A
rear‐view
window,
because
we
need
to
understand
where
we’ve
come
from
to
see


where
we’re
going.
The
road
stretches
back
30—or
100
years,
to
the
beginning
of
the

American
capital
markets.

The
lessons
(as
I
see
them):


1)  Narcissism
of
the
Boomer
GeneraIon.
Belief
that
we
are
the
apotheosis.
Refusal

to
acknowledge
history.
In
our
refusal
to
accept
that
the
world
will
not
end
when

we
do,
we
are
also
complacent
about
destroying
our
collecIve
future.

2)  BureaucraIzaIon
of
knowledge
(the
original
sense
of
this
quote).

DisproporIonate
absorpIon
of
American
talent
into
financial
services,
which

reduces
our
compeIIveness
and
our
ability
to
go
on
creaIng
wealth.

3)  The
big
bluff
by
banks
and
“sophisIcated”
insItuIons,
which
the
market

swallowed
hook,
line
and
sinker.

4)  The
awe‐inspiring
power
of
the
raIng
agencies
(NaIonally
Recognized
StaIsIcal

RaIng
OrganizaIons,
which
I
like
to
call
Wizards
of
Odds)
who
disappointed
us

because
they
turned
out
to
be
human,
and
vulnerable
to
human
temptaIon.

5)  The
“talking
heads”
of
structured
finance,
in
fact,
know
very
liXle
about
the

technical
details
of
the
market.
For
the
first
25
years,
ignorance
was
bliss
as
we

allowed
deals
to
go
to
market
over‐enhanced
(safer
than
they
seemed).
Since

2002‐2003,
our
ignorance
led
us
into
a
death
spiral
of
leverage.

6)  How
can
we
presume
to
“fix”
a
problem
we
have
not
yet
understood?

See
Slide
2.

The
quote
“the
end
of
history”
first
surfaced
in
a
paper
wriXen
by
Dr.
Fukuyama
in

1989
(indicated
by
the
fulcrum).



This
slide
shows
how
dramaIc
the
changes
have
been
to
the
consumer
finance

industry
since
WWII.
Most
striking
are
the
long
structural
decline
in
manufacturer

credit,
the
coincident
rises
of
banks,
and
the
inverse
relaIonship
between
banks
and

“securiIzaIon
SPEs”
(a
Fed
word),
which
shows
the
strategic
use
of
off‐balance
sheet

financing
by
the
banks
acer
the
Basel
Accord
of
1988.
The
last
date
(Jan‐09)
is
an

arIfact
of
the
scaling
in
Excel.

See
Slide
2.

The
world
of
asset‐backed
securiIes
(including
ABS,
RMBS,
CMBS):
to
the
lec,
the

Plain
Vanilla
AmorIzing
(PVA)
securiIzaIons,
where
a
single,
amorIzing
pool
of

loans
is
refinanced
(zone
1);
and,
to
the
right,
revolving
securiIzaIons
(zone
2).
PVAs

and
CCMT
series
use
the
“Actuarial
method”
(Slide
18)
which
uses
empirical

performance
data
on
the
assets
to
re‐underwrite
the
loans,
benefiIng
the
analysis

with
new
informaIon.
ABCP
uses
the
“Default
method”
(Slide
18),
which
is
based
on

a
raIng—no
new
empirical
data,
no
re‐underwriIng,
and
an
opportunity
to
mask

leverage
are
its
consequences.

The
world
of
repackaged
corporate
debt.
All
of
this
debt
(Zone
2)
uses
the
“Default

method”
(Slide
18),
which
is
based
on
a
raIng—no
new
empirical
data,
no
re
‐underwriIng,
and
an
opportunity
to
mask
leverage
are
its
consequences.

The
world
of
repackaged
repackaged
(that’s
right:
2x
repackaged)
debt.
All
of
this

debt
(Zone
2)
uses
the
“Default
method”
(Slide
18)
and
its
express
purpose
is
to

distort
credit
quality
by
masking
leverage.

The
world
of
syntheIcally
replicated,
syntheIcally
repackaged
and
syntheIcally

repackaged‐repackaged
(that’s
right:
3x
syntheIc
and
2x
repackaged)
debt.
The

syntheIc
world
developed
mainly
for
traders
who
didn’t
know
how
to
analyze

structured
credit
but
thought
they
understood
syntheIc
replicaIon
anyway.

