Structured Finance and Collateralized Debt Obligations E-Book

Janet M. Tavakoli

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 777

Veröffentlichungsjahr: 2008

Beschreibung

An up-to-date look at the exploding CDO and structured creditproducts market In this fully updated Second Edition, financial expert JanetTavakoli provides readers with a comprehensive look at the CDO andstructured credit products market amid recent developments. Inaddition to a detailed overview of the market, this book presentskey issues in valuing structured financial products and importantquality control issues. Tavakoli shares her experiences in thisfield, as she examines important securitization topics, includingthe huge increase in CDO arbitrage created by synthetics, thetranches most at risk from new technology, dumping securitizationson bank balance sheets, the abuse of offshore vehicles bycompanies, the role of hedge funds, critical issues with subprime,Alt-A, and prime mortgage securitizations, and securitizations madepossible by new securitization techniques and the Euro. Whileproviding an overview of the market and its dynamic growth,Tavakoli takes the time to explore the types of products nowoffered, new hedging techniques, and valuation and risk/returnissues associated with investment in CDOs and synthetic CDOs.

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

Acronym Key

CHAPTER 1 - Securitization Terminology

SIMPLIFIED CASH CDO

THE CDO ARBITRAGE

CHAPTER 2 - Structured Finance and Special Purpose Entities

SPCs AND HISTORICAL ABUSE

SPEs AND SPVs

DOCUMENTATION

SETUP COSTS

EXAMPLE OF A MULTIPLE ISSUANCE ENTITY

CAYMAN-DOMICILED SPEs

REPACKAGINGS TO SATISFY INVESTOR DEMAND

CREDIT-LINKED NOTES AND FUNDING COSTS

STRUCTURED FLOATERS

PRINCIPAL-PROTECTED NOTES

LOAN REPACKAGINGS

LIQUIDITY

MISMATCHED MATURITIES

UNWIND TRIGGERS LINKED TO DERIVATIVES TRANSACTIONS

DAX-LINKED NOTE WITH TRIGGERS

RATINGS

MASTER TRUSTS

OWNER TRUSTS

GRANTOR TRUSTS

REAL ESTATE MORTGAGE INVESTMENT CONDUITS

MULTISELLER AND SINGLE-SELLER CONDUITS

DOMESTICALLY DOMICILED CORPORATIONS

BANKRUPTCY-REMOTE?

ENRON, JPMORGAN CHASE, AND SURETIES

CHAPTER 3 - Credit Derivatives and Total Rate of Return Swaps

RISK TO PORTFOLIO VALUE

CREDIT DERIVATIVES AND CREDIT DEFAULT SWAPS

NEGOTIATED LANGUAGE

BASIS RISK: PERSISTENT CDS LANGUAGE ISSUES

PHYSICAL SETTLEMENT AND CASH SETTLEMENT NEGOTIATIONS

DIGITAL, BINARY, ZERO-ONE, ALL-OR-NOTHING, OR FIXED RECOVERY CASH SETTLEMENT

INITIAL VALUE × (PAR - MARKET VALUE)

NORMALIZED PRICE METHOD—ALTERNATE TERMINATION PAYMENT

HEDGE COSTS IN CASH AND SYNTHETIC CDOs

DELIVERABLES: CDOs AND THE CHEAPEST-TO-DELIVER OPTION

CONVERTIBLE BONDS AND ASSET SWAPS

NEGATIVE BASIS TRADES

DEFAULT AND RECOVERY RATE

THE DEFAULT PROTECTION SELLER: COUNTERPARTY CREDIT AND CORRELATION

DEFAULT LANGUAGE FOR SOVEREIGN DEBT

DEFAULT LANGUAGE FOR NONSOVEREIGN DEBT: CONTROVERSY AND CDOs

CDS PRICING ISSUES

SYNTHETIC CDOs

TOTAL RATE OF RETURN SWAPS (TOTAL RETURN SWAPS)

PRICING TRORS ON LEVERED CDO TRANCHES

TRORS VERSUS REPOS

EQUITY TRORS: CORPORATE LOANS DISGUISED AS CAPITAL INJECTIONS

INFORMATION ASYMMETRY AND MORAL HAZARD

CDS VERSUS TRORS

PAY-AS-YOU-GO

INDEXES

CHAPTER 4 - CDOs and the Global Capital Markets

EVOLUTION OF THE CDO MARKET

CHAPTER 5 - Risk and Valuation Issues

THE PORTFOLIO DIVERSIFICATION MYTH

MODERN PORTFOLIO THEORY: BANE OF CDOs

ABNORMAL IS NORMAL

MARK-TO-MARKET HAZARD

CASH FLOW HAZARD

GLOBAL DERIVATIVES RISK

LOANS AND LEVERAGED LOANS

THE LEVERAGE PARADOX

NEW STRUCTURED FINANCE DEALS

FRAUD

HEDGE FUNDS: A NEW INVESTOR CLASS

TAVAKOLI’S LAW, HEDGE FUNDS, AND THE GREAT UNWIND

BRAIN DAMAGE THEORY

DEAD MAN’S CURVE AND LEVERAGED FUNDS

MARGIN OF SAFETY VERSUS ONE-SIDED ILLIQUID LEVERAGED BETS

CHAPTER 6 - Early CDO Technology

TRUE SALE HYBRID AND SYNTHETIC STRUCTURES

CREDIT ENHANCEMENT

MONOLINE AND MULTILINE INSURANCE

CDO CLASSIFICATION

MARKET VALUE CDOs

CASH FLOW CDOs

THE ORIGINS OF U.S. SECURITIZATION

COLLATERALIZED MORTGAGE OBLIGATIONS

CHAPTER 7 - Early Warning Commercial Financial Services

RATING AGENCIES’ FAILED MODELS

ANATOMY OF A FLAWED PROCESS

TERMINOLOGY

EARLY RED FLAGS

CFS GETS CREATIVE

SELLING OUT THE FUTURE

IGNORING AN AUDIT REPORT

LESSONS TO BE LEARNED

FALLOUT FROM CFS’S BANKRUPTCY

CHAPTER 8 - Subprime and Alt-A Mortgages: Collateral Damage

TRUTHINESS IN LENDING AND BORROWING

THE PREDATORS FALL

CLASSIC PONZI SCHEME

PORTFOLIO RISK

THE RISK MANAGERS’ DILEMMA

HOW TO CREATE A SECURITIZATION DISASTER

MODELS VERSUS COMMON SENSE

LACK OF APPROPRIATE DUE DILIGENCE AND/OR DISCLOSURE

INVESTORS AND RATINGS

HEDGE FUNDS AND ABX INDEXES: ALPHA BETS

A GOOD YEAR (FOR SOME)

BSAM’S HEDGE FUNDS UNDONE BY LEVERAGE

BEAR STEARNS’ HEDGE FUND LENDERS BAILOUT

DISCLOSURE: INVESTOR FALLOUT FROM THE MORTGAGE DEBACLE

“THE FIRST THING WE DO, LET’S KILL ALL THE LAWYERS”

