled and securitized, their high interest rates relative to the interest rates paid on the resulting securities, together with the high valuation of the retained interest, enabled Superior to record gains on the securitization transactions that drove its apparently high earnings and high capital. A significant amount of Superior 's revenue was from the sale of loans in these transactions, yet more cash was going out rather than coming in from these activities."
The bubble burst when regulators required the bank to revalue its residual interests when the bank became undercapitalised and was ordered to be closed.
In the history of securitization, there are several examples of wrong accounting for securitization interests, but here is a case where a regional bank was shut down on account of wrong accounting for residual interests in a portfolio that was completely rotten. We have covered the failure of this bank on our news pages - click here. For a detailed case study on the failure of this bank, click here.
See also our page on accounting issues.
See our page here.
See news reports on our site here.
In terms of the legal history of securitization, LTV Steel was a crucial case in that it sought to shake the very legal foundations of the securitization industry by alleging that the sale of accounts receivables in the transaction was not a true sale but disguised funding. Not that there have not been challenges to true sale before, but this one involved a transaction structure that could easily resemble any other securitization deal.
Read about the true sale issue here.
This is by far the most sordid instance of lack of due diligence on the part of all connected parties. Part of the repute also lies in the fact that the case is known as the largest Ponzi scheme in US history where the total loss to investors was some USD 450 million. Ponzi schemes, known after Charles Ponzi who in 1920s in the USA swindled millions, Ponzi schemes rely upon borrowing from one to pay the previous borrower with high rates of interest, in a chain.
Towers Financial Corp. (Towers) was a Delaware corporation with its principal place of business in New York. Beginning in July 1990, Towers formed a series of five subsidiaries, named Towers Healthcare Receivables Funding Corporations I through V ("Funding Corporations"). Between July 1990 and July 1992, the Funding Corporations as the SPVs sold approximately USD 210 million of bonds to 27 institutions, denominated as asset-backed bonds, presumably backed by healthcare receivables which the Funding Corporations will buy from Towers, and Towers in turn will buy from healthcare service provides such as doctors, private hospitals, etc. These receivables are essentially the short-term receivables as medical practitioners and hospitals are often paid by insurance companies from whom the patients have taken medical insurance cover.
The investors were all institutional investors in this private placement.
Sometime after having collected the money, Towers as well as the Funding Corporations applied for bankruptcy protection. In its financials for 1992, the Funding Corporations showed receivables of USD 300 million as having been bought from Towers, for which it had paid USD 155 million, and the balance was a liability to Towers. Upon investigation by the trustee appointed by the Court, it was discovered that the Towers had been overstating receivables generated by it by some USD 126.5 million, as it actually had receivables worth only USD 28.5 million, and not USD 300 million, as shown as having been sold. In other words, these were the receivables that never existed, but were "sold" to the SPVs.
Where did the money go? In fact, Towers used the proceeds to pay off some of its existing liabilities, which were also based on non-existing assets. Towers had been issuing promissory notes to investors for the past some time with which it was contendingly buying healthcare receivables. In fact, the money was spent in paying lavish salaries to Towers officials. Thus, overtime, it had accumulated liabilities not represented by assets. To defray these, Towers officials masterminded the securitization scam.
In SEC v. Towers Financial Corp. et al., 93 Civ. 744 (WK) (S.D.N.Y.) concerned officials of Towers were held criminally responsible for the fraud. Steven Hoffenberg, the mastermind behind the fraud, admitted fraud, tax evasion, etc. and was sentenced for 20 years in 1995.
Askin Capital Management is a case of wrong investment priorities by investing in mortgage-backed securities and speculating on interest rates. David Askin was a mortgage trader who had floated investment funds, investing in high-quality mortgage securities. On the promise of liquidity high and leverage low, "risk neutral" investment strategies, investors handed over some USD 630 million to Askin's hedge funds - Granite Partners, Granite Corporation, and Quartz Hedge Fund.
Askin invested in PO strips of CMOs.
However, in 1994, interest rates, especially short-term rates, rose dramatically. As is the feature of PO strips, when interest rates rise, prepayments come down and the value of PO strips falls.
Four Askin funds with $600 million in assets filed for bankruptcy when the rising rates drove down the market values of POs. Investors lost virtually everything, and the collapse stopped the MBS market in its tracks, generating a string of lawsuits, some of which are still pending. Askin was barred by the SEC from the securities industry for two years, and agreed to pay a $50,000 fine without admitting or denying guilt.
For more on PO and IO strips and why do they relate to interest rate movements, see our page on RMBS here.
Orange County is a county in California. In December 1994, Orange County stunned the markets by announcing that its investment pool had suffered a loss of $1.6 billion. This was the largest loss ever recorded by a local government investment pool, and led to the bankruptcy of the county shortly thereafter.
Bob Citron, the County Treasurer, who was entrusted with an $7.5 billion portfolio belonging to county schools, cities, special districts and the county itself. Among others, Citron made heavy investments in inverse floaters. [See our RMBS page for meaning of inverse floaters]. His strategy was based on a speculation that interest rates will either stay flat or will come down. Bob was working on a leveraged portfolio with high amount of repo borrowings. During 1994, the Fed started a series of interest rate hikes which led to heavy losses on inverse floaters.
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