By now, institutional investors worldwide are painfully aware that those “conservative” investments in private label mortgage securities (“PLS”) are very distinct from other fixed income holdings in terms of the factors that drive value, liquidity, and the dynamics for recovering lost value. Despite the highest of investment grade ratings, the poor performance of the underlying collateral exceeded the worst case cash flow models of Wall Street’s rocket scientists, leaving many fund managers scratching their heads wondering how things could have gone so awry.
There has been so much press dedicated to assigning blame and the political debate regarding consumer and institutional bailouts, the plight of pension fund and investment managers with fiduciary responsibilities has been largely overlooked. It almost seems that investors in these securities are being tarred and feathered with the same brush as hedge fund gurus and other high risk participants in the securitization process, virtually ignoring the reality that working class retirement funds and support for vital municipal services like school budgets are also at stake.
The meltdown in PLS has also exposed flaws in the securitization structures, leaving unclear or unanswered many questions that remain to be tested in today’s unprecedented market conditions. Despite the sheer magnitude of the loss experienced at every rating level, it seems that investor response to date represents a state of paralysis, with investors looking to gauge what, if any, action should be taken to recover or mitigate losses.
Several explanations for the delayed reaction are:
- The exposed structural flaws further complicate already complex investments to the point that investment managers and their advisors cannot get a handle on their relative rights and appropriate recovery strategies;
- A considerable population of the investor base is comprised of highly leveraged hedge funds with outstanding borrowings to the very same institutions that distributed the PLS. Their priority is the deleveraging of their funds, at which point strategies to recover lost value may take a front seat;
- Unrealistic hopes that legislative action will restore market confidence, with imminent and significant improvements to value: and
- The time lag to acquire needed expertise due to conflicts of interest. Experts in this area are firms or individuals that played key roles in the rating, underwriting, or distribution of the securities, greatly limiting their ability to perform services for investors that suffered related losses.
So what are the alternatives? No doubt, the pace of lawsuits will gather momentum, as the legal community will come to the rescue of the victims of the crisis, as long as deep pockets are involved. Lawsuits will be based upon the alleged misrepresentations or inadequate disclosure of risks in connection with the sale of PLS. These cases (often referred to as 10(b)5 actions based upon the rule promulgated under the 1933 Securities and Exchange Act dealing with disclosure requirements) promise to be long drawn out affairs, taking many years and considerable expense to reach resolution. Moreover, this adversarial approach pits parties against each other that will sour future business dealings to the detriment of all involved.
Another, less adversarial approach, relies on the enforcement of recourse obligations embedded in many of the securitization structures to materially improve cash flows and values. The validity of this approach depends upon a number of factors, including the structure of the securitization and the nature and financial capacity of the counterparties. For purposes of this commentary, this approach is referred to as “Recourse Recovery.”
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