MARKET FALLOUT FROM THE MORTGAGE DEBACLE

REDLINING AND RED INK

CHAPTER 9 - Cash versus Synthetic Arbitrage CDOs

COMPARISON OF MANAGED ARBITRAGE CDO FEATURES: CASH VERSUS SYNTHETIC DEALS

THE ARRANGER AND THE MANAGER

MANDATE AGREEMENT

DEAL ASSEMBLY

CDS LANGUAGE FOR THE SYNTHETIC CDO

SELECTING THE PORTFOLIO AND IMPACT ON RATING

RATING CRITERIA AND RESTRICTIONS

SUBSTITUTION AND REINVESTMENT CRITERIA

WAREHOUSING ASSETS

PRICING AND CLOSING

RAMPING UP THE PORTFOLIO

REINVESTMENT PERIOD

NONCALL PERIOD

PAY-DOWN PERIOD

WEIGHTED AVERAGE LIFE AND EXPECTED FINAL MATURITY

EARLY TERMINATION

LEGAL FINAL MATURITY

TRANCHING AND THE SYNTHETIC ARBITRAGE ADVANTAGE

WATERFALLS FOR CASH VERSUS SYNTHETIC ARBITRAGE CDOs

PAYMENT-IN-KIND TRANCHES

PSYCHIC RATINGS: RATING AGENCY TREATMENT OF PIK TRANCHES

THE SUPER SENIOR ADVANTAGE

CDS VERSUS CASH ASSET SPREADS

HEDGING THE CDO PORTFOLIO CASH FLOWS

SETTLEMENT IN EVENT OF DEFAULT OR CREDIT EVENT

DOCUMENTATION

CASH VERSUS SYNTHETIC ARBITRAGE CDO EQUITY CASH FLOWS

SAMPLE CASH FLOWS

SUMMARY OF CASH ARBITRAGE CDOs VERSUS SYNTHETIC ARBITRAGE CDOs

CHAPTER 10 - CDO Equity Structures

ACCRUING ERRORS

PROBABILITY OF RECEIPT

THE BEST AND WORST EQUITY INVESTMENTS

THE BEST EQUITY EARNS ALL RESIDUALS

EQUITY INVESTOR INJECTS CASH AS OVERCOLLATERALIZATION

RATED EQUITY EARNS STATED COUPON APPROPRIATE TO RATING

RATED EQUITY: STATIC DEAL

EQUITY INVESTOR EARNS A STATED COUPON ON THE REMAINING EQUITY INVESTMENT

MORAL HAZARD AND CONFLICT OF INTEREST

LEVERAGING THE BEST: UNFUNDED EQUITY INVESTMENTS—ULTIMATE LEVERAGE

ACTIVELY TRADED AND LIMITED SUBSTITUTION SYNTHETIC ARBITRAGE CDOs

INTEREST SUBPARTICIPATIONS: WHEN EQUITY ISN’T FIRST LOSS

PARTICIPATION NOTES

CAPPED PARTICIPATION NOTES

COMBINATION NOTES

INVESTOR MOTIVATION

PRINCIPAL-PROTECTED STRUCTURES

FIRST- (AND NTH-) TO-DEFAULT BASKET SWAPS

FIRST-TO-DEFAULT NOTES

THE SMARTEST EQUITY INVESTMENT: PROTECTION MONEY

CHAPTER 11 - CDO Managers

BEST PRACTICES

THE VALUED FEW

CHAPTER 12 - Balance-Sheet CLOs and CDOs

TRUE SALE (FULLY FUNDED): DELINKED STRUCTURE

LINKED NONSYNTHETIC STRUCTURES

LINKED BLACK-BOX CLN CDOs

SYNTHETIC STRUCTURE WITH SPE

PARTIALLY SYNTHETIC LINKED CDOs

FULLY SYNTHETIC CDOs

SMALL TO MEDIUM-SIZE ENTERPRISES—EUROPE

SMEs: UNITED STATES VERSUS EUROPE

SECURED LOAN TRUSTS

BANK REGULATORY CAPITAL AND BASEL II

CHAPTER 13 - Super Senior Sophistry

CASH FLOW MAGIC TRICK

RATING AGENCIES—MOODY’S TRANCHING

THE AAA DISAPPEARING ACT

RATING AGENCIES AND RATINGS SHOPPING

TRIPLE-A BASKET WITH 2 PERCENT FIRST-LOSS TRANCHE

SUPER SENIOR ATTACHMENT POINT

SUPER SENIOR PRICING

SUPER SENIORS OR SENILE SENIORS?

WHERE ARE THE REGULATORS?

JUNIOR SUPER SENIORS

SUPER SENIOR INVESTORS

NEGATIVE BASIS TRADES

LEVERAGED SUPER SENIORS AND CONSTANT PROPORTION PORTFOLIO INSURANCE

FINAL THOUGHTS ON SUPER SENIORS

CHAPTER 14 - Synthetics and Mark-to-Market Issues

SYNTHETIC CASH WINDFALL

SYNTHETIC EQUITY

PORTFOLIO SWAPS

BESPOKE TRANCHES: SINGLE-TRANCHE CDOs

SHORT MEZZANINE AND LONG EQUITY

BANKS’ INVISIBLE HEDGE FUNDS

EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CORRELATION

DELTA HEDGES, CORRELATION MODELS, AND JUNK SCIENCE

SYNTHETIC NOTIONAL AND ACTUAL RISK

EXPLOSIVE GROWTH, UNCERTAIN FUTURE

FOUND MONEY AND MORAL HAZARD

CHAPTER 15 - Comments on Selected Structured Finance Products

MULTISECTOR CDOs: CDOs

FUTURE FLOWS: PAYMENT RIGHTS SECURITIZATIONS

EMERGING MARKET CAVEATS

CONSTANT PROPORTION DEBT OBLIGATIONS AND RATING AGENCIES

CONSTANT PROPORTION PORTFOLIO INSURANCE

MULTILINE INSURANCE PRODUCTS: DISAPPOINTMENT AND PROMISE

HOLLYWOOD FUNDING

TRANSFORMERS

SEC GASLIGHT ON LIFE SETTLEMENTS

SPECIAL PURPOSE ACQUISITION COMPANIES

CHAPTER 16 - Credit Funds

CREDIT HEDGE FUNDS

HEDGE FUNDS AND STRUCTURED CREDIT

IO AND PO TRANCHES: JUNIOR TRANCHES AND EQUITY OIDs

LIMITED PURPOSE FINANCE CORPORATIONS

STRUCTURED INVESTMENT VEHICLES

CREDIT DERIVATIVE PRODUCT COMPANIES

HEDGE FUNDS AND COLLATERALIZED FUND OBLIGATIONS

CHAPTER 17 - The Credit Crunch and CDOs

RATING AGENCIES, REGULATORS, AND JUNK SCIENCE

SAVVY INVESTORS IGNORE RATINGS

MISFORTUNE’S FORMULA: STRUCTURED CREDIT RATINGS

ABCP CRISIS AND MLEC

CONSTELLATION CDOs: FALLING STARS

NEW FLAWED MODELS REPLACE OLD FLAWED MODELS

RATING AGENCIES IN CRISIS

MONOLINE MELTDOWN: FINANCIAL GUARANTORS IN CRISIS

RATING AGENCIES IN DENIAL

OVERWHELMING LOSSES

POOR ACTUAL RECOVERIES

UNDERCAPITALIZED FINANCIAL GUARANTORS

DICEY DEALS DONE DIRT CHEAP

COMPETITIVE PRESSURE

UNCERTAIN FUTURE

COUNTRYWIDE’S BAILOUT AND MORAL HAZARD

CHAPTER 18 - Future Developments in Structured Finance

REGULATORY FAILURE: INVESTORS ARE ON THEIR OWN

APPENDIX - Interesting Web Sites

Bibliography

Index

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Copyright © 2008 by Janet M. Tavakoli. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

Originally published as Collateralized Debt Obligations and Structured Finance.

