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Arearviewwindow,becauseweneedtounderstandwherewevecomefromtosee

whereweregoing.Theroadstretchesback30or100years,tothebeginningofthe

Americancapitalmarkets.


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Thelessons(asIseethem):

1) NarcissismoftheBoomerGeneraon.Beliefthatwearetheapotheosis.Refusaltoacknowledgehistory.Inourrefusaltoacceptthattheworldwillnotendwhen

wedo,wearealsocomplacentaboutdestroyingourcollecvefuture.2) Bureaucrazaonofknowledge(theoriginalsenseofthisquote).

DisproporonateabsorponofAmericantalentintofinancialservices,which

reducesourcompevenessandourabilitytogooncreangwealth.

3) Thebigbluffbybanksandsophiscatedinstuons,whichthemarketswallowedhook,lineandsinker.

4) Theaweinspiringpoweroftherangagencies(NaonallyRecognizedStascalRangOrganizaons,whichIliketocallWizardsofOdds)whodisappointedus

becausetheyturnedouttobehuman,andvulnerabletohumantemptaon.

5) Thetalkingheadsofstructuredfinance,infact,knowveryliXleaboutthetechnicaldetailsofthemarket.Forthefirst25years,ignorancewasblissaswe

alloweddealstogotomarketoverenhanced(saferthantheyseemed).Since

20022003,ourignoranceledusintoadeathspiralofleverage.

6) Howcanwepresumetofixaproblemwehavenotyetunderstood?


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SeeSlide2.


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ThequotetheendofhistoryfirstsurfacedinapaperwriXenbyDr.Fukuyamain

1989(indicatedbythefulcrum).

Thisslideshowshowdramacthechangeshavebeentotheconsumerfinance

industrysinceWWII.Moststrikingarethelongstructuraldeclineinmanufacturercredit,thecoincidentrisesofbanks,andtheinverserelaonshipbetweenbanksand

securizaonSPEs(aFedword),whichshowsthestrategicuseofoffbalancesheet

financingbythebanksaertheBaselAccordof1988.Thelastdate(Jan09)isan

arfactofthescalinginExcel.


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SeeSlide2.


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Theworldofassetbackedsecuries(includingABS,RMBS,CMBS):tothele,the

PlainVanillaAmorzing(PVA)securizaons,whereasingle,amorzingpoolof

loansisrefinanced(zone1);and,totheright,revolvingsecurizaons(zone2).PVAs

andCCMTseriesusetheActuarialmethod(Slide18)whichusesempirical

performancedataontheassetstoreunderwritetheloans,benefingtheanalysis

withnewinformaon.ABCPusestheDefaultmethod(Slide18),whichisbasedonarangnonewempiricaldata,noreunderwring,andanopportunitytomask

leverageareitsconsequences.


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Theworldofrepackagedcorporatedebt.Allofthisdebt(Zone2)usestheDefault

method(Slide18),whichisbasedonarangnonewempiricaldata,nore

underwring,andanopportunitytomaskleverageareitsconsequences.


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Theworldofrepackagedrepackaged(thatsright:2xrepackaged)debt.Allofthis

debt(Zone2)usestheDefaultmethod(Slide18)anditsexpresspurposeisto

distortcreditqualitybymaskingleverage.


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Theworldofsynthecallyreplicated,synthecallyrepackagedandsynthecally

repackagedrepackaged(thatsright:3xsynthecand2xrepackaged)debt.The

synthecworlddevelopedmainlyfortraderswhodidntknowhowtoanalyze

structuredcreditbutthoughttheyunderstoodsynthecreplicaonanyway.


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HereIhaveplacedalltheOBSissuersonasingleaxiswhoseendpointsarethetwowaysoffinancingthecorporaon:

(a) Onthele:structuredfinance,wherethedebtisbackedbyafinitepoolofcompanyassets.Structuredfinanceisolatesthecollateralcashflowsandplacesthemwithinastructureofcovenantsthatarelegallybinding,sothatinvestorsreceivethereturnstheyexpectgiventherangandthestructure.Thisispossible,becauseanSPEhasnomanagementoroperaonstospeakof.Itexistspurelytoservicefinancialassets.

(b) Ontheright:corporatefinance,wheredebtisbackedbythegoodfaithandcreditofthecorporaon,withorwithoutalienoncollateral.Corporatefinancegivesalargeamountofdiscreontoasmallnumberofofficersoverthedisposionofcompanyresources.Thisisappropriate,sincethedaytodayrisksofoperangcompaniesaresystemacallyhigher.Theserisksandchallengescannotberesolvedoraddressedbysengrules:humanmindsareneeded;ameremachinewillnotdo.

