The Winter of Our Disconnect

Asset-Backed Alert has been kind enough to allow us to republish their one article from this morning's edition. It brings to the fore various of the topical issues that face and undermine the future securitization as a whole: lack of transparency, lack of supervision, and an unwillingness for market participants to take responsibility for anything that isn't explicitly defined to fit within their specified, direct jurisdiction. Without further ado, I hand you over to Asset-Backed Alert (all emphasis added by them):

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BONY Keeps Distance From CDO Tussle

Hildene Capital has hit a snag as it tries to have Cohen & Co. removed as manager of four collateralized debt obligations.

Hildene, which has been butting heads with Cohen for about two months, fired its latest salvo last month by trying to organize a vote among noteholders. But trustee Bank of New York balked when Hildene asked it to help arrange the ballot, saying it’s not the bank’s job to circulate such proposals.

The matter underscores an ongoing debate among market players about the roles trustees should play, especially when it comes to serving as a conduit of information and policing potential indenture violations. Some believe those shops are best suited to handle requests like the one from New York-based Hildene, as investors are often unaware of the identities of other bondholders.

Hildene holds junior paper from the Cohen deals — Alesco Preferred Funding 1, 2, 3 and 4 — and has nominated itself to step in as manager. The deals, issued in 2003 and 2004, were each backed by trust-preferred shares. Their combined face value was initially almost $1.5 billion.

At issue is a practice in which Cohen has moved collateral in and out of the transactions even though the underlying asset pools are supposed to be static. Cohen has said that it acted properly. But Hildene, which bought its interests on the secondary market, insists that Cohen’s moves are grounds for the Philadelphia firm’s dismissal.

Hildene’s complaint revolves around the idea that it was misled into basing its purchases on evaluations of the Alesco issues’ original obligors, as Cohen wasn’t supposed to trade the underlying collateral. Hildene cites an example in which Cohen removed $24 million of shares issued by FBR Capital from one of the deals this year and replaced them with $25 million of shares from Colonial Bank, which was subsequently seized by the FDIC.

Hildene said in an Oct. 5 letter to Bank of New York that such swaps violate the transactions’ indentures, and thus are illegal. The firm followed up on Nov. 25 by sending a letter to investors that it knows to hold stakes in the Alesco issues, requesting that they cast ballots to fire Cohen from its management role. It asked for Bank of New York’s help in the voting process around the same time.

Cohen, meanwhile, responded by asking Bank of New York to distribute a Dec. 7 letter in which it proposes to stop trading the deals’ underlying shares unless it receives investor approval. The firm also promises to direct any proceeds from such sales to investors, including all fees.

Cohen’s letter reiterates the firm’s denials of wrongdoing and reaffirms that it had the right to carry out the trades Hildene is disputing. “Moreover, we believe that asset exchanges helped to stabilize the portfolio and resulted in an enhancement of the financial interests of our investors,”
Cohen wrote.

The Alesco deals were among 17 that Cohen issued under that banner.

Too Big Too Frail, or a King’s Gambit

Looking back at the years from the late 1990s to, really, 2006, the escalation of securitization acted as a vehicle for tremendous growth in the United States. It provided an additional source of demand for receivables from student loans and credit cards to residential mortgages; and it allowed investors the ability to gain exposure to certain of these asset classes in accordance with their desired risk level.

If rapid economic growth was the advantageous result of securitization, what was the cause? The usual suspects: to avoid certain taxes and regulatory capital charges, taking assets off banks’ balance sheets in such a way as to allow or promote almost unlimited lending.

Having grown together and having fallen apart together, it’s difficult not to see securitization and our economy in a similar light, or at least to see the art form of securitization as a microcosm for the U.S. financial economy as a whole.

The parallels are uncanny

While European and Asian investors, post the Asian crisis, had an insatiable desire from the supposedly safe and reliable U.S. market, structured finance investors’ appetites were similarly indefatigable. Foreign investors moved steadily from U.S. Treasuries to agency mortgages to corporate bonds, non-agency mortgages and on as their confidence increased; structured finance investors transitioned from CMOs to CBOs, CLOs, trust preferred CDOs and then on to CDOs of CMOs, CDOs of CDOs of CMOs, and even collateralized fund obligations (CFOs).

Both foreign investors and structured finance investors were burnt. Both the U.S. economy and the securitization market are trying to struggling new ways to grow, to reinvent themselves. Both are recovering from severe criticism pertaining to their regulation (e.g., the SEC has been faulted for its failures to investigate certain Ponzi schemes like that of Madoff, and to monitor the credit rating agencies (CRAs); while the CRAs are heavily criticized for their ratings on residential mortgage-backed securities, among other products).

And both are realizing that the interconnectedness of their risks pose “systemic” risk issues: while “too-big-to-fail” banks are purportedly being supported by the U.S. government to mitigate against further widespread turmoil, the effects of single mortgage and corporate credit failures are rolling through the structured finance products network, from direct securitizations to resecuritized products like RMBS CDOs, CDO-squareds and even CFOs, backed by hedge funds that have often invested in structured finance securities.

The “holes” that exist in certain CDOs and have been exploited recently by, among others, TPG, Marathon, Goldman Sachs, Cohen and KKR, remind us of the vulnerabilities in our financial system, where Marxist (or Michael Moore-like) capitalistic short-term measures continue to be the order of the day, be it in the form of bonuses or aggressive trading strategies. It’s not your money, and hey if it doesn’t work out, there’s always another firm looking for an aggressive trader. Reputation and responsibility to the client or customer seem to be a thing of the past. (Think of Billy Joel's Allentown or Bruce Springsteen's -- ironically called the "Boss" -- My Hometown.) The U.S. work culture is moving further and further away from the “permanent employment” environment, such as that of Japan.

Financial product regulation needs to be mindful of, and consistent with, the changing working environment and investment tendencies.

The King’s Gambit opening in chess is just that – a gambit. White offers a free pawn and weakens his king’s safety in exchange for a gamble on speedy development. The quick expansion leaves “holes” that can only be ignored for so long. If the speedy development doesn’t prove successful (i.e. meaningful and lasting) white is in danger of having a weakened, exposed king, and must quickly consolidate if he wishes to survive.

Relative to the economy, the problem is not how big the banks are, but how exposed they are to poor investments, how well their risks are managed and how liquid their capital. Do we have the transparency to regulate them, and can they adequately manage themselves? (State Street and US Bancorp are examples of “big” institutions that have not failed, being service rather than investment-heavy: the key differences being strategy, focus and management.) It’s not, therefore, a question of “too-big-to-fail” as Mortimer Zuckerman suggests. Nor is it a problem of too-big-to-succeed. (BlackRock has shown us that.) It is a problem of too-complex-to-regulate.

Consolidation, thus, ought to comprise a slew of objectives, including: ensuring all players in the game are more responsible and perform the necessary due diligence; ensuring that regulators understand and are able to accurately gauge the marginal and cumulative risks involved before approving the usage or purchase certain financial products; and requiring that regulators be granted the necessary authority and be incentivized to apply it, responsibly, to enable their efforts to have a lasting effect.

And so we end off with our financial reform motto: the key challenges at hand are to better align regulatory interests and to create an environment that encourages market transparency, consistency, and responsibility. Liquidity will inevitably follow.