naked capitalism

Latchy says:

I think much of it has to do with Insta-Credit. When the credit issuers started providing a lend/no lend decision in fewer than 5 minutes the FICO score became pre-eminant. At first this worked great because there was a lack of trust in the modeling and the only persons that qualified have very high FICO’s and the rest were sent for manual review. Even that is often done though without the lender so much as speaking to the customer. Of course this doesn’t apply to mortgages (at least not here in Canada). Credit card lending though is more about preventing fraud as long as the minimum FICO cut-offs are met, then digging into any of the 4C’s of basic lending. The computer does ALL that because the decision needs to be made quick. When I was a manager at one of these bailed out banks large processing offices we saw only 20% of applications for manual review. The computer did the rest of the instant gratification. Worse yet I actively worked with the credit bureaus on coming up with a similar system for small businesses, so they too could borrow without an owner cosigning….I’ve been out of the industry for 3 years now, but I wonder what that loan book looks like now.

nadezhda says:

I certainly share your concerns about the parallel phenomena of erosion of credit skills and excessive reliance on mechanical, quantiative techniques. The quantitative should have been used as terrific tools to enhance, not replace, credit skills. Maybe the MBA programs can help to start restoring some balance.

But I don’t think it’s only in the credit departments that we find folks failing to do old-fashioned homework. I’ve been appalled by the fund managers who failed to do the most rudimentary due diligence on Madoff-type schemes, such as “where are the custody controls”. And it’s not just fraud. Take, frex, the big-time pension managers who got caught not understanding the junior tranches they were buying in CDOs. But they could do a lot of handwaving with detailed graphs and charts about performance benchmarking. We can point fingers at a huge amount of misselling on the sell side, but it takes a lot of credulous supposedly-sophisticated stuffees on the buy side to produce these catastrophes.

So as I see it, it’s a broader erosion of responsibility for exercising good judgment that’s been accompanied by the increased use of quantitative CYA techniques. I don’t know how we go about changing incentives so that what was a “safe harbor” — see, I met the quantitative rules — doesn’t become a substitute for the exercise of responsible judgment.

I want, however, to come back to a theme from prior threads — your concern about whether/how to restart securitization and the future of dis- or re-intermediation.

You say:
Getting better customer input is crucial whether the powers that be are successful in putting in the reforms needed for private securitization to revive (the inaction on this front speaks volumes) or whether the end game is more on balance sheet lending by banks. So here are some questions.

What “reforms” do you think are needed to restart private securitization? Should those “reforms” put limits on securitization that would encourage re-intermediation, and if so, how would those “reforms” be designed in order to limit undue securitization risks? If so, how do you think we should be strengthening bank balance sheets so they will be able to handle a big chunk of debt financing moving out of the capital markets and back onto bank balance sheets? Re-intermediating is going to mean that the banks raise even more of their funding from the markets rather than from deposits. Which will make the “too-big-to-fail” problem potentially even larger.

I seem to be clearly missing something, but I’m not sure what we need in the way of “reforms” to restart plain vanilla securitization in housing and receivables. The impediments right now have to do primarily with risk appetite and pricing problems in the credit markets that aren’t unique to securitized assets. And at least for awhile, I doubt that “exotics”, where the disasterous risks were buried, are going to be marketable. So at least for awhile, we don’t need “reforms” to protect us from the high risk junk.

FWIW, Lew Ranieri (for whom I have a good deal of respect) thinks the steps the government is taking is making it possible for the plain vanilla stuff to start to get some traction. He said at the Miliken Conference that it will take awhile, but he’s surprisingly upbeat. And he’s not somebody whose simply a mindless cheerleader. He was certainly among those who were early in warning about the use of mortgage-backed markets to produce opaque layers of unmanageable risks. So though he’s clearly a supporter of securitization, he’s also well aware of its dangers. And he thinks the plain vanilla markets can recover.

Your thoughts?

Hugh says:

I think that the deterioration in lending expertise is another aspect of the paper economy and tracks with its growth. That is to say that it goes back to the Reagan Adminstration. I would think that the Savings and Loan debacle would be an important milestone. Another would be Greenspan’s easy credit policies. When you had so much money entering the system, there was little incentive to monitor individual loans. Then you hit the Bush years where all these tendencies get magnified through deregulation, overleveraging, and bubble/Ponzi economics.

In Debt We Trust says:

The problem is that bank officers have outsourced risk – it used to be that banks actually needed to know and be apprised of the client. Now that risk is securitized and packaged into someone else’s problem (aka supposedly the mkt). That explains why the skillset of compliance and risk went out the door.

B/c supposedly OTC mkts are excellent places for price discovery.

Anonymous Jones says:

I think nazhedzha’s post is one of the better posts we ever see here on NC, but as much as I respect Ranieri, I’m not sure the spreads in vanilla securitizations could ever support the transactions costs involved (without duplicity or massive fraud by rating agencies and the likes of AIGFP). Why would anyone expend the effort to engage in securitizations (with all the legal and finance costs involved) without a payout that is above market? Color me skeptical.

nadezhda says:

@Anonymous Jones: Thanks for your comment! Let me follow up on your skepticism, however. You wrote:
Why would anyone expend the effort to engage in securitizations (with all the legal and finance costs involved) without a payout that is above market? Color me skeptical. Because the plain vanilla stuff involves neither huge transaction costs nor an above-market payout.

Basic securitization, involving standardized, well-understood cash-flow streams with a pretty big equity cushion embedded in the structure was a very valuable financial innovation. It uses the capital markets to match risk/yield/duration preferences of different classes of investors. Take conforming mortgages with max 80% LTV ratios and what used to be pretty standard credit assessments of repayment capacity of borrowers. Standardization and a sizeable equity cushion means that the transaction costs of bundling, tranching and marketing the securitized assets are modest relative to the size of each bundle. The cash flows from the bundles could be sliced to give different risk/yield outcomes. The investors who bought the safest tranches were paying more (getting lower yield) than the mortgage market for individual loans. The yield differential went to investors who were looking for a higher yield and willing and able to take on greater risk.

What destroyed securitization was adding a whole bunch of bells and whistles to try to get to the same result as plain vanilla securitization. So they used models that relied heavily on diversification, ignoring that the apparently diversified bundles would heavily correlate in wide-spread economic distress. (Plalin vanilla securitization does include diversification as one technique to enhance risk protection but doesn’t rely primarily on diversification.) They added wraps from AAA rated institutions where neither the rating agencies nor the markets were taking into account the extent to which the AAA status was being destroyed by the promiscious monetization of the AAA rating. They added to homogenous bundles of mortgages lots of odds and ends of “highly rated” junk when even their poorly designed models didn’t produce the right results. They layered securitized assets and derivatives in increasingly exotic and model-dependent instruments that appeared like magic to make risk disappear.

It’s this stuff that ultimately doesn’t make sense financially due to transaction costs and “an above-market payout”. It’s not going to come back — at least for a few years.

But the inefficiences of exotics doesn’t change the cost-effectiveness and market efficiences (intermediating borrower and investor preferences) of plain vanilla securitization.