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eISBN : 978-0-470-44344-6

1. Asset-backed financing—United States. 2. Mortgage-backed securities—United States. I. Title. HG4028.A84T38 2008 332.63’2044—dc22 2008008483

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Preface

What’s new in structured finance? Since the first edition of this book came out in 2003, the structured finance landscape has sustained several seismic shifts, particularly in the collateralized debt obligation (CDO) market. New technologies blossomed, along with problems of transparency and application. Rapid growth became explosive growth, peaking in the second half of 2007. Abuse led to a rapid decline in new CDO issuance in 2008, and future deals will employ more tested tradecraft and fewer opaque financial engineering techniques.

Post-Enron accounting changes have made CDO equity a hot potato for former investors who do not want to consolidate entire deals on their balance sheets. This has opened the door to the rise of inexperienced CDO managers, new and unknown offshore entities, hedge fund investors, and private equity investors.

CDO managers of all types—from the savvy to the naïve—waded into the global securitization market. Even former stints at SEC-alleged Ponzi schemes or fines paid after SEC-alleged accounting fraud were not deterrents for investment banks doing business with reinvented CDO managers. CDO managers giving the appearance—if not the reality—of investing in CDO equity were pushed through internal approval committees of investment banks.

Not-so-savvy hedge funds purchased the sucker tranches of CDOs. Savvy hedge funds became CDO managers recognizing the benefits of being on the right side of a cash flow engineering windfall. Some hedge funds became major participants in the CDO market, embracing the leverage afforded by synthetic technologies, financial engineering, and the fees to be earned by managing CDOs. Other hedge funds became independent speculators in the CDO markets, using hedging techniques such as shorting the ABX indexes as tools for wildly profitable speculation.

Single-tranche CDOs rose and waned to be overshadowed by constant proportion debt obligations (CPDOs), constant proportion portfolio insurance (CPPI), and other highly structured leveraged products.

Cash securitizations explored novel asset classes. Belts and braces sometimes gave way under the strain of unrealized cash flow. Investment banks have become major lenders to originators of products with unprecedentedly low underwriting standards combined with unprecedentedly risky products.

Retail investors are being solicited through products that employ form-over-substance sleight of hand. Products that could not be sold to retail investors through the debt markets in the United States due to Securities and Exchange Commission (SEC) restrictions are being sold through the stock markets, through structured notes, through mutual funds, and through pension funds.

New products require another look at credit default swaps (CDSs) and total rate of return swaps in the context of synthetic securitizations. Synthetics introduce unique structural risks to CDOs and structured finance products. We will look at recent changes in the CDS market posed by CDSs on asset-backed securities (CDSs of ABSs). We will also look at synthetic indexes.

Securitization groups continue to use their financial institutions’ balance sheets. Securitization technology originally moved mortgage-backed securities, consumer loans, and other loans off financial institutions’ balance sheets so they could reduce balance sheet risk and do more business. In recent years, securitization groups added risk to a variety of financial institutions’ balance sheets, added invisible risk to trading books, or placed risk in stagnant conduits in order to earn fee income. As a result, banks, investment banks, hedge funds, insurance companies, and conduit investors were more exposed to concentration risk and losses due to fraud.

The Sarbanes-Oxley Act of 2002 (Sarbox) was meant to combat fraud on a corporate level for firms regulated by the SEC. Whatever its value at the corporate level, it has not hampered structured financing as many feared, nor has it affected the evolution both positive and negative of structured finance in a significant way. In fact, evidence is presented later in this book that suggests securitization professionals feel free to ignore the beneficial intent of Sarbox.

Fraud has been an ongoing concern, particularly in the way we originate assets. Even when fraud is absent, markets have been plagued by poor underwriting standards combined with risky assets. The current market has seen a surge in problematic loans. The subprime and Alt-A mortgage loan markets in several countries provide handy examples. This book focuses primarily on the dynamics of the U.S. mortgage market because it is the largest of the affected markets and the most egregious offender. The role of financial institutions that provided credit to mortgage bankers is examined in Chapter 8. While the mortgage market is one example, it is not the only one. Other asset classes present their unique problems: commercial real estate, project loans, corporate receivables, and more.

As we are all aware, fraud can be internal to an arranger securitizing a deal; fraud can be external, as when a corporation fudges its accounting; and fraud can take the form of a conspiracy when both external parties and internal deal makers agree to hide relevant facts. We shouldn’t be surprised by fraud; we should expect to deal with it and can take steps to guard against it.

For instance, we know that in the United States one-third of small businesses that lose money do so not because of utility cost increases, not because of rent increases, not because big companies take their business, but because of employee fraud. We’ve also discovered that fraud isn’t committed by petty thieves or uneducated thugs. Eighty percent of fraudulent employees are white; they are 16 times as likely to be managers or executives, 4 times as likely to be men, and 5 times as likely to have postgraduate degrees. We also know that many employees will commit fraud given the right circumstances. These “right circumstances” are known as the fraud triangle: need, opportunity, and the ability to rationalize one’s behavior.

Knowing human nature, we can’t expect it to change in large corporations, in commercial banks, in investment banks, in insurance companies, in hedge funds, or in other financial institutions. We can expect the individual to feel his own needs are greater than those of the whole. The need for a Rolex, the need for an estate in Florida, the need for a castle in the South of France, the need for an enormous annual bonus—all of these so-called needs seem to be greater in the finance business. Given the keen intelligence of the players and the complexity of structured financial products, opportunity and the ability to rationalize behavior may be greater as well. Decreasing opportunity increases sound business.

While we look at some instances of fraud in this book, we also look at instances of gray-area opportunities presented by structured products. And we look at opportunity costs due to both ignorance and intent.

One would think that in an efficient market, the deterrents in place would stop this behavior. Even in the absence of legal remedies, censure by other firms can be costly. Yet even with predetermined sanctions, the market is not always efficient about routing out this behavior, and we shouldn’t expect it to be.

In isolated incidents we see financial institutions and individuals black-balled for pulling a fast one, but increasingly it is also true that we see people relying on the depth and breadth of the market to move on to a new set of unaware market players.

Synthetic CDOs—namely, securitizations incorporating credit derivatives technology to transfer asset risks and cash flows—make up most of the CDO market. This is due to the seeming arbitrage advantage of synthetic versus cash assets caused by creation of a super senior tranche, and the increased leverage of the equity tranche. The ability to sell synthetic CDOs backed by investment-grade collateral is another huge advantage over cash CDOs in the current credit environment.

