Inventing mortgage-backed securities

Lewis Ranieri is credited with inventing mortgage-backed securities two decades ago, and recently he sounded warnings about mortgage risks. Yet he couldn´t save his own company from getting tangled in the real-estate loan bust.

That´s alarming — not just for investors in his small Franklin Bank Corp., but for anyone hoping the credit crisis would end soon.

If someone with Ranieri´s clout missed the mark on the mortgage mess, what other land mines could still loom at financial firms with less experienced directors.

"It is a matter of faith among the risk management community that Lewis Ranieri is God — or at least knows God," said Christopher Whalen, managing director at the consulting firm Institutional Risk Analytics. "But at the moment Ranieri, who is best known as one of the founders of structured finance, is not having a lot of fun."

Housing prices have tumbled and borrowers at alarming levels have defaulted on their home loans. That has wreaked havoc on the credit portfolios of many banks and other financial institutions. They´ve collectively taken more than $200 billion in write-downs over the last year on their assets, largely to reflect the plunging valuations of their mortgage securities.

If anyone could have seen this coming, it should have been Ranieri. He is known as the pioneer of the mortgage securitization business, whereby home loans are repackaged as bonds and sold off to investors. He built that into a big business while at Salomon Brothers in the 1980s, and it grew into a lucrative profit driver for many investment banks, especially during the recent housing market boom.

His expertise also made Ranieri a sought-after speaker on the subject, and in recent years he publicly voiced concerns over the lack of transparency in the process of taking risky loans made to borrowers with no income or credit history and bundling them into bonds.

"Mandated level of disclosure for capital markets has not kept up with the mortgage-product innovation, making the risk level in residential mortgage-backed securities not readily available or easily transparent," Ranieri said at a conference in December 2006. "This stuff doesn´t just get sold to money managers. It gets sold to the public and to foreign investors who don´t have a clue what to look for."

But even with all of his insight, Ranieri fell down on the job as the chairman of Houston-based Franklin Bank, which he founded in 2001 with CEO Anthony Nocella.

On Franklin´s Web site, it says the bank´s senior management team has "extensive experience building high quality, profitable financial services franchises in our niche products."

Franklin´s profit growth slowed in 2007 as defaults rose in its home and commercial loans. It finished the year with a $66 million loss. Investors began losing faith, pushing its stock down from levels around $20 a share at the start of last year to just over $4 a share by year end. Its shares now trade at around 96 cents.

Monday´s news took the situation from bad to worse: The board´s audit committee found during a 10-week investigation certain weaknesses in the company´s accounting, disclosure and other issues relating to its residential real estate loans.

Franklin improperly booked certain single-family mortgage loan modifications, which had been done in an effort to reduce delinquencies and mitigate foreclosure losses. It also failed to charge off certain uncollectible loans, and did not properly record, or in some cases write-down, the value of certain mortgage investments.

The company also said that it wasn´t properly marking-to-market — which revalues assets based on current market rates — certain loans.

The bank said in a statement that it forwarded the audit findings to the Securities and Exchange Commission, "which has commenced an informal inquiry."

"We are disappointed and surprised at the extent of the accounting weaknesses," said Jon Arfstrom, an analyst at RBC Capital Markets Corp. "The specifics of the announcement are clearly troubling and the fundamental issues at Franklin may be too severe to correct without additional capital or other strategic alternatives."

As a result of the audit, CEO Nocella "will accelerate his personal plans to retire," the bank said in a news release. Ranieri, who will take over as interim CEO, said in a statement that the board "fully accepts the findings of the independent review" and it will "take the necessary steps to implement the recommendations."

Ranieri didn´t return a call for additional comment, but Franklin executive vice president Glenn Mealey told The Associated Press that the board´s decisions were viewed to be "in the best interest of the company and its shareholders."

So Ranieri keeps his job for now. His reputation, however, has been tarnished.

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