For the past seven quarterly issues, a vital mission of this journal has been to feature a variety of experts to explain, in the clearest possible terms, the basic causes of the financial crisis as they relate to structured finance and, to an increasing degree as we move on, what is needed to fix the system. Our first two articles are focused squarely on this mission. Charles Calomiris provides a comprehensive comparison of this crisis to previous ones, draws lessons from the similarities and differences, and shares his thoughts on the future direction of monetary and regulatory policies, securtization, the credit rating process, and the structure of the commercial and investment banking businesses. Then Faten Sabry and Chudozie Okongwu pay particular attention to controversies over the role of structured financial instruments in escalating the crisis, addressing issues such as the decline in mortgage underwriting standards, the increasing portion of structured products contained in collateralized debt obligations (CDOs), and incorrect assumptions about the correlation risk in CDOs. Next Mr. Calomiris and Peter Wallison address a controversy that has stirred through four decades over how Fannie Mae and Freddie Mac were originally set up, how their charters were changed, how they carried out their lobbying campaigns under the mantra of increased U.S. home ownership, how their principal officers were able to earn huge salaries and bonuses, and how the U.S. government ultimately bore the brunt of what turned out to be excessively risky financial practices.
Jerome Fons addresses the continuing difficulty in the valuation of residential mortgage-backed securities (RMBS), the emergence of the ABX.HE home equity indices, which are based on current credit default swap price data, and how their valuation performance compares with ABSTRACK®, a newer valuation model that is based on transaction-specific data from mortgage service reports. Mr. Fons comments that one needs access to at least two important data sources to value RMBS: 1) individual loan data supplied by the originator of the securitization, which can reach up to 95 data fields per loan and cover mainly static information on the type of loan, a description of the property, and the borrower's financial position, and 2) pool performance data summarizing prepayments, delinquencies, and losses, as well as the status of various tranches. He notes that the relevance of the individual loan data diminishes as a securitization seasons. In a perfect world, he says, security holders would have access to real-time loan-by-loan data, including any change in loan-to-value ratios, FICO scores, and borrower income. Ultimately, Mr. Fons points out, an estimate of value is an estimate of future cash flows. Because of the range of possible future outcomes, it is unlikely that any two analysts would arrive at the same valuation. And valuing RMBS in this way is only the first step in valuing far more complex collateralized debt obligations (CDOs). In the next article, rounding out our section on structured finance and the financial crisis, Jörg Hashagen, Nigel Harman, Michael Conover, and Jitendra Sharma focus on one of the other major causes of the crisis, the lack of sufficiently powerful and effective organization-wide risk management functions in many of the largest financial institutions - functions that might have called greater attention to many of those institutions' disproportionately high exposure to mortgage credit risk.
Christopher Price and Lauren Lebioda illustrate the counterparty risks faced by the buyer of a loan participation in a large real estate loan and, in so doing, show us how a complex syndicated loan with participation interests and sold-off portions goes beyond the scope of traditional commercial bank lending and enters into the realm of structured finance. Elizabeth Mann provides an update on aircraft financing and an evaluation of how various structures such as enhanced equipment trust certificates and portfolio lease securitizations as well as bank loans and export credit agency financing are getting the job done in the current economic environment. Prakash Deo wraps up this issue with a useful spreadsheet model for evaluating a leveraged lease from both a lessor's and a lessee's point of view.
TOPICS: CLOs, CDOs, and other structured credit, legal and regulatory issues for structured finance
Henry A. Davis
Editor
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