Cash CDO issuance has also ballooned, as financial institutions rushed to securitize everything from mortgage loans to the value of intellectual capital. The availability of credit derivatives to hedge cash CDOs has contributed to the unprecedented growth of this market.

CDOs are still an evolving product, especially in Europe where special venue considerations introduce technological challenges. This market has enthusiastically embraced credit derivatives, since synthetic structures solve certain venue issues for risk transfer. Credit derivatives also often allow special gimmicks to be employed, which can produce certain regulatory advantages.

The purpose of this book is to point out key issues in valuing structured financial products. I review the basics of the market so that any reader with some knowledge of the capital markets will understand the components required to evaluate structured products. Readers looking for a book on models should go elsewhere.

The irony of the complex CDO market is that the basic principles of sound finance are often violated in ways the models cannot capture. Models are a secondary overlay in determining fundamental value. Therefore, this book focuses on preserving fundamental value, and it does not focus on mechanical models. Yet model building is in vogue, particularly the building of inferior correlation models, and the industry has produced many “model monkeys.” They produce encyclopedias of code, but even if the code is correct, it is often of little practical value.

Richard Feynman once pointed out that students in Brazil memorized the definition and formulas for triboluminescence, but they had no idea what they meant. While they could spout the theory of the production of light in the destruction of a crystalline lattice, the students had no idea which crystals produce light when crushed or why they produce light. Feynman wanted to send them into a closet with a sugar cube and a pair of pliers to observe the faint blue flash of light produced by crushing the crystals.

I’m not saying models have no value; I use models. I’m simply pointing out that if you don’t know where you are going, writing a model isn’t going to get you there.

Quality control in CDOs and structured credit products is uneven. A small number of firms have built sound business models with strong professional teams, but they are the exceptions. Many structurers and credit derivatives professionals are inadequately trained in the capital markets to be competent in their jobs, and the investor community is suffering the results. A major problem in today’s markets is lack of cross training. The result is poor understanding of the basic mechanics of the products of the global financial markets. The problem is exacerbated by the fact that securitizations have recently become a lot more global.

Credit derivatives professionals often have never traded cash products or traded an interest rate swap. Some have no exposure to the bond markets, or even the currency or swap markets. Many cannot explain how to construct a par asset swap, one of the benchmark relative-value instruments for their market. Some have no exposure to repurchase agreements. This lack of general knowledge has caused dangerous misunderstandings.

I believe the reason this problem falls below the radar screen is that financial institutions rapidly grow these departments and need to dub ad hoc “experts” to satisfy a need. The growth in business of managing CDOs, and the influx of new participants such as hedge funds and pension funds, has made what was formerly a big problem into a critical one. The required qualifications and training take a backseat to representing to upper management that departments are in place. Upper management is often confused by the complexity of these products and, as a result, many institutions are going through growing pains, and some may not make it to full maturity.

Another reason this problem hasn’t been solved is that upper management often has difficulty assessing true performance. If a group has lost money, there seems to be a ready reasonable excuse. Many groups have no clear idea why they lose money or why they make money. They make a bet and it either wins or it loses. There is no business model in place to support consistent revenue growth. If they make a little money, they persuade management that a hockey stick profit projection profile depicts the future of their fledgling department. The philosophy is to tell management what they want to hear, even if it isn’t close to the truth. Don’t tell management the department is nothing more than just a few guys taking bets. Opportunity cost is invisible.

In Europe in particular, where synthetic securitizations often seem to pose a solution to sticky venue issues, there is a dearth of capital markets experience in the structuring community. Virtually any asset can be securitized, and virtually anyone thinks he can do it.

One securitization professional told me he’d been an unsuccessful emerging markets trader, but now he felt he’d found his niche. Lack of experience was no impediment. He informed me he was a native Italian, and the language skill was more valuable. He cloned mandate letters of his more experienced colleagues and sent them to banks to ask them to allow him to do their balance sheet securitizations. When that strategy wasn’t successful, he simply lowered his costs. In his mind, that was all it took. The ability to offer creative structural solutions or value added wasn’t a chief concern for him. This attitude has the potential to hurt this growing market.

Cash flows can be manipulated to solve almost any problem; they can also be manipulated to hide almost any problem. Much of what we consider unethical practice is a matter of custom, legislation, and the time in which we live. That applies as much to financial practices as it does to sexual practices. Giving kickbacks in Europe was almost standard operating procedure until the Lockheed scandal caused vilification in the United States of the U.S. participants. Many Europeans were initially confused by the uproar, but in the end, the negative publicity caused the European business community to rethink this practice. Determining what is unethical is sometimes a difficult call, and opinions are divided. Nonetheless, I attempt to address this issue where applicable.

I do not delve deeply into tax products or accounting issues, because it would require an additional book to do them justice. Furthermore, these issues change and they vary by venue. One should always refresh the relevant rules when doing a securitization. Structured finance tax products have long hangovers. Investors may need to produce documentation for accounting and tax-related transactions years after the product matures. One Cayman Islands-based investor received calls from the U.S. Department of the Treasury for 15 years after a tax-related product matured. Tax laws are constantly changing. Single-venue tax code interpretation is complex, and cross-border tax code interpretation adds another layer of complexity.

Despite the caveats, I’m an enthusiastic proponent of structured financial products and welcome the growth of new products in the market. Wherever possible, I’ve tried to point out how existing structuring technology has benefited new markets and has the potential to create even better products. It is my intent to facilitate a clearer understanding of these products that will encourage investors to confidently participate in this fascinating market.

Acronym Key

CHAPTER 1

Securitization Terminology

Structured finance is a generic term referring to financings more complicated than traditional loans, generic bonds, and common equity. Relatively simple transactions that lower corporations’ funding costs by converting floating rate obligations to fixed rate obligations (or the opposite) through the use of interest rate swaps are traditionally considered structured finance transactions. Financial engineering involving special purpose entities (SPEs) is also considered a part of structured finance. Extremely complicated leveraged products such as constant proportion debt obligations (CPDOs) and complicated securitizations such as collateralized debt obligations of collateralized debt obligations (CDOn) are also included in the definition of structured finance.

Key motivations for using structured finance include lowering funding costs, changes in debt and equity composition of the balance sheet, taking companies public or private, freeing up balance sheet capacity, monetizing balance sheet assets, financing assets, regulatory capital arbitrage, sheltering corporations from operating liabilities, tax management, financing leveraged buyouts, poison pill takeover defenses, hedge fund speculation, accounting rule compliance, and leverage. The structures may address several issues at once including risk transfer, accounting, taxation, bankruptcy, and credit enhancement.

Securitization is a generic term for a subset of structured finance. A securitization is simply the creation and issuance of securities backed by a pool of assets, also called the portfolio, usually with multiple obligors. A synthetic securitization employs credit derivatives technology to transfer asset risk (see also Chapter 3, “Credit Derivatives and Total Rate of Return Swaps”). Securitization offers the possibility of portfolio diversification, even when it doesn’t always deliver on this promise. Virtually any combination of financial assets or stream of cash flows can be securitized. In the early 1990s Prudential brought so-called death bonds to the market. These were securitizations of the life insurance premiums owed to Prudential. The firm provided actuarial information showing dropout rates and potential death rates of the premium payers so investors could get an idea of the future cash flows. Investors learned a new meaning for the term deadbeat. This structure was one of the early future flows deals. The risk was in whether the projected future cash flows would be realized, due to the ultimate lack of future of the premium payers.