Here
I
have
placed
all
the
OBS
issuers
on
a
single
axis
whose
end‐points
are
the
two
ways
of

financing
the
corporaIon:


(a)  On
the
lec:
structured
finance,
where
the
debt
is
backed
by
a
finite
pool
of
company

assets.
Structured
finance
isolates
the
collateral
cash
flows
and
places
them
within
a

structure
of
covenants
that
are
legally
binding,
so
that
investors
receive
the
returns
they

expect
given
the
raIng
and
the
structure.
This
is
possible,
because
an
SPE
has
no

“management”
or
operaIons
to
speak
of.
It
exists
purely
to
service
financial
assets.


(b)  On
the
right:
corporate
finance,
where
debt
is
backed
by
the
good
faith
and
credit
of
the

corporaIon,
with
or
without
a
lien
on
collateral.
Corporate
finance
gives
a
large
amount

of
discreIon
to
a
small
number
of
officers
over
the
disposiIon
of
company
resources.

This
is
appropriate,
since
the
day‐to‐day
risks
of
operaIng
companies
are
systemaIcally

higher.
These
risks
and
challenges
cannot
be
resolved
or
addressed
by
sekng
rules:

human
minds
are
needed;
a
mere
machine
will
not
do.


(c)  In‐between,
hybrids
of
the
two
financing
prototypes.
Zone
2,
in
blue,
are
SPEs
chartered

with
more
discreIon—necessary,
once
you
go
down
the
road
of
revolving
structures,

because
of
the
need
to
replace
amorIzing
collateral
with
new.
Zone
3,
in
green,
are

special‐purpose
companies
whose
economic
essence
is
not
very
different
from
that
of
an

ABS
(or
CDO)
but
that
have
emerged
in
fulfillment
of
a
policy
role.
GSEs:
for
the

government;
Monolines,
for
the
raIng
agencies.


(d)  A
fundamental
conclusion
of
our
analyIcal
research
is
that
these
hybrids
of
corporate

and
structured
finance
introduce
exogenous
risks
into
the
structured
framework
because

they
ulImately
use
the
discreIon
they
are
given
to
evade
the
rules
by
which
they
are

supposed
to
operate—it
is
a
faster,
“smarter”
way
to
make
money—than
compeIng

honestly,
as
insItuIons
in
Zone
4
are
required
to
do.


9
Credit
Spread
Arbitrage
refers
to
how
securiIzaIon
discovers
and
moneIzes
value
locked
up

in
the
balance
sheet
in
the
form
of
private
contracts
whose
value
is
not
disclosed
through

tradiIonal
accounIng
disclosure
mechanisms.
This
happens
via
the
process
of
re‐underwriIng

that
precedes
repackaging
of
plain
vanilla
amorIzing
securiIes:
ABS,
RMBS
and
some
CMBS.



Following
the
re‐underwriIng
step,
there
is
a
slicing
and
dicing
of
cash
flows
into
tranches
of

different
credit
grades
(each
with
an
undivided
interest
in
the
pool)
with
a
goal
of
issuing
as

much
AAA
debt
as
possible.
This
lowers
the
overall
cost
of
capital
so
that
financing
an

ensemble
of
tranches
is
cheaper
than
financing
the
undivided
pool
as
a
unit.
This
is
called

Market
Spread
Arbitrage,
and
it
is
the
main
source
of
value‐added
to
Zone
2
issuers.
The

reason
why
Zone
2
issuers
do
not
benefit
from
the
informaIon
advantage
discussed
above
is

that
there
is
no
re‐underwriIng.
The
collateral
analysis
is
based
on
pre‐exisIng
raIngs.
But,

this
leads
to
systemaIc
low‐balling
of
the
risks
of
such
deals
because
the
raIngs
are
not
good

measures
of
the
payment
volaIlity
of
individual
securiIes.
They
are
only
intended
to
signify

expected
defaults
or
losses
for
a
large
cohort.


Public
Policy
Outcome
refers
to
the
fact
that
Zone
3
insItuIons
fund
are
allowed
to
fund

themselves
at
a
subsidized
cost
of
capital,
due
to
a
belief
that
the
public
policy
benefit
of
the

subsidy
exceeds
the
cost.
Note
that
banks
used
to
operate
in
this
zone
unIl
the
ceiling
on

deposit
rates
was
liced,
and
they
have
been
using
securiIzaIon
to
claw
their
way
back
to

Zone
3
ever
since.


Ordinary
corporaIons,
including
banks,
are
expected
to
finance
themselves
on
their
franchise

strengths,
which
have
been
honed
through
market
compe>>on.


