Bankruptcy

Lots of Smart People Couldn't Possibly F*%! Up, Could They?

By Adam Levitin

In relation to the chain of title argument on securitization, I have been repeatedly confronted (often unsolicited) with an argument that there's no way there were massive screw-ups because thousands of top Wall Street legal minds were working on securitization deals.  Yes, and there's no way the underwriting was lousy on the mortgages themselves because thousands were being done.  I tend to get this argument from people with a large financial stake in ensuring that securitizations don't fail. This is a really bad argument, so let me just debunk it now (and hopefully never hear it again):

•  First, even smart people screw up sometimes.  We lesser folks tend to screw up even more. Anyone remember Long Term Capital Management?  Weren't those the "Smartest Guys in the Room?"

• Second, this isn't generally a question of deal design, which is where the brain power in securitization was applied.  Chain of title is a question of deal execution.  The exception is the question of whether notes can be transferred in blank to a trust, but that's not an essential design question.    

• Third, the best legal minds in the country weren't doing diligence on endorsements on securitization deals.  Those people who did the diligence faced lots of time and economic pressures militating against careful diligence.  As a general matter, the quality of legal diligence (and I'm guessing other diligence) on most deals, regardless of the quality of the law firm is shockingly bad--often diligence is conducted by associates who have no idea what a problem would look like and are under intense time pressures to get the diligence done in time for a closing date. I think the problem was likely worse in structured finance. Say there were 7,000 mortgages in a typical RMBS deal.  No one wanted to pay out partner bucks to have 7,000 sets of signatures examined.  If a partner reviewed around 50 notes an hour, it would take about two weeks to do the diligence just on this one point and at say $700/hr billing, that would be around $100k in added legal expense and would be time that the partner couldn't spend on other more important matters (like other deals).  If there's enough work to keep everyone busy as can be, as there was during the bubble, why not give the mindless diligence to the first year who is billed out at $200/hr? The point here isn't that $=quality (they don't), but that the mind-numbing diligence on the endorsements was likely done by inexperienced attorneys because of the economics. 

• Fourth, it's pretty easy to imagine the way an error in the diligence process could occur, even with a diligent associate. Some deals do not require a full chain of endorsements, so there could be a path dependence problem where associates got diligence instructions based on that deal template and then mindlessly repeating the process on another deal that required the full chain of endorsements.  

• Fifth, there was certainly no incentive for an associate to be overly diligent.  Everyone wanted the deals to happen, no one wanted to stand in the way.  Structured finance associates had no trouble meeting minimum billables during the bubble, so why spend extra time being careful and getting behind on your work and losing the sliver of non-work time that existed?  No one got paid more for finding mistakes in the endorsements. 

• The ASF white paper says that a dozen or so top law firms reviewed it. If so, this to me is simply proof of the problem--if a bunch of top securitization firms reviewed the ASF white paper and didn't comment about the lack of discussion about trust law, there's a real concern about how well the attorneys involved really did understand the legal framework for securitization. (I would also note that these law firms probably have large exposure to this issue both from having conducted the diligence and from having written opinion letters about the assets being bankruptcy remote, although the "would" or "should" language in those opinions will give some cover as the letters assume compliance with the deal terms.) 

• Finally, remember Y2K?  We got lucky with that, but we nearly had an example of lots of smart people screwing something basic up.  We'll have to see if this turns out to be a dud Y2K or the real deal.  Of course, if we think it might be the real deal, it might be best to act now, rather than later when there is a real crisis to try and fix things. 

This isn't to say that things are necessarily screwed up, but surely the presence of lots of smart people in designing securitization deals does not support an argument that the deals were properly executed.  

Full post as published by Credit Slips on November 22, 2010 (boomark / email).