Collateralized debt obligation (CDO) is a generic term for a subset of securitizations. Collateralized debt obligations can be backed by any type or combination of types of debt: tranches of other collateralized debt obligations, asset-backed bonds, notes issued by a special purpose entity that purchases other underlying assets that are used as collateral to back the notes, hedge fund obligations, bonds, loans, future receivables, or any other type of debt.

The term collateralized debt obligation encompasses collateralized bond obligations (CBOs), collateralized mortgage obligations (CMOs), collateralized fund obligations (CFOs), asset-backed securities (ABSs), synthetic credit structures, and more. In the U.S. capital markets, the term asset-backed securities was originally used to describe deals backed by credit card receivables and auto loans. In recent years, this term has also been used to describe residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).

Terms used in the mortgage market are sometimes difficult to interpret. Collateralized mortgage obligations usually refer to mortgage-backed securities with strict underwriting standards, where risk is primarily defined by the allocation of principal and interest payments. RMBS and CMBS are terms usually reserved for deals backed by a portfolio of mortgage loans tranched into various classes of credit risk. Similarly, mortgage-backed CDO is a term usually reserved for deals backed by a portfolio of mortgage-backed bonds that are tranched into various classes of credit risk.

Credit derivative is the generic term for any derivative contract used to transfer credit risk on a reference entity or reference obligor between a credit protection seller that is short the credit risk, and a credit protection buyer that is long the credit risk. A credit default swap is a bilateral contract between the protection buyer that is short the credit risk and the protection seller that is long the credit risk.

A total return swap (TRS), also known as a total rate of return swap (TRORS), is considered a type of credit derivative, and it is fundamentally a form of financing. An investor uses financing (i.e., leverage) and obtains the economic benefits of an asset (or assets) without owning the asset or ballooning its balance sheet. The investor is the receiver of the total return on a reference asset or assets, including interest, capital gains/losses, or other economic benefits during the predefined payment period. The investor’s counterparty finances the transaction and receives a specified fixed or floating cash flow usually related to the creditworthiness of the investor. The reference asset may be virtually any financial obligation.

Special purpose entities (SPEs) are powerful structured finance tools frequently used in securitizations and CDOs. Special purpose entity is a global term and is used interchangeably with the term special purpose vehicle (SPV) and special purpose corporation (SPC). Special purpose entities can be trusts or companies. They house asset risk either through the purchase of the assets or in synthetic form. The assets are then used as collateral for notes or other forms of risk transfer (see also Chapter 2).

Market professionals agree all CDOs are structured products, but total agreement usually ends there. Market professionals often disagree on the definitions, so I attempt to be clear at all times how I am using terminology in specific examples throughout this book. Some market definitions are confusing and redundant. We deal in a global market with people with a wide variety of professional backgrounds and ethnic origins. It is always best to agree on definitions of terms before engaging in any new transaction.

Structured finance benefits participants in various ways:

• Securitization may provide funding and liquidity by converting illiquid assets into cash.

• Structured finance can reduce borrowing costs. Often captive finance companies and independent companies can obtain capital at rates better than those obtainable for the originator of the securitized assets.

• Securitization may transfer the risk of assets or liabilities to allow an asset originator to do additional business without ballooning its balance sheet. Corporations use structured finance vehicles to finance assets used in the course of their business.

• Securitization can enable a financial institution to exploit regulatory capital arbitrage. At times, both banks and insurance companies engage in regulatory capital arbitrage as a prime motivation for securitization of assets that offer a low return on regulatory capital.

• Structured finance vehicles can be used to shelter corporations from potential operating liabilities.

• Securitizations and structured finance vehicles can be used for tax management.

To do all of these things, structures must address issues of bankruptcy, accounting issues, tax issues, and credit enhancement.

Traditionally securitization has been a means for financial institutions to reduce the size of their balance sheets and to reduce the risk on their balance sheets. This allowed them to do more business and allowed investors access to diversified pools of assets to which they otherwise would not have had access. Securitization was a good deal for almost everyone.

SIMPLIFIED CASH CDO

A simple cash collateralized debt obligation is based on a portfolio of corporate bonds. The bonds throw off coupon income and are redeemed at par at maturity. In practice, cash CDOs have a target average life and target final maturity due to the varied maturities of the underlying bonds. At the final maturity, the bonds are redeemed at par. Figure 1.1 shows the basic CDO structure.

A CDO backed by the portfolio of bonds might be tranched into four classes of risk with the following ratings: a senior (“AAA”) tranche, two mezzanine tranches (rated “A” and “BBB” respectively and shown in the figure as one block), and one unrated first-loss or equity tranche. First-loss risk is also called equity, or preferred shares, or residual, or junior tranche (especially used for the highly leveraged first-loss slice of a portfolio of highly rated assets), or by other names, but it is not to be confused with common equity or preferred shares issued by corporations with ongoing businesses.

A special purpose entity usually houses the collateral pool and becomes the issuer of the various classes of debt. By this means, the deal arranger/structurer isolates the risks and opportunities. Investors want to have exposure to a specific pool of assets, but they have various appetites for risk.

The deal arranger is typically the underwriter selling or retaining all of the tranches at market prices. The difference between the income from the portfolio and the cash owed to the investors (the liabilities), less the deal expenses (legal, rating agencies, structuring fees, and more), is known as the CDO arbitrage. In particular, the investment bank arranger will normally presell the first-loss tranche, the riskiest tranche, also called the equity. The implied internal rate of return at which this equity risk can be sold to an outside investor is a key determinant of the CDO arbitrage.

FIGURE 1.1 Basic CDO Structure

THE CDO ARBITRAGE

In practice, there is actually no such thing as a CDO arbitrage. An arbitrage is a money pump. A true arbitrage guarantees a positive payoff in some scenario, with no possibility of a negative payoff and with no net investment. The opportunity to borrow and lend at two different fixed rates of interest, leading to an assured profit, is an arbitrage. Another example is the ability to simultaneously buy and sell the same security in different marketplaces and earn a profit at no cost and with no risk. The efficient market hypothesis asserts that the market will take into account all relevant information and price risk accordingly. Therefore, arbitrageurs will force the rates to converge and drive the arbitrage out of the market. In other words, it shouldn’t be possible to make a guaranteed risk-free profit.

Note that the process of buying bonds on the bid side of the market for later resale to customers at the offer side of the market is called trading. Often both sides of the trade do not occur simultaneously; traders must assume market risk, and so trading isn’t considered an arbitrage. Profits are not guaranteed. We often loosely and incorrectly use the word arbitrage to describe a hedged position that made money. For instance, we might say that a long bond position was arbitraged by a short sale.

Structurers of CDOs buy collateral and resell the collateral risk in another form at a lower all-in cost. As we shall see later, sometimes the risk is not completely sold and is held in a trading book due to distribution challenges. Sometimes the risk represented in the CDO tranches (the notes or liabilities issued by the CDO) is not the same risk represented by the collateral of the CDO. Sometimes the residual risk is deliberately held in a trading book and dynamically hedged. Sometimes an entire tranche, usually the super senior tranche, is held in the trading book with no hedge whatsoever, and is marked-to-market in theory, but not in actual practice.

