Introduction to Securitization

FRAUD RISK

Among the operational risks in an asset-backed transaction, the risk of fraud should not be underrated. Fraud risk remains present in every sphere of activity, but there is reliance on several independent agencies each handling a fragment of the transaction in securitizations. This is the perfect setting for a fraudster, who takes advantage of the fact that there is no one with overall responsibility for the transaction; each party has a split segment of responsibility. The servicer is concerned only with what he is paid for, the originator is presumably hands-off, and the trustees are legal watchdogs who step into action only when they are made to smell something wrong.

While instances of systematic Ponzi-type devices exist in the past, such as Towers Healthcare, one of the recent instances of fraud in asset-backed securities was National Century. National Century Financial Enterprises (NCFE) filed for bankruptcy in November 2002 and brought to the fore some unique risks of mishandling securitization funds. NCFE specialized in health-care funding and used to buy health-care receivables from several health-care centers in the United States. These receivables were securitized. Shortly before the bankruptcy filing, it was revealed that the company was misusing the funds collected on behalf of its securitization clients. Investigations revealed frauds by the company’s top executives, resulting in a filing of the bankruptcy petition. Approximately $3.5 billion of asset-backed ...