10
Credit
spread
arbitrage
releases
the
value
locked
up
in
the
balance
sheet
of
producers

and
“creaIves”
–
the
so‐called
Risk‐Adjusted
Net
Spread
–
rather
than
transferring
it

to
banks,
whose
wealth
originally
was
established
through
systemaIc
transfers
of

wealth
from
the
producIve
sector
to
the
financing
sector.
See
slide
10.

See
slide
10.

See
slide
10.

They
preXy
well
knew
how
to
bluff.

Pity
the
poor
bank,
whose
liabiliIes
became
deregulated
with
the
removal
of
the

deposit
ceiling
and
whose
assets
became
regulated
under
the
Basel
Accord.
When

these
measures
were
taken,
banks
were
unprepared
to
compete
as
other
companies

do.
They
created
the
illusion
of
intellectual
property
when
in
reality
their
only

compeIIve
strengths
resided
in
the
ability
to
amass
cheap
capital
or
move
their

acIviIes
off‐balance
sheet

and
play
unfairly
in
the
rogue
sector
governed
by
raIng

agencies.


15
Perhaps
the
biggest
risk
of
all
in
the
banking
sector
is
yet
to
come:
covered
bonds,

which
allow
banks
to
go
to
market
with
AAA‐rated
bonds
without
enough
capital
to

cover
their
obligaIons.
What
they
have
done
illegiImately
for
the
past
six
or
seven

years
will
now
become
legiImized.


16
Structured
finance
transformed
raIng
agencies
from
the
fiduciary
conscience
of
the

American
capital
markets
in
the
early
1900s
into
a
kind
of
rogue
Federal
Reserve

presiding
over
a
large,
grey‐market
financial
system.
In
the
structured
market,
raIngs

agencies
used
different
methodologies
to
rate
debt
from
the
different
zones,
thereby

seeding
and
perpetuaIng
arbitrage
opportuniIes
going
between
the
zones.
In
the

beginning,
their
role
was
innocent.
Later
on,
it
would
become
difficult
to
say
it
was

without
knowledge.


18
See
slide
18…in
the
process,
the
massive
amount
of
leverage
raIng
agencies
allowed

into
the
system
is
very
difficult
to
comprehend.
And,
in
fact,
few
understand
just
how

much
damage
was
done
through
raIngs,
or
over
what
Ime
frame.
According
to
our

research,
unIl
2002
there
was
a
surplus
of
value
in
the
“rogue
financial
system.”

However,
it
was
quickly
spent
from
2003
unIl
today.
Much
of
this
debased
collateral

is
now
on
the
books
of
the
banks.


19
Willful
ignorance
allowed
us
to
live
with
a
system
that
we
did
not
fully
understand
for

35
years.
In
the
first
25
years,
that
system
was
beXer
than
we
thought.
So
much
so,

that
we
aggressively
reduced
the
amounts
of
structural
protecIon
behind
the

securiIes
going
to
market
unIl
“opIcally”
it
was
impossible
to
lower
credit

enhancement
further.
At
that
point,
we
began
to
accept
inferior
collateral
in
place
of

good
collateral,
without
adjusIng
for
the
differences
in
value.
In
other
words,
we

allowed
fraud
to
be
commiXed
on
a
massive
scale.

One
thing
not
well
understood
about
why,
in
structured
finance,
PVAs
are
so
safe
and

why
the
measurement
can
be
so
precise,
is
that
the
risk
measures
are
on
total
risk,

not
average
risk.
Total
risk
measures
are
very,
very
different
from
average
risk

measures.
That
is
why
it
is
impossible
to
compare
structured
debt
to
corporate
debt

in
accounIng
terms.
It
is
only
possible
to
compare
corporate
debt
to
structured
debt

in
structured
terms.


21
There
is
an
“amorIzing
opIon
risk”
in
pools
of
amorIzing
loans,
similar
to
the

amorIzing
“opIon
value”
in
derivaIves.
AmorIzaIon
of
this
opIon
risk
causes
the

credit
quality
in
the
tranches
of
well‐structured
deals
to
migrate
from
whatever
the

original
raIng
is
to
AAA,
within
the
life
of
the
transacIon.
This
improvement
in
the

risk
profile
translates
into
a
value
improvement
that
is
hidden,
because
no
official

valuaIon
system
captures
it.
RaIngs
do
not.
Intex
does
not.



This
hidden
value
arguably
belongs
to
the
company
that
creates
it
in
the
first
place.

But,
it
must
be
earned
out
in
Ime.
If
it
is
taken
for
granted
or
ignored,
a
terrible

moral
hazard
is
created,
which
is
exactly
what
happened.