Structuring groups that have separate profit and loss statements (P&Ls) from trading desks can with some truth claim that they benefit from a CDO arbitrage, but their financial institution does not. The structuring group means that they put together a deal, pay themselves a structuring fee, pass the risk of distribution and management of the tranches to the trading desk, and declare victory for the structuring group. They have acted as middlemen, taken out a fee, and washed their hands of the risk management and distribution challenges. Many deal arrangers are set up this way. They recognize this moral hazard, link structuring and trading P&L, and track CDO profitability throughout the deal life, but many deal arrangers do not.

Financial institutions that structure CDOs come closest to approaching an arbitrage when they buy the collateral, tranche the exact risk represented by the collateral, and sell every tranche of the collateral through their distribution network. Time elapses between the accumulation of collateral and the closing of the transaction, especially in a cash asset-backed deal. During this warehouse period, there may be significant market and credit risk that must be hedged, if possible. The hedge may generate gains or losses, and this risk (or reward) is usually borne by the deal arranger—usually an investment bank or commercial bank—but it may be borne by the equity investor(s) if it is pre-agreed. Once the deal closes, there may be further risk to the bank arranger due to holding tranches in trading book inventory before the deal is entirely sold.

Financial institutions also make a secondary market in the CDO tranches, and these positions are usually hedged. Reserves are held as a cushion for the residual risk of ongoing trading and risk management. The financial institutions that use this business model have the cleanest type of transaction management from the arbitrage point of view, but it is still not strictly an arbitrage.

It is more correct to call the cash calculation of the CDO the economics rather than the arbitrage. The economics of a typical CDO are calculated as follows:

Cash thrown off by the collateral plus interest on collateral, if any, minus structuring fees; plus/minus hedging gains/losses; minus underwriting fees or sales fees (of the tranches or liabilities); minus legal fees, trustee fees, and management fees, if any; minus administration fees, special purpose vehicle fees, rating agency fees, and listing fees; minus the payments due on the CDO notes (the tranches, which are the liabilities, of the CDO), equals profit.

Later we look at the CDO economics in more detail. We examine the failure of arbitrage terminology to describe the fluctuating profitability, and sometimes the loss, in these transactions, especially for financial institutions that do not distribute all of the liabilities of the CDO.

CHAPTER 2

Structured Finance and SpecialPurpose Entities

Special purpose entity (SPE) is a global term and is used interchangeably with the term special purpose vehicle (SPV). An SPE is either a trust or a company. Special purpose corporations (SPCs) are used for a variety of purposes, including structured risk management solutions. In securitizations, the SPE houses the asset risk either through the purchase of the assets or in synthetic form. The assets are then used as collateral for notes issued by the SPE.

Special purpose entities are powerful structured finance tools. They can be either onshore or offshore. Because of their normally off-balance-sheet, bankruptcy-remote, and private nature, SPEs can be used for both legitimate and illegitimate uses. Most of the structures discussed in this book are legitimate uses of SPEs. I point out several structures along the way that lend themselves to money laundering, disguising loans as revenue to misstate earnings through wash trades, concealment of losses, embezzlement, and accounting improprieties. Even when used legitimately, the way the issuance of SPEs is represented is sometimes ethically marginal.

All of the following are examples of SPEs: SPCs that may or may not be special purpose subsidiaries or captives; master trusts; owner trusts; grantor trusts; real estate mortgage investment conduits (REMICs); financial asset securitization investment trusts (FASITs); multiseller conduits; single-seller conduits; and certain domestically domiciled corporations.

Special purpose entities are often classified as either pass-through or pay-through structures. Pass-through structures pass all of the principal and interest payments of assets through to the investors. Pass-through structures are therefore generally passive tax vehicles and do not attract tax at the entity level. Pay-through structures allow for reinvestment of cash flows, restructuring of cash flows, and purchase of additional assets. For example, credit card receivable transactions use pay-through structures to allow reinvestment in new receivables so bonds of a longer average life can be issued.

For securitization of cash assets, the key focus is on nonrecourse financing (i.e., nonrecourse to the originator/seller). The structures are bankruptcy-remote so that the possible bankruptcy or insolvency of an originator does not affect the investors’ right to the cash flows of the vehicle’s assets. The originator is concerned about accounting issues, especially that the structure meets requirements for off-balance-sheet treatment of the assets, and that the assets will not be consolidated on the originator/seller’s balance sheet for accounting purposes. For bankruptcy and accounting purposes, the structure should be considered a sale. This is represented in the documentation as a true sale at law opinion. The sale is also known as a conveyance.

The structure should be a debt financing for tax purposes, also known as a debt-for-tax structure. Tax treatment is independent of the accounting treatment and bankruptcy treatment. An originator selling assets to an SPE will want to ensure that the sale of assets does not constitute a taxable event for the originator. The securitization should be treated as a financing for tax purposes, that is, treated as debt of the originator for tax purposes. This is represented in the documentation in the form of a tax opinion.

The structured solution to the bankruptcy, true sale, and debt-for-tax issues varies by venue. The deal arranger may be a bank, insurance company, hedge fund, CDO manager, independent asset originator, or other entity that has the ability to accumulate assets. For example, if a U.S. arranger wants to securitize receivables, the structure requires two SPEs to avoid a federally taxable asset sale and to achieve off-balance-sheet financing and a bankruptcy-remote structure. In the United States, SPEs are usually organized as trusts (for tax reasons) under the laws of the state of Delaware or of New York. The first SPE is a wholly owned, bankruptcy-remote subsidiary of the originator/seller, and the SPE buys the assets in a true sale. The assets are now beyond the reach of both the originator/seller and its creditors. Wholly owned subsidiaries are consolidated with the originator/seller for U.S. federal tax purposes, so this achieves the debt-for-tax objective. The second SPE is the issuer of the debt (or asset-backed security, ABS) and is entirely independent of the originator/seller. It is a bankruptcy-remote entity. The second SPE buys the assets of the first SPE as a true sale for accounting purposes, and a financing for tax purposes. A schematic of this structure appears in Figure 2.1.

Other venues are more problematic, and the regulations with respect to the local equivalent of the U.S. Bankruptcy Court’s automatic stay procedures, accounting rules, and tax laws must be verified with experts who have local expertise.

FIGURE 2.1 Double SPE Structure for U.S. Accounting and Tax Regulations

For example, two entities are required for Italian securitizations. The first entity can be onshore and purchases the assets. The onshore entity cannot issue bonds, or it will attract heavy Italian taxes. The second entity is offshore and it issues the bonds.

Synthetic securitizations do not get true sale treatment for accounting purposes, since no asset has been sold. This is true whether the vehicle is an SPE or a credit-linked note. Bank arrangers usually do these deals to reduce regulatory capital according to regulatory accounting principles, for credit risk relief, and to free up balance sheet capacity. Hedge funds, investment banks, and other entities do these deals for risk transfer, for balance sheet management, and for profit. Partial funding is feasible with a hybrid structure. We compare and contrast synthetic and true sale structures in Chapter 12.

