[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.
NextBank's NextCard Credit Card Securitization
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.
- FDIC Failed Bank page contains basic facts about the NextBank failure and the role of FDIC
- Material Loss Review of NextBank by Department of Treasury Inspector General – 53 page report has several observations about the conduct of the securitization transaction also
- Bank of New York's Investor Reporting site – BNY is the trustee for the transaction, the site has reports about the NextCard transaction too
- FDIC's division of Receiverships and Resolutions, report about the NextCard transaction
- US DC District Court's opinion that the FDIC's decision not to honour the early amortization clause in the Master Trust deed is not illegal
- Bank of New York has apparently appealed against this opinion.
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 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.
- Vinod Kothari's book Securitisation: The Financial Instrument of the New Millennium covers the Superior Bank case at length
- See article on the FDIC complaint against E&Y in this case – click here
- More on securitisation accounting