This
picture
says
that
a
very
aggressively
structured
(2‐tranche)
transacIon
can
sIll

perform
very
well,
if
defaults
or
losses
are
within
the
original
boundaries
of

expectaIon.
However,
staIsIcally
speaking,
there
is
a
convex
relaIonship
between

risk
and
performance,
such
that
if
losses
are
outside
expectaIon,
the
security‐level

results
can
be
dramaIcally
different—usually
for
the
worse.


In
this
picture,
the
riskiest
structure
(maroon
line
with
sharp,
right‐angle
turns)
has
a

1%
equity
tranche
and
99%
senior
tranche.
It
is
either
AAA
or
junk,
where
defaults
go

from
31%
to
32%.

This
picture
says
the
same
thing.
The
separaIon
point
between
feasible
deals
and

infeasible
deals
is
only
readily
apparent
at
extremes
of
leverage.
That
is
where
the

benefit
of
the
Market
Spread
pushes
deals
towards
AAA
if
the
default
rate
is
within

the
original
range
of
expectaIon
(that
is,
the
“expected
unexpected
loss”).



That
is
the
meaning
of
the
parallel
lines
at
the
top
that
dric
up
to
AAA.
But
when
risks

exceed
the
capacity
of
the
deal
to
absorb
them,
as
happened
at
the
point
of

separaIon
between
the
gray
and
orange
lines
(31%
vs.
32%),
tranche
value
craters.

As
a
society,
we
mistakenly
delegated
the
dirty
business
of
finance
to
the
people

whose
business
is
money.
Now
we’re
surprised
that
they
took
us
to
the
cleaners.



The
simple
truths
in
this
presentaIon
are
known
informally
but
are
not
recognized

formally,
because
they
are
massively
inconvenient
to
the
money
masters.
Without

bringing
these
facts
to
light
and
holding
an
open
debate
on
the
policy
quesIon
of

what
are
appropriate
boundaries
of
profitability
and
piracy
for
the
banks,
I
would

argue,
it
will
be
difficult
to
put
the
financial
system
back
on
a
sound
fooIng.

Fundamentally,
the
meaning
of
the
financial
crisis
is
a
death
struggle
by
the
banks
for
the
right

to
go
on
pockeIng
a
substanIal
amount
of
risk‐adjusted
net
spread.
But,
if
all
of
that
spread

goes
towards
bonuses
and
fees
to
accountants
and
lawyers,
and
if
finance,
law
and
accounIng

conInue
to
siphon
off
much
of
the
talent
of
America
given
that
this
is
where
all
the
value
of

America
is
going,
there
will
be
very
liXle
lec
over
to
grow
the
producIve
sector,
improve
the

quality
social
services,
or
serve
the
arts,
science
and
technological
innovaIon—the
basis
of

the
good
life.
That
is
the
real
hope
and
the
brilliance
of
securiIzaIon,
that
it
is
an
informaIon‐
intensive
method
for
allocaIng
resources
into
the
economy
through
the
capital
markets.
But,

on
the
other
hand,
fundamentally,
it
does
emasculate
the
banks.



SecuriIzaIon
worked
best
in
the
period
when
banks
did
not
yet
know
how
to
game
the
rules,

and
before
the
raIng
agencies
allowed
themselves
to
be
gamed
because
doing
so
made
them

more
profitable.
SecuriIzaIon
would
work
even
beXer
if
the
buy
side
understood
more
about

how
it
works
and
were
willing
to
integrate
structured
finance
analysis
with
corporate
finance

analysis.
But
the
result
of
this
might
be
to
make
the
role
of
banks
even
more
redundant.



If
the
banks
are
to
reassert
their
tradiIonal
role
in
the
next
phase
of
financial
restructuring,

the
quesIon
for
the
rest
of
us
is—at
what
cost.
How
do
we
draw
the
boundary
between
an

appropriate
level
of
bank
profitability
and
economic
piracy?



Now
that
we
have
learned
through
securiIzaIon
how
to
find
and
parse
the
risk‐adjusted
net

spread
fairly,
it
may
be
difficult
to
put
the
proverbial
genie
back
in
the
boXle.
These
are

difficult
quesIons
that
we
are
just
beginning
to
come
to
terms
with.
The
strong
reacIon
of
my

fellow
panelists
when
I
raised
the
possibility
of
a
world
without
banks
is
an
indicaIon
of
how

troubling
some
of
these
realiIes
are.
I
would
argue
that
we
have
not
yet
figured
out
“where

we
want
to
go.”
But
wherever
that
is,
we
may
indeed
not
get
there.

26