Creditflux Newsletter

As usual, the credit committee meeting was in the boardroom. But this was hardly a typical credit committee meeting for Financial Security Assurance (FSA).

It was 7 April, 2006, and we were meeting to determine if FSA should join the rest of the triple A rated financial guaranty industry and begin insuring the most senior tranches of ABS CDOs. The boardroom at 31 West 52nd Street, New York, was packed.

Although the analysis and presentation was the responsibility of the pooled corporate deal team, the residential mortgage team participated, too, because of the prevalence of residential mortgage-backed securities (RMBS) collateral in ABS CDOs. In addition to the heads of these two groups and some members of their teams, most of senior management was present, along with representatives of the legal department, the surveillance department and the corporate research department.

While I was quite confident that the right decision would be made given the scepticism of FSA’s senior risk officer and myself, I was keenly aware of the amount of work the deal team had put into this presentation and accompanying analysis. I was also aware, more importantly, of the building frustration on the new-business side of the firm that FSA was steadily losing ground to competitors in the ABS markets.

This loss of market share was particularly galling in light of FSA’s legacy as the first financial guarantor of ABS. Indeed, FSA was founded in 1985 on the premise that structured finance investors would welcome a financial guarantor in that space, and issuers would pay a financial guarantor to improve their market access, lower the cost of issuance, and enhance secondary market liquidity. And FSA did dominate in structured finance wraps through most of the 1990s. By 2006, however, FSA was far from dominant. Over the years, the company had turned down many opportunities to participate, shunning entire structured finance sectors including CMBS, time share securitisations, aircraft-backed transactions, whole business securitisations, student loan securities, and most of the trups and credit card sectors.

So it was with some trepidation that I briefly introduced the topic to be discussed and turned the meeting over to the deal team’s senior underwriter, who was responsible for the presentation and would make the case for FSA to participate.

Everyone in the room was aware that FSA’s competitors were wrapping the most senior tranches of ABS CDOs – and on what appeared to be a very conservative basis. They were not attaching at the triple A level but, rather, at two times to three times the triple A level. So, for a typical “high grade” ABS CDO where an 11% deductible, or subordination, would earn triple A ratings, MBIA or Ambac might attach in the 20% to 30% range.

Indeed, FSA was the dominant financial guarantor in the pooled corporate sector where FSA would typically attach at one times the triple A attachment point for CLOs and one to two times the triple A attachment point for CDS referencing pools of corporate credits. As the deal team pointed out, ABS CDOs was a sector where FSA could attach at a higher multiple of triple A, earn at least 10% to 15% more in premium and gain portfolio diversity in the process.

Given the attractive premium and apparently strong credit of the deal under consideration, the committee gave the deal team a serious hearing. The deal, “Ischus Synthetic ABS CDO”, had a structure similar to a corporate CDS trade, except the reference obligations were “mezz” ABS, primarily triple B rated RMBS tranches (including up to 45% subprime). At the time, RMBS was considered a high quality sector and, learning from some of the dicier ABS CDOs from the early 2000s, manufactured housing, aircraft and project financings were ruled out.

The issuer was a vehicle buying protection from counterparties, either on an unfunded basis for the senior and super senior tranches or on a funded basis via credit linked notes for the lower rated tranches. In turn, it sold protection to Bear Stearns.

One distinctive portfolio requirement was Moody’s maximum “correlation factor”, which replaced the “diversity score” that Moody’s applied in CLOs. Like the diversity score, this was a black box application where the portfolio parameters are input and the correlation factor pops out. In this case, the correlation of the portfolio, according to Moody’s black box, could not be greater than 17.88%

To arrive at an independent view of the credit risk, the deal team focused on the reference obligations’ historical default and recovery rates and the sensitivity of the structure to the assumed maximum correlation factor. As with CLOs, the deal team created its own Monte Carlo model, which assumed the lowest rated, most concentrated, and longest tenor portfolio permitted. If Moody’s maximum correlation assumption was used, the transaction easily met FSA’s claim frequency underwriting standard.

However, given the paucity of structured finance default and recovery history and, more importantly, the relatively benign environment for the residential home and mortgage markets since 1991, the deal analysts developed more stressful scenarios under which the WARF almost tripled to low double B and/or the recovery rate was cut by 50% to approximately 13%.

FSA’s claim frequency underwriting standard was met if either the WARF or recovery rate was stressed but failed if both were stressed. Finally, the deal team stressed Moody’s maximum 17.88% correlation assumption and found, not surprisingly, the structure was extremely sensitive to this variable. If the correlation factor was doubled to 35.8% the resulting claim frequency either tripled or more than quadrupled depending on the stress scenario run.

So the credit committee was faced with how much weight to give different stress scenarios: FSA’s own, where some would fail our primary underwriting standard, and those using the rating agencies’ assumptions, where there was almost no chance of a claim against FSA.

The conversation quickly gravitated to two issues: first, the imbedded leverage in the transaction and, second, the correlation assumption.

One way the group thought about leverage was simply to consider the notional of all the underlying mortgages and other obligations, which was about $14 billion; it then calculated FSA’s subordination as a percentage of that amount. The result indicated that the deal’s 44% subordination provided about 1.6% of incremental enhancement against loss. In short, the margin for error appeared slim.

The correlation question was thornier. While we all agreed correlation increases in stressful periods, no one could determine by how much. S&P’s analysis was completely opaque, and Moody’s suffered from admitted weaknesses of inadequate data and history. Certainly most of the committee felt it was not far-fetched for Moody’s to be off by a factor of two.

After an hour of discussion, the committee’s consensus was that the available premium was inadequate for a one-off trade and that, before any regular participation in the sector could be considered, we would have to get a better handle on how to measure portfolio correlation.

It’s fair to say that this one credit decision saved the firm, resulting in the retention of AAA and Aa ratings and FSA’s eventual sale to Assured Guaranty Corp. Although FSA did not dodge all the bullets flying around during the housing market euphoria of 2005 to 2007, this one, which was more akin to a nuclear missile, we avoided.

While Wall Street and Congress debate the proposed 1,500 page Financial Reform Bill, it’s worth considering the reasons FSA decided not to participate in the ABS CDO sector. The decision had nothing to do with regulatory or rating constraints. These transactions were never questioned by the relevant state insurance commissioners and were obviously waved in by the rating agencies. Indeed, S&P assigned a miniscule 10bp capital charge to such exposures. Rather, the primary reason FSA passed on the ABS CDO sector was the risk-averse credit culture that was deeply imbedded in senior management starting at the top. The chief executive, Bob Cochran, had served as the firm’s chief underwriting officer earlier in his career and he had a deeply held and often expressed credit philosophy. Cochran was CEO for 19 years, and the firm inculcated his analytically rigorous approach, which demanded that risk be properly understood. One of the pillars of this philosophy was the avoidance of “inch wide, mile deep” risks, where losses could threaten the existence of a firm, which, like its competitors, had leverage of more than 100 to 1.

Legislation cannot create a culture like the one that saved FSA. Perhaps the only way society can reap the benefits of financial innovation is to give companies the freedom to pursue it within a framework of full disclosure and prudent capital requirements.

Douglas Watson was FSA’s chief underwriting officer for US asset-backed securities and global pooled corporate securities from 2003 to 2008. He left FSA shortly after the firm was acquired by Assured Guaranty in July 2009. Previously, he was a managing director at Moody’s.