12/23/2008

Financial Crisis: Doopey Hacks and Savvy Crooks

By Sean Hayes (Korea Times 12/11/08)

Discord in our financial institution is not caused by structured finance (securitization) or other ``complex" financial instruments, but dopey hacks and savvy crooks.

I had a conversation with an attorney from one of Korea's best known law firms. The attorney, to my surprise, was obviously not familiar with securitization and thus naively blamed the financial crisis on these ``complex schemes.''Securitization may be considered a complex scheme, but complex does not necessarily have to lead to tribulations.Chess is one of the most complex games man has made.

Few understand or can even spell Latvian Gambit or Alehine's Defense.However, chess and the complex tools (moves) used are not maligned because of complexity. However, a hack player leads to poor games and cursing by eccentric masters.

Likewise, the securitization tool in the hands of hacks leads to poor performing markets and cursing taxpayers. When we throw the crooks into the mix the situation is exasperated and leads to lawsuits, defaults, write-downs and eventually government bailouts.Securitization should not be maligned because of its players, since without it our access to capital would be stymied, interest rates would rise, and our growth rates would decrease.

In America, the advent of our modern structured finance, in the mortgage industry, began in the early 1970s by Ginnie Mae.Ginnie Mae, a government corporation, intended, through securitization, to create a secondary market for residential mortgages, thus, increasing liquidity. This increased liquidity led to an increase in homeownership.Securitization is not as complex as one would imagine.

Securitization, in short, is simply when a non-marketable asset is converted into a marketable security. This is accomplished, in the mortgage context, by the pooling of an originator's illiquid individual mortgages.The new pooled security is then sold by the originator to other financial institutions, thus, replacing a potentially non-performing asset on the originator's books with cash.The cash can then be used to offer more mortgages.

Thus, the originator does not need to raise additional cash through the more expensive tools of issuing debt or equity.These mortgage-backed securities (MBS) are enticing to investors, since they guarantee a fixed rate of return.

All individuals, including homeowners, benefit from securitization, since it increases market efficiencies while promoting additional access to capital.Problems occur when markets are dominated by dopey hacks and savvy crooks.

For example, a type of security called a collateralized debt obligation (CDO) is a security, in short, where assets and loans are pooled and the pool is divided into classes (tranches).Each tranche represents a different risk with the higher risk tranche receiving a higher yield than a lower. The safer, lower yielding tranche, normally is the senior tranche, thus during default, will be paid first. CDOs allow great flexibility, thus encouraging more investment.Problems occur when language in the agreement is worded in a manner that obfuscates.

The unintentional obfuscation by the dopey hack or the intentional obfuscation by savvy crooks causes litigation.For example, Citigroup's billion-dollar CDO is ending in litigation because of conflicting language in the CDO contract.

This wouldn't occur if it was drafted in a clear manner and all parties were astute enough to understand the implications of their investments.These same dopey hacks and savvy crooks had their hands in our rating agencies, government sponsored enterprises, financial institutions, congressional hallways, academic institutions, think tanks and even in some of our best known law firms.

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SeanHayes@ipglegal.com