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COMMENTARY: SECURITIZATION IS NO SECURITY BLANKETThere's a problem with securitization, and James E. Moore knows it well. He's president and chief executive officer of ContiFinancial Corp. (CFN), and his business depends on the process; pretty much all he does is make loans and bundle them into bonds to raise more money. But sometimes the whole drill can leave a guy with a headache. ''These deals are so outrageously complicated,'' Moore says. ''The thing that's tricky about this business is that it kind of looks like it's in English, but it's really math.'' It's this elaborate structuring of cash flows that makes securitization work. It's the reason a company like Conti, with a credit rating below investment grade, can issue AAA bonds. But this very complication can lead to the mystification of securitization. PUSHING THE ENVELOPE. Securitization is a creative way to connect people who want money to people who have it. It does not eliminate risk in lending. Nor does it guarantee financing will always be available. But the Wall Street masters of this universe keep pushing the envelope, pitching securitization to an increasingly wide audience. And that has cost some investors dearly. ''It isn't securitization that is a problem--it's viewing securitization as a panacea,'' says Hyperion Partners Chairman Lewis Ranieri, who pioneered securitization while working at the former Salomon Brothers Inc. in the 1970s. ''Securitization did what it was supposed to do. It was an alternative to the financial system. It could deliver very large amounts of funds at very competitive rates.'' A classic example of the perils of securitization can be observed in ContiFinancial's business--subprime home equity lending, which typically caters to borrowers with tarnished credit histories, looking to pay off credit-card or other consumer debts. Since 1996, more than a dozen companies have been taken public to do nothing but make these loans, package them as bonds, and lend again. In almost all cases, the share prices of these companies have crashed this year. The flaw in this process is that it's a very complicated way to make money. In a securitization, companies essentially promise to use their revenues to pay off the buyers of their bonds--first. Once the investors are paid, the company keeps whatever money is left over. That's its profit. But how do you book a profit that could take years to materialize? Accountants require the issuers to make an estimate of how much profit they expect--right away, when the bonds are issued--and then to revise that estimate, quarter to quarter, as the cash actually arrives. This year, among home equity lenders, these estimates proved way off base. Ironically, faster payments deprived the companies of expected interest income. And investors reacted like the police inspector played by Claude Rains in Casablanca: They were shocked, shocked, to discover that gambling was being conducted on the premises and unloaded their shares. But the truly shocking thing was that so many companies went public so quickly to conduct a business that so few people understood. ''There was a general lack of understanding of the accounting,'' says Brenda B. White, managing director of UBS Securities. ''It was almost like a drug addict--the accounting became the enabler. It enabled the company to believe the product was worth more than it proved to be worth.'' That shouldn't happen again. The Financial Accounting Standards Board is on the right track when it considers requiring listed companies to provide greater detail about the assumptions they make when estimating securitization profits. Looking to regulators, however, to save us from securitization may not be very fruitful. The power of securitization is that it bypasses the banking system that is the focus of current regulation. In fact, securitization already has eroded the value of a key regulatory tool--requiring banks to hold a certain amount of capital against loans. Banks now can securitize safe loans--because they don't feel a need to hold so much capital against them--and keep risky ones. As Federal Reserve Chairman Alan Greenspan has said: ''The possibility that regulatory capital ratios may mask true insolvency probability becomes more acute.'' The best policy, for the time being, is caution. Securitization is a powerful tool--but only in the right hands. ''This business is only for well-managed institutions,'' says Michael L. Brosnan, Deputy Comptroller of Risk Evaluation & Market Risk for the Comptroller of the Currency. ''It's not meant to be done home alone without adult supervision.''
By Gary Silverman RELATED ITEMS
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Updated Oct. 15, 1998 by bwwebmaster
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