Reshaping Narrow Law and Art: Structured Finance

Disclaimer: the author is not an expert on this topic and is merely taking notes.

"Structured Finance" refers to a class of financial products that involve structured investment vehicles (SIVs).

A SHORT DESCRIPTION OF STRUCTURED INVESTMENT VEHICLES

Usually a structured investment vehicle (SIV) is a type of legal entity called an "express trust."¹ Trusts are famously used by wealthy people to manage assets that they want to pass on to their children, but they were also used in the latter 19th century to pool the interests of shareholders in multiple corporations--allowing many competing firms to become more profitable by acting as a monopoly. Hence, the efforts of Pres. Theodore Roosevelt to restore competitive markets were known as "antitrust actions" or "trust-busting."

Express trusts are also used to "own" securities and apportion payouts according to a legal formula. In the example in the footnote, the trust was created to own loans. It would then use the proceeds to make payments on the loan certificates (which it gave to ACE Securities Corp in exchange for loans it already had).

Not all SIVs are trusts; some are more complex business entities, such as corporations or limited partnerships.²

SIVs are used to own financial assets with different risk levels, pooling the returns as a hedge against the risk of any single asset class. They are also used to make the trustees' actions very difficult to track, such as when the top investment banks in the USA unloaded toxic assets on their own customers, or when the trustees want to avoid taxes/regulations.

The SIVs exist to own long-term commercial paper, including residential mortgage-backed securities (RMBS), and finance the long-term lending with short-term borrowing (such as repurchase agreements). Short-term borrowing is cheaper than long-term borrowing, except for the stress associated with rolling over debt every few days.

Typically SIVs are organized in tax havens such as the Cayman Islands, Liechtenstein, or Channel Islands. They can issue debt or equity (shares of ownership); they are effectively regulated by the ratings agencies (Fitch, Moody's, Standard & Poor), since they are otherwise beyond the reach of any direct regulation.

STRUCTURED FINANCE

The follow attributes are common to structured finance:

a complex financial transaction that may involve actual or synthetic transfer of assets or risk exposure, aimed at achieving certain accounting, regulatory, and/or tax objectives;
a transaction ring-fenced in its own SIV;
a bond issue that is asset-backed and/or external reference index-linked;
a combination of interest rate and credit derivatives;
a transaction employed by banks, other financial institutions, and corporations as a source of funding and/or favorable capital, tax, and accounting treatment;
disintermediation between banks and other corporate entities.

Financial transactions employing several of these features are generally characterized as structured finance.³

A typical form of complex security that does not involve structured finance would be an indexed fund. In this case, the fund is actually an account in a financial center that takes the money of investors and uses it to buy shares of companies listed in an index (say, the S&P 500) at a fixed ratio. Movement of individual shares in the companies listed are "passed through" to the investors in the proportion that the shares have in the index.

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Tranching refers to the creation of different tiers, or ranks of priority of repayment in the event of default. When a borrower can no longer meet mortgage payments, the pool to which that mortgage belongs loses value by some amount. Holders of super-senior tranches are first in line to get reimbursed in the event of default, followed by senior, mezzanine, and equity. In exchange for accepting a lower priority of repayment, the lower tranches receive a higher rate of return in the event of non-default.

The benefits of tranching were that they permitted originators to generate securities with risk-return values that met what the market demanded. Even if the average mortgage in a pool had an effective rate of return of 6%, an equity tranche could offer a far higher rate in exchange for the normally-low likelihood of default. In an historic period of exceptionally low real interest rates (see figure) and reduced fears of debt default (because of rising housing prices), tranching made housing finance cheap and attractive.

BIS (2005, p.5) explains the significance of tranching to the whole deal:

Tranching, in turn, contributes to both the complexity and risk properties of structured finance products. Beyond the challenges posed by estimation of the asset pool’s loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired characteristics, such as the seniority ordering of the various tranches, will be delivered under all plausible scenarios. In addition, complexity may be further increased by the need to account for the involvement of asset managers and other third parties, whose own incentives to act in the interests of some investor classes at the expense of others may need to be balanced.

Unfortunately for the rest of the planet, there was a poor grasp of what "all plausible scenarios" meant. The BIS article goes on to compare tranches with conventional bond portfolios, where the risk of loss in the event of massive nonperformance was comparatively small. In other words, for investors in a bond portfolio, default would lead to loss of some capital, but not a wiping out of "junior" investors. This may have marginally impacted the way the crisis unfolded, as investors had an extremely strong incentive to bail out at any cost.