(c) Inbetween,hybridsofthetwofinancingprototypes.Zone2,inblue,areSPEscharteredwithmorediscreonnecessary,onceyougodowntheroadofrevolvingstructures,becauseoftheneedtoreplaceamorzingcollateralwithnew.Zone3,ingreen,arespecialpurposecompanieswhoseeconomicessenceisnotverydifferentfromthatofanABS(orCDO)butthathaveemergedinfulfillmentofapolicyrole.GSEs:forthegovernment;Monolines,fortherangagencies.

(d) Afundamentalconclusionofouranalycalresearchisthatthesehybridsofcorporateandstructuredfinanceintroduceexogenousrisksintothestructuredframeworkbecausetheyulmatelyusethediscreontheyaregiventoevadetherulesbywhichtheyaresupposedtooperateitisafaster,smarterwaytomakemoneythancompenghonestly,asinstuonsinZone4arerequiredtodo.

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CreditSpreadArbitrage referstohowsecurizaondiscoversandmonezesvaluelockedup

inthebalancesheetintheformofprivatecontractswhosevalueisnotdisclosedthrough

tradionalaccounngdisclosuremechanisms.Thishappensviatheprocessofreunderwring

thatprecedesrepackagingofplainvanillaamorzingsecuries:ABS,RMBSandsomeCMBS.

Followingthereunderwringstep,thereisaslicinganddicingofcashflowsintotranchesofdifferentcreditgrades(eachwithanundividedinterestinthepool)withagoalofissuingas

muchAAAdebtaspossible.Thislowerstheoverallcostofcapitalsothatfinancingan

ensembleoftranchesischeaperthanfinancingtheundividedpoolasaunit.Thisiscalled

MarketSpreadArbitrage,anditisthemainsourceofvalueaddedtoZone2issuers.The

reasonwhyZone2issuersdonotbenefitfromtheinformaonadvantagediscussedaboveis

thatthereisnoreunderwring.Thecollateralanalysisisbasedonpreexisngrangs.But,

thisleadstosystemaclowballingoftherisksofsuchdealsbecausetherangsarenotgood

measuresofthepaymentvolalityofindividualsecuries.Theyareonlyintendedtosignify

expecteddefaultsorlossesforalargecohort.

PublicPolicyOutcomereferstothefactthatZone3instuonsfundareallowedtofund

themselvesatasubsidizedcostofcapital,duetoabeliefthatthepublicpolicybenefitofthe

subsidyexceedsthecost.Notethatbanksusedtooperateinthiszoneunltheceilingon

depositrateswaslied,andtheyhavebeenusingsecurizaontoclawtheirwaybackto

Zone3eversince.

Ordinarycorporaons,includingbanks,areexpectedtofinancethemselvesontheirfranchise

strengths,whichhavebeenhonedthroughmarket compe>>on.

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Creditspreadarbitragereleasesthevaluelockedupinthebalancesheetofproducers

andcreavesthesocalledRiskAdjustedNetSpreadratherthantransferringit

tobanks,whosewealthoriginallywasestablishedthroughsystemactransfersof

wealthfromtheproducvesectortothefinancingsector.Seeslide10.


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Seeslide10.


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Seeslide10.


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TheypreXywellknewhowtobluff.


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Pitythepoorbank,whoseliabiliesbecamederegulatedwiththeremovalofthe

depositceilingandwhoseassetsbecameregulatedundertheBaselAccord.When

thesemeasuresweretaken,bankswereunpreparedtocompeteasothercompanies

do.Theycreatedtheillusionofintellectualpropertywheninrealitytheironly

compevestrengthsresidedintheabilitytoamasscheapcapitalormovetheir

acviesoffbalancesheetandplayunfairlyintheroguesectorgovernedbyrangagencies.

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Structuredfinancetransformedrangagenciesfromthefiduciaryconscienceofthe

Americancapitalmarketsintheearly1900sintoakindofrogueFederalReserve

presidingoveralarge,greymarketfinancialsystem.Inthestructuredmarket,rangs

agenciesuseddifferentmethodologiestoratedebtfromthedifferentzones,thereby

seedingandperpetuangarbitrageopportuniesgoingbetweenthezones.Inthe

beginning,theirrolewasinnocent.Lateron,itwouldbecomedifficulttosayitwaswithoutknowledge.

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Seeslide18intheprocess,themassiveamountofleveragerangagenciesallowed

intothesystemisverydifficulttocomprehend.And,infact,fewunderstandjusthow

muchdamagewasdonethroughrangs,oroverwhatmeframe.Accordingtoour

research,unl2002therewasasurplusofvalueintheroguefinancialsystem.

However,itwasquicklyspentfrom2003unltoday.Muchofthisdebasedcollateral

isnowonthebooksofthebanks.

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Onethingnotwellunderstoodaboutwhy,instructuredfinance,PVAsaresosafeand

whythemeasurementcanbesoprecise,isthattheriskmeasuresareontotalrisk,

notaveragerisk.Totalriskmeasuresarevery,verydifferentfromaveragerisk

measures.Thatiswhyitisimpossibletocomparestructureddebttocorporatedebt

inaccounngterms.Itisonlypossibletocomparecorporatedebttostructureddebt

instructuredterms.

