Zia Rahman - In the Light of What We Know

What Payne told me over coffee changed my life. The scheme is easy enough to explain because, once I got to grips with it in my own time, it came to form the basis of pretty much everything I did for more than a decade.

In a securitization, a so-called sponsor takes mortgages or corporate loans, things that promise a stream of cash flows, and synthesizes securities out of them. Like any bright idea, it was really startlingly simple, once someone had it. You create a special company, somewhere offshore for perfectly legal tax reasons, and then have that company buy a pool of mortgages, say, so that it stands to receive mortgage repayments. The company then offers to sell to investors a security of its own creation that promises a series of payments funded by the pool of mortgage repayments. When I say pool of mortgage repayments, I mean repayments from upward of tens of thousands of mortgages. That was part of the point: Investors who might be interested in buying these synthetic securities, pension funds and hedge funds, for instance, had no interest in an anemic dribble from a few mortgages.

As I gather my thoughts here in order to get to the point, I am reminded of a joke Zafar made when he was still in banking. I say joke, but Zafar was always rather serious about banking and often talked about accountability, as he called it. This stuff is so esoteric, he once said, that the only people who understand it are in the business. What about regulators? I asked. Regulators, he replied, have one eye on the revolving door. Academics make money teaching traders their latest research, and politicians don’t know their arses from their elbows. Can you imagine the people on a march against finance? The guy on a megaphone shouting: What do we want? And everyone answering: Specific curbs on short selling in certain circumstances. When do we want it? In phases and at appropriate times.

That’s the joke. It was funny at the time.

However important the details of securitization may be, the important thing here is what I took away from my conversation with Payne.*

The synthetic securities we offered to investors had to be assessed for risk. Potential investors needed to know how likely it was that the mortgage repayments behind the securities would dry up. Rating agencies have the job of assessing the risk in a security before it’s offered for sale and of giving it a credit rating, as if its being a separate company from the ones arranging the creation of the securities guaranteed independence! Not so much arm’s length as shoulder to shoulder. Securities with triple-A ratings, the same ratings enjoyed by U.S. government bonds, are considered the safest. And the ratings go down the list, all the way down to subinvestment grade, the ratings given to so-called junk bonds or distressed debt (or where there’s no rating at all). The triple-A rating is the one that’s prized, the one investors in CDOs were looking for.

At our meeting, Payne described the difficulties she’d been having persuading ratings agencies to give the securities a high rating.

I’m sure you can be very persuasive, I said.

Yellow-bellied, spineless chickenshits. Ask what’s bugging them and they can’t say. If they weren’t so gutless, they’d be making money as traders and not working nine to five as actuaries in ratings agencies. Fucking salarymen.

How do they rate the securities?

They haven’t yet.

I mean, what’s the methodology?

Can’t get their heads around them. We asked them to work with us. Moody’s, S&P, they’ll work with you on a consultancy basis. But they’re just so damn slow. We’re going round the fucking houses with them. We need one of them to bite, and the others will climb aboard. They actually stand to make a fuckload of money in fees.

What about Forrester?

No.

Might be worth a try.

If the big ones won’t touch it—

Not being the biggest might mean they’re hungry.

Maybe.

What happens to the lowest tranche? That has to be a hard sell, I said. I had a few technical questions about what she’d told me. And, besides, I rather enjoyed trying to test her.

The sponsor holds on to the equity tranche; shows the sponsor’s got some skin in the game.

How do you deal with the risk?

What do you mean?

What if the mortgage market goes belly-up?

Really?

Humor me.

Well … you can use a credit derivative, a credit default swap — you could even use it just to enhance the credit of the securities.

Who writes those credit default swaps?

Anyone could. Insurance companies have the stomach. AIG will want a piece of the pie.

Here’s a question for you. What’s to stop the sponsor taking the equity tranche — you called it equity tranche presumably because it behaves more like equity than a bond?

Right.

What’s to stop the sponsor taking the equity tranche, funding it, and getting it off their books?

Using it as collateral to borrow against?

Yup.

The market wouldn’t like that. Potential investors will get jittery about the sponsor’s valuations. Then there’s the fact the sponsor will still be on the hook for services to the SPV, so that means investors will want the sponsor to keep a dog in the fight.

But what’s to stop my bank helping the sponsor fund the equity tranche, once the securities are issued?

Nothing. Just bad risk management. Why would a bank want to take on that risk? Especially a bank advising on the issue. Anyhow, you like it, don’t you?

Very attractive. Incredible it’s not been snapped up already.

The ratings agencies are a bottleneck, for one thing. It’s new, and new always scares the accountants.

All this must be keeping you busy.

Keeps me off the streets.

Can’t leave you much time for other things?

If I wanted a part-time job, I’d run for office or shine trophies for the Red Sox.

What I understood from Payne was that getting one ratings agency onside was the next step. I knew that putting the structure together and gaining the market’s interest would take some time, but, of course, I was already thinking of Forrester.

Just when I thought the whole thing was a wash, Payne Cutler surprised me.

You wanna get a cocktail tomorrow night?

Sure.

I’ll call you when I leave the office.

Sounds good.

I stayed late at the office, but I didn’t hear from her until a half hour before midnight.

It’s Payne, she said. Heading out now. See you at the Soho Tavern in fifteen.

* * *

By the time my father arrived, the evening had ended and the guests had left. We were tired and after a nightcap we all turned in. The next morning, the three of us had a long breakfast of bacon, eggs, and French toast, after which my mother left for the Sunday farmers’ market.

Zafar once told me that his parents had never asked him if anything was troubling him, never asked what the matter was. He had wondered in later life if that was because he had never let on or because they had never picked up on anything, or because, despite picking up on something, they could not bring themselves to ask. I found this last proposition difficult to grasp, when it seemed to me that the natural instinct of parents — biological or otherwise — was to respond to the faintest distress of those they rear. That basic level of sensitivity and solicitousness is something one finds even in good friends.

It was noon already, and my father suggested we go to the pub. If we stay there long enough, he said, your mother can join us and we can all have a Sunday roast together.

We drove out to the Trout in Wolvercote, north of Oxford, right on the water. My father came back to the table with two pints of bitter and a broad smile. The man doesn’t like bitter, but when I pointed it out, his reply was that he likes having bitter in an English pub: when in Rome.