Investors in CDOs want to invest in a risk class of a pool of receivables and want the asset to be bankruptcy-remote so the supplier of the assets has no further claim on the assets. It is also usually important that the deal is structured in such a way so that the equity class investor does not have to consolidate the entire special purpose entity on its balance sheet.

In the United States, before Enron’s collapse, the minimum outside investment for an off-balance-sheet special purpose entity was 3 percent. In reaction to Enron’s collapse and the revelations of its massive abuse, accounting rules regarding SPEs changed. The following summary of changes in U.S. accounting reflects changes post-Enron and is subject to interpretation and change. It also varies by venue. Anytime a securitization is done, the rules must be revisited and reinterpreted, because they are subject to change. Nonetheless, the following summary gives an idea of the changeable nature of the rules. Changes can present both problems and opportunities.

A qualifying SPE (QSPE) does not have to be consolidated on the balance sheet of an issuer or equity investor, but it is more difficult to claim that status.

If the SPE is not a QSPE, it may or may not be a variable interest entity (VIE). If it is a VIE, then you have to determine the primary beneficiary for consolidation purposes. The primary beneficiary records the assets on the balance sheet at fair value or, if the assets are transferred to the primary beneficiary, they may be recorded at book value while recording the fair value of the liabilities and the fair value of the minority interests in the VIE.

The SPE is not a VIE if the total equity investment is sufficient to finance activities without additional financial support, and that is not necessarily 10 percent; it might actually even be less. If the equity is adequate and if it is well dispersed, the SPE may not be deemed to be a VIE. But this is subject to interpretation. In addition, it is not a VIE if equity investors have a direct or indirect ability to make decisions through voting or similar rights, or they have an obligation to absorb expected losses and the right to receive residual returns. If it is not a VIE, then special consolidation applies.

A number of proprietary solutions are employed to avoid consolidation of an SPE in the United States and in some European venues.

SPCs AND HISTORICAL ABUSE

Special purpose corporations, also known as shell corporations, have been around in various forms for decades. They have been used and abused throughout their history. Later chapters detail legitimate uses of SPEs, but recent U.S. corporate scandals threaten to give them a bad name, so it is worthwhile to spend some time discussing abuses.

Special purpose entities are a convenient tool for criminals. They are often offshore, usually bankruptcy-remote, and the ownership structure is undisclosed. The board seemingly makes investment decisions, but these are virtually dictated by the entity that structured the SPE in the first place. The entity that paid the original setup costs is the puppet-master, or the actual driver of the vehicle.

There is nothing wrong with SPEs in and of themselves, just as there is nothing wrong with any other tool. A hammer can be used to build a house or used like “Maxwell’s silver hammer” to kill someone. A car can be a vehicle for driving children to school, or it can be the vehicle used as a getaway car in a bank robbery.

Enron used SPEs to indulge in creative accounting, but they weren’t the first and they weren’t even the boldest. Enron was a surprise only to those who had forgotten financial history.

In the mid-1970s through the early 1980s, the august hierarchy of the Catholic Church participated in a financial game of shells and shills. In 1974, the crash of Franklin National Bank was the largest bank crash in the history of the United States up to that time. Michela Sindona was sentenced to 25 years in the Otisville U.S. federal prison for his role in the collapse. He ran a money laundering operation for the Sicilian and U.S. Mafias. A United States Comptroller of the Currency’s report showed that Big Paul Castellano, among others, had a secret account at Franklin National Bank. (Castellano was gunned down outside New York’s Spark Steak House on East 46th Street in an unrelated mob hit in December 1985.) Few people in the securitization business remember Sindona’s name, but at the time he was internationally famous for his bold financial crimes.

Sindona hated prison and sought revenge when his longtime friend Roberto Calvi, the chairman of Banco Ambrosiano (also known as “the priests’ bank”), turned his back on him. Sindona told Italian banking authorities to start investigating Calvi, Calvi’s foreign special purpose corporations, and Calvi’s links to the Vatican Bank. Sindona was later turned over to Italian authorities. The Vatican Bank lost $55 million when Franklin collapsed. Archbishop Paul Marcinkus was also a suspect when it was revealed Sindona paid a total $6.5 million to him and to Roberto Calvi. The payment was allegedly for a stock price-inflating scheme involving three banks: Franklin, Ambrosiano, and the Vatican. In March 1986, Sindona was found poisoned to death after drinking a cup of coffee in an Italian prison where he served a sentence for ordering the death of investigator Giorgio Ambrosioli.

Archbishop Paul Casimir Marcinkus was a huge, charming American of Lithuanian heritage, born in 1922 in Cicero, Illinois—Al Capone’s neighborhood. He got his big break in the early 1970s when a knife-wielding assassin lunged at Pope Paul VI during a papal tour in the Philippines. Marcinkus tackled the assassin, saved the pope’s life, and instantly became a star in the Vatican. Pope Paul VI gratefully made him head of Vatican Intelligence and Security. Then, with Cardinal Spellman’s backing, Marcinkus became chairman of the Istituto per le Opere di Religione (the Institute of Religious Work, known in Europe as the IOR), better known in the United States as the Vatican Bank.

Marcinkus was now bishop of Orta, chairman of the Vatican Bank, chief of Vatican intelligence, and mayor of Vatican City. The Vatican is a sovereign state surrounded by Italy. Archbishop Marcinkus headed both the bank and the intelligence service. That seems a bit like allowing the CIA to run the Federal Reserve Bank. Who watches the watchers? Such concentration of power can speed up a due diligence meeting, and the charming archbishop liked his spare time; he was an avid golfer.

Among other functions, the Vatican Bank administered some of the tithe, also called “Peter’s pence,” that the global congregation of the faithful contributed to the collection basket during the ceremony of the Mass. The faithful give their hard-earned after-tax money with the trust that it is being used to spread the word of the gospel and to do good works.

When Pope Paul VI died in 1978, the College of Cardinals elected Albino Luciani, the cardinal of Venice. He ascended to the papal throne as Pope John Paul I. The new pope was furious with Marcinkus, who had sold the profitable Venetian Bank, Banco Cattolica del Veneto, to Roberto Calvi over the then Cardinal Luciani’s vehement objections. He vowed if he became pope, he would put an end to Archbishop Marcinkus’s power and influence over Vatican affairs.

Pope John Paul I didn’t have a chance to implement his plan. He reigned only 33 days. Vatican intelligence said Pope John Paul I died of natural causes, albeit he was reputed to be in good health. Speculation over the cause of his death inspired a scene in the movie The Godfather Part III, depicting the Mafia-directed murder of a fictitious pope.

Pope John Paul II’s election was a stroke of luck for Marcinkus. The Polish pope was initially an outsider in the Vatican power structure. He was the first non-Italian pope since Hadrian VI in 1522, almost 500 years earlier (the current pope, Benedict XVI, is the second). Marcinkus and the new pope became fast friends; both were hulking Slavic men, and they instantly hit it off. The traditional Italian Vatican power structure gradually lost its control. Marcinkus helped the pope find his power base and reported directly to him.