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Thereisanamorzingoponriskinpoolsofamorzingloans,similartothe

amorzingoponvalueinderivaves.Amorzaonofthisoponriskcausesthe

creditqualityinthetranchesofwellstructureddealstomigratefromwhateverthe

originalrangistoAAA,withinthelifeofthetransacon.Thisimprovementinthe

riskprofiletranslatesintoavalueimprovementthatishidden,becausenoofficial

valuaonsystemcapturesit.Rangsdonot.Intexdoesnot.

Thishiddenvaluearguablybelongstothecompanythatcreatesitinthefirstplace.

But,itmustbeearnedoutinme.Ifitistakenforgrantedorignored,aterrible

moralhazardiscreated,whichisexactlywhathappened.


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Thispicturesaysthataveryaggressivelystructured(2tranche)transaconcansll

performverywell,ifdefaultsorlossesarewithintheoriginalboundariesof

expectaon.However,stascallyspeaking,thereisaconvexrelaonshipbetween

riskandperformance,suchthatiflossesareoutsideexpectaon,thesecuritylevel

resultscanbedramacallydifferentusuallyfortheworse.

Inthispicture,theriskieststructure(maroonlinewithsharp,rightangleturns)hasa

1%equitytrancheand99%seniortranche.ItiseitherAAAorjunk,wheredefaultsgo

from31%to32%.


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Thispicturesaysthesamething.Theseparaonpointbetweenfeasibledealsand

infeasibledealsisonlyreadilyapparentatextremesofleverage.Thatiswherethe

benefitoftheMarketSpreadpushesdealstowardsAAAifthedefaultrateiswithin

theoriginalrangeofexpectaon(thatis,theexpectedunexpectedloss).

ThatisthemeaningoftheparallellinesatthetopthatdriuptoAAA.Butwhenrisks

exceedthecapacityofthedealtoabsorbthem,ashappenedatthepointof

separaonbetweenthegrayandorangelines(31%vs.32%),tranchevaluecraters.


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Asasociety,wemistakenlydelegatedthedirtybusinessoffinancetothepeople

whosebusinessismoney.Nowweresurprisedthattheytookustothecleaners.

Thesimpletruthsinthispresentaonareknowninformallybutarenotrecognized

formally,becausetheyaremassivelyinconvenienttothemoneymasters.Withoutbringingthesefactstolightandholdinganopendebateonthepolicyquesonof

whatareappropriateboundariesofprofitabilityandpiracyforthebanks,Iwould

argue,itwillbedifficulttoputthefinancialsystembackonasoundfoong.


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Fundamentally,themeaningofthefinancialcrisisisadeathstrugglebythebanksfortherighttogoonpockengasubstanalamountofriskadjustednetspread.But,ifallofthatspreadgoestowardsbonusesandfeestoaccountantsandlawyers,andiffinance,lawandaccounngconnuetosiphonoffmuchofthetalentofAmericagiventhatthisiswhereallthevalueofAmericaisgoing,therewillbeveryliXleleovertogrowtheproducvesector,improvethe

qualitysocialservices,orservethearts,scienceandtechnologicalinnovaonthebasisofthegoodlife.Thatistherealhopeandthebrillianceofsecurizaon,thatitisaninformaonintensivemethodforallocangresourcesintotheeconomythroughthecapitalmarkets.But,ontheotherhand,fundamentally,itdoesemasculatethebanks.

Securizaonworkedbestintheperiodwhenbanksdidnotyetknowhowtogametherules,andbeforetherangagenciesallowedthemselvestobegamedbecausedoingsomadethemmoreprofitable.SecurizaonwouldworkevenbeXerifthebuysideunderstoodmoreabouthowitworksandwerewillingtointegratestructuredfinanceanalysiswithcorporatefinanceanalysis.Buttheresultofthismightbetomaketheroleofbanksevenmoreredundant.

Ifthebanksaretoreasserttheirtradionalroleinthenextphaseoffinancialrestructuring,thequesonfortherestofusisatwhatcost.Howdowedrawtheboundarybetweenanappropriatelevelofbankprofitabilityandeconomicpiracy?

Nowthatwehavelearnedthroughsecurizaonhowtofindandparsetheriskadjustednetspreadfairly,itmaybedifficulttoputtheproverbialgeniebackintheboXle.Thesearedifficultquesonsthatwearejustbeginningtocometotermswith.ThestrongreaconofmyfellowpanelistswhenIraisedthepossibilityofaworldwithoutbanksisanindicaonofhowtroublingsomeoftheserealiesare.Iwouldarguethatwehavenotyetfiguredoutwherewewanttogo.Butwhereverthatis,wemayindeednotgetthere.

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