Structured finance products are generally rated by the major agencies. To the best of my knowledge, ratings agencies are typically based in the USA and subject to the US government's regulatory regime (or lack thereof). According to BIS (2005, p.6), structured finance accounted for 40% of rating agency revenues.⁴

Another feature of structured finance, finally--from which the term "structured" comes--is the use of a carefully chosen pool of assets to achieve the desired rating. Usually, the notion that a security has any value whatever arises from the issuer's ability to pay its obligations. A share of stock's value is determined, ultimately, from the future income stream of the issuing firm: if investors believe the future business prospects of the firm are poor, then investors will not want to own a share of stock, and the price of the share will be lower. Likewise, bond ratings reflect the ability of the borrow to earn enough money to pay off the interest and principle. Structured finance, in contrast, usually features an SIV which doesn't earn income because its sole function is to own assets and distribute capital gains. The allure of ownership arises from the quality of the assets included in the SIV. So parties creating SIVs select assets with a carefully-chosen blend of high-risk, high-yield assets that are in some way hedged against failure.

In one sense, the phenomenon of collateralization was extremely old for lenders. From the very beginning of the business of lending wealth, lenders asked for collateral: if the borrower had some other asset, such as a house, then the lender could seize the collateral if the borrower failed to pay. But the SIVs made collateralization a perpetual motion machine: borrowers possessed as collateral the asset they were buying with the loan, which in turn created the market for the asset.

Moreover, the role of collateral was dramatically different. Whereas before, a lien on the borrower's collateral was a deterrent against default; borrowers reliably hoped that their collateral would always be irrelevant to the actual borrowing and repayment process. Here, the income stream of the originating firm was legally and economically detached from the SIV, so that the ability of the SIV to meet its financial duties was dependent entirely on the asset pool. If those assets stopped performing or lost value (as, for example in the event of a price bubble popping), then the lending involved not only became unsecured, it became non-performing.

GENERAL OBSERVATIONS

While structured finance was an innovation of the 1990s that led rather obviously to the Financial Crisis of 2008, it seems hard to take seriously the idea that it can be legislated out of existence. One reason is that the Financial Crisis did not destroy the power of its principals, the way the Banking Crisis of 1931-1933 did.⁵

However, structured finance remains an insidious force. If the industrialized nations of the world were not going through a political implosion, and if the business managers who had instigated this crisis were subject to some accountability, then I think it is fair to say that they would not be allowed in the future to flout banking regulations though the shadow banking system. Instead, financial intermediaries would be obligated to deal with all of their liabilities on their regular books.

Notes

For example, see this pooling and servicing agreement (1 Sept 2007) involving ACE Securities Corp, as depositor, Wells Fargo Bank, N.A., as master servicer/securities administrator, Clayton Fixed Income Services Inc., as credit risk manager, and HSBC Bank USA, National Association, as trustee. I use the full legal term "express trust" to distinguish it from far more common uses of the word "trust."

Peter Levine (2009) describes SIVs as trusts, and the sample SIV linked in note 1 is an express trust. However, Moorad Choudhry (2007, p.1147) describes SIVs as emerging in 1988 as fully-formed corporations, with a perpetual existence. Indeed, this perpetuity distinguishes CDOs from SIVs, according to Choudhry.

Fabozzi, Davis, & Choudhry (2006), p.2. Another definition, from Stefano Gatti, Structured Finance: Techniques, Products and Market, Springer (2005), insists on the importance of the SIV and its near-synonym, the special purpose vehicle (SPV). According to Gatti, the SPV is paramount for fulfilling the aims of the originator ("sponsor").

An alternative definition is from the Bank of International Settlements (BIS):
Structured finance instruments can be defined through three key characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional "pass-through" securitizations); (3) de-linking of the credit risk of the originator, usually through the use of a finite-lived, standalone special purpose vehicle (SPV).
BIS (2005), p.5

The above is cited in Fabozzi, Davis, & Choudhry (2006), p.2. Note that the BIS definition emphasizes the permanence of the SPV/SIV.

A well-nigh universal observation is that the ratings agencies had a perverse incentive structure; they were paid by the entities seeking a rating. Evidence suggests that there was massive conflict of interest in which Moody's, Fitch, and S&P sought to accommodate companies marketing financial products with favorable ratings. See, for example, Daniel M. Covitz & Paul Harrison, "Testing Conflicts of Interest at Bond Ratings Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate" Federal Reserve Board (2003). As is now well established, the Fed was wrong and the naysayers were right.

For a summary of the events of the 1931-33 Banking Crisis, see Charles Poor Kindleberger, The world in Depression, 1929-1939University of California Press (1986). It was actually quite unusual that the Great Depression, unlike the many other financial and economic crises in US history, resulted in a severe blow to the status of financiers and industrialists. One reason was that the crisis of the '30s pitted rival capitalists against each other.