What do Enron Corp. (ENRNQ), the mom-and-apple-pie home mortgage market, and the gritty business of lending to people with bad credit have in common? Explosive growth, fueled by a much-lauded innovation--structured finance--that lets businesses pass along their credit risks to others.
The $7 trillion Wall Street industry packages companies' streams of future revenues--everything from credit-card to mortgage payments to natural-gas sales--as securities and sells them to investors. Structured finance, or securitization, has become the grease that keeps capital markets spinning. It helped fund the boom in corporate finance through the 1990s and the steady growth in consumer credit and homeownership that have kept the economy afloat in recent months.
But the Enron blowup has tarnished the business. The former energy giant's complex deals, which were used to hide debt, destroyed the company and gave structured finance a nasty smell. Although the vast majority of deals don't involve fraud, more bad stuff is bubbling up, and the market's performance is now the worst ever. In the first half of 2002, Standard & Poor's (MHP) downgraded 172 so-called asset-backed securities, compared with 192 downgrades in the whole of 2001, says S&P analyst Joseph Hu. And a record 38 defaults occurred in the first half of 2002.
Now, a major new worry is the fate of securities based on the receivables of subprime lenders. Such companies lent record amounts to people with poor credit in recent years because it was so easy to sell their repackaged loans, which carry higher fees and interest rates than regular consumer loans. But with the economic downturn, those loans--and the securities they back--are fast turning sour. In the past 12 months, subprime lenders Conseco, AmeriCredit (ACF), and Metris (MXT) have seen bad loans soar.
The result: Billions in losses will soon hit the portfolios of pension funds, insurance companies, and mutual funds, the main buyers. So far, they've simply looked on as the securities have wilted in value. But, says Charles Peabody, an analyst with Ventana Capital, a research boutique: "Somewhere between now and the end of the year, they are going to have to recognize reality" in their portfolios.
Investors are starting to balk. "We're being very cautious," says Daniel J. Ivascyn, portfolio manager at PIMCO, the giant bond-fund company. During the bull market when everything was doing well, the banks got more aggressive about their deals. At the same time, the rating agencies felt they could relax their standards because the structured finance market was maturing. "These [markets] have not been tested over a full economic cycle," Ivascyn says.
Already, some investors have been badly hurt. In July, 2001, American Express Co. (AXP) shocked the market when it reported a $1.1 billion loss on its investment in the fastest-growing segment of the market, collateralized debt obligations, or CDOs. These securities are backed by high-yield bonds and credit-default swaps, which are a form of insurance for bank loan and bond holders. Since their introduction in the late 1990s, the outstanding volume of CDOs has grown to more than $100 billion. But they have performed poorly in the past year--nearly 20% of all CDOs have been downgraded.
None of the gathering problems will make structured finance go away; it's just too central to America's capital markets these days. But if enough burned investors pull out, that could make it much harder for businesses to raise money and lay off their risks. The banks, too, could pull in their horns. Already, those that arranged deals for Enron are the targets of lawsuits. And the legal woes could spread quickly as problems from other transactions emerge.
In theory, structured finance eliminates dangerous concentrations of risk by spreading it over many investors. And it provides bond investors with more places to put their money. Because the securities are subdivided into tranches, priced according to their riskiness, potential investors have a wide range of yields to choose from. Overall, structured-finance securities have performed better than corporate bonds. They're particularly appealing when, as now, they can pay double the yield of just over 4% on 10-year Treasury bonds.
Some critics argue that the ease with which companies can now unload risk onto others has actually made the financial system more fragile. Companies have less incentive to make sure the assets they're selling are going to perform. Likewise, fee-hungry bankers who arrange the deals are less picky than they would be about loans that they keep on their own books. "Wall Street learned to securitize everything, for the immediate gratification of fees," says Robert W. Justich, managing director, TimesSquare Capital Management Inc., a money management firm.
The business is as old as the hills: Bonds backed by mortgages have been around since the 1800s. But it didn't start hopping until the guacamole-chugging, telephone-tossing Salomon Brothers bankers immortalized in Liar's Poker started selling mortgage-backed securities in earnest in the mid-1980s. The government-sponsored housing finance agencies, Fannie Mae (FNM), Freddie Mac, and Ginnie Mae, were the first to jump in, but commercial lenders really embraced the concept after the savings and loan crisis of the late 1980s and early 1990s, when bad real estate loans sank much of the industry.
The market quickly grew to include such offbeat offerings as Bowie Bonds backed by rock star David Bowie's royalties (they underperformed). Now, securities are appearing backed by Italian tomato crops, Lotto winnings, and even fines levied on tobacco companies. The phenomenal growth attracted Wall Street's most talented and aggressive bankers. Says a senior partner at a top accounting firm: "These were the smartest, brightest guys, and they were taught to think outside of the box."
Regulators were no match for them. A boom-era political climate favored a hands-off approach to any financial regulation. Although the Enron debacle has changed that, regulators still have a hard time getting a handle on the constantly evolving business. The Financial Accounting Standards Board has drafted rules that would force companies to consolidate more securitized assets on to their balance sheets. Bankers say the rules aren't likely to make the business more responsible. "In general, it takes FASB about seven years to get something done, and then it takes an investment bank about seven minutes to figure out a way around it," says one structured-finance specialist.
Still, some bankers are starting to police themselves by saying no to the riskiest deals and putting themselves on the line if things go bad. The main victims of structured-finance deals have a few things in common, says Richard D. Levinson, co-founder of Penstock Partners, a structured-finance boutique. They bought things they didn't understand from investment banks that didn't have any "skin in the game," he says. To attract investors, Penstock retains the riskiest portion of the CDOs it markets and spreads fees over the life of the deals rather than collecting them up front.
And, some of the largest banks say they have already gotten the message that the cowboy mentality of the Liar's Poker era has to change. After a very public humiliation at hearings in Congress, J.P. Morgan Chase (JPM) and Citigroup (C), the energy firm's biggest bankers, vowed to change the way they use these products. In an Aug. 7 letter to employees, Citigroup CEO Sanford I. Weill said the company would do structured-finance transactions only for clients who agree to disclose them promptly, including the nature and amount of the obligations.
That's a step in the right direction, but it's little consolation to investors who were hurt by past deals that turned sour. Many senior bankers still feel that the business really only needs a little tweaking. "There's no doubt that drunk driving is a bad thing," says one. "But no one is suggesting we get rid of cars." Of course not. But it wouldn't hurt to revoke a few drivers' licenses.
Read a Letter to the Editor about this story. By Heather Timmons in New York