The Vatican Bank (IOR) controlled several offshore shell companies involved in the embezzlement of funds from Banco Ambrosiano. For example, the IOR accepted time deposits from Banco Ambrosiano’s Lima, Peru, operation. The IOR lent the money to a Panama shell company. At maturity, the IOR refused to pay, claiming the Panama company owed the money, but the Vatican Bank held the share certificates for the company as controlling fiduciary for Banco Ambrosiano.

In 1982, Banco Ambrosiano collapsed. Roberto Calvi was alleged to have looted $1.3 billion from Banco Ambrosiano. The Vatican Bank paid a $250 million settlement to the defrauded depositors of Banco Ambrosiano, but the Vatican Bank admitted nothing. Calvi had turned to the Catholic Church in his hour of greed, and the worldwide Catholic community unknowingly gave a large donation to help cover his malfeasance. Catholic priests take a vow of poverty. Members of the congregation sometimes wonder just who it is the priests have vowed to impoverish.

Marcinkus used the Alzheimer’s defense: “I’m not a crook, I just can’t help it if I don’t have all my wits.” He claimed he didn’t know what he was signing. He had studied law in Rome and was chairman of the Vatican Bank for 10 years, yet he claimed he’d never read or didn’t understand the documents he signed. He said he trusted Calvi and claimed Calvi took advantage of his naïveté.

At the time of Banco Ambrosiano’s collapse in 1982, Roberto Calvi was serving time for illegal foreign money transfers. After being released on appeal, Calvi fled to London, carrying a briefcase stuffed with incriminating documents. Flavio Carboni, another bank officer, joined him. Shortly after his arrival in London, Roberto Calvi’s corpse was found hanging under Blackfriars Bridge. His pockets were stuffed with rocks, and it was rumored his wrists looked as if they had been bound with rope that was later removed. Carboni and the documents were missing.

After his side trip to London with Calvi, Carboni resurfaced. Italian officials arrested him attempting to extort $900,000 from Vatican officials in exchange for Calvi’s stolen documents. Bishop Pavel Hnilica, a key member of Marcinkus’s inner circle, was arrested trying to buy back the incriminating documents.

Archbishop Paul Marcinkus was indicted and sought for questioning by Italian authorities during the investigation of Banco Ambrosiano’s collapse. He lived in the Vatican for six years during the papacy of John Paul II, never stepping foot in Italy, where he would have faced arrest. Eventually the Vatican came to an agreement with Italy to drop the matter. Marcinkus did not step aside as head of the Vatican Bank until 1989, and he remained pro-president of Vatican City until his retirement in 1990. He retired to the United States and lived as a parish priest in Sun City, Arizona, where he enjoyed his favorite pastime, golf.

Roberto Calvi’s death was officially deemed a suicide in 1982, after a hasty investigation by London authorities. In 2002, 20 years after Calvi’s death, Italy performed a new postmortem examination of his remains using modern forensic techniques. The examiners concluded that Calvi’s murder was staged to appear to be a suicide. He had been strangled and then strung up to the scaffolding under London’s Blackfriars Bridge. Licio Gelli, a former grand master of the illegal P2 Masonic lodge, serving a prison sentence for his role in the Banco Ambrosiano fraud, was investigated. Four others were indicted in 2005: Flavio Carboni, who had fled with Calvi to London; Manuela Kleinszig, Carboni’s Austrian girlfriend; Ernesto Diotavelli, an underworld figure from Rome; and Pippo Calo, a boss of the Cosa Nostra, who is already in prison for other crimes. Prosecutors suspected Calvi knew too much about Mafia money being laundered through the Vatican Bank and through Banco Ambrosiano. All of the suspects were found not guilty in June 2007.

Marcinkus died on February 20, 2006, at the age of 84, without ever volunteering any information—despite the ongoing trial—that might have helped solve the murder of Roberto Calvi. In the face of murder and suspicious financial transactions, the Catholic Church has remained silent. The Vatican is still a sovereign state, and it is still a popular offshore venue with a unique approach to nonregulation.

If you can’t trust the Vatican Bank to safeguard your money, whom can you trust? The answer is no one. At least, you can’t just accept things at face value without doing independent verification.

That’s why the financial markets are pushing for greater transparency. One should know one’s customer. Suspicious transactions must be reported. The trouble is that many of these transactions appear legitimate on the surface. At the time of Calvi’s creative workmanship, it would have been extremely difficult to untangle the ownership structure of the shell corporations, especially with bank officers involved in the deception.

As an example of how a web of shell corporations obscures ownership, let’s suppose I’m a drug lord with lots of cash. My circle of friends seems to have the same problem I do. We want to spend our money to buy nice things, but people don’t want to do business with us if they can trace the money back to our enterprises. We might begin by using couriers to carry currency out of our home countries. We might even buy gems and jewelry and smuggle them out. I might make a very generous donation to my church in my home country, which later shows up as a bank balance in my name in another country. The money is transferred directly from the church account to the account of several shell companies to disguise its true ownership. I’d use some corporate-friendly venues to set up the phony corporations.

Now suppose you are investigating me and find an account set up in the name of RANA Corporation, and you suspect this account has links to my drug money. The only reason you suspect this is because you got a tip-off. Apollo Corporation owns 60 percent of RANA, and Delphi Corporation owns 40 percent. Tech Corporation owns 30 percent of Apollo, and Mark Corporation owns 70 percent. Lana Corporation owns 50 percent of Delphi, and Capa Corporation owns 50 percent. Are you still with me? Or have you fallen asleep after wading through a stack of documents that could sink a ship?

I own Tech Corporation. RANA Corporation’s only assets are a $1.2 billion cash account in a Basel bank. That means that of the $1.2 billion, my share is 30 percent of 60 percent of $1.2 billion, or $216 million. And that’s just in the RANA account. Tech Corporation also has part ownership in a few other corporations.

These are private corporations. They don’t have to disclose anything. It is extremely difficult—if not impossible—for you to discover that I’m the true owner of Tech. It’s also difficult for you to discover the true owners and ownership interests in the other corporations.

This is what all the fuss is about. Legitimate means can always be twisted to serve illegitimate purposes. The legitimate international banking community is doing its best to crack down on money laundering and suspicious movement of money across borders.

Yet chicanery continues. Long after the Banco Ambrosiano scandal, Enron’s former officers set up corporations with complex ownership structures. Loans were made; interests were conflicted; pockets were lined; officers were indicted and jailed. RBG Resources PLC, Allied Deals Inc., Hampton Lane Inc., and SAI Commodity Inc. allegedly used shell corporations to falsify transactions and fraudulently secured cashable letters of credit.

American Tissue was the fourth largest tissue company in the United States before its bankruptcy in 2001. Several lawsuits include the following allegations. The owners allegedly borrowed hundreds of millions and diverted the money through a network of affiliated corporations. American Tissue was owned by Middle American Tissue as its sole asset, which was owned by Super American Tissue. It’s estimated American Tissue had more than 25 subsidiaries. One of the owners set up around 45 companies, which were affiliates of American Tissue. American Tissue lent money to the affiliates, and the loans required no interest payments and had no maturity. American Tissue bought machinery for several million dollars, and sold it to one of the owners for one dollar just two months later. Arthur Andersen, American Tissue’s auditor, is being investigated by the U.S. Department of Justice for allegedly taking a role in shredding American Tissue documents.