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Do the Treasury Proposals on Securitization Reform Go Far Enough?

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The Treasury Department’s plans for securitization reform are being bandied about in the press. A key question is whether it can or will fix the now-broken private securitization process.

Credit became more dependent on securitization than many realize. By pretty much any metric, the role of banks relative to other players has declined since 1980, by some measures as much as a 50% drop in market share. Securitization, which is the process of putting loans into pools and often slicing and dicing the cash flows to create instruments that are more appealing to investors, has been the big culprit.

In case you missed it, securitization has slowed down to a trickle. In the US, non-agency securitization was $900 billion in 2007, $150 billion in 2007, and a mere $16 billion through April. Now some of that was dodgy CDOs and other subprime spawn that is better off not coming back. However, if the securitization machine remains impaired, the alternative is on-balance sheet bank lending, and the authorities do not appear interested to going back to banking circa 1980. As the Financial Times notes today:

Securitised markets – which financed more than half of all credit in the US in the years immediately preceeding the crisis – are essential for the US economy. Without a recovery in these markets, the flow of credit will not return to more normal levels, even if US banks overcome their problems.

The reason securitization became so widespread is that it is cheaper than on-balance-sheet bank lending. Traditional lending requires banks to recoup their cost of equity and FDIC insurance premiums. For assets that can be packaged, securitization is more attractive.

From a policy standpoint, therefore, the desire to restart securitization is two-fold. First, it in theory produces more abundant and cheaper credit (although any reduction in yield depends on whether the banks and other participants keep all the cost savings in the form of increased profit or pass some of them on to borrowers). Second, going back to old-fashioned lending wold require banks to have much larger balance sheets, hence more equity. The banks are having enough trouble coming up with enough capital to support their current footings that raising even more equity would seem to be a non-starter.

However, it is not clear that the ideas floated by the Treasury will do the trick. It has two components: the first is requiring that the party that originates the loans to be securitized retain 5% of the deal. The second is to eliminate gain-on-sale accounting, which increased the attractiveness of securitization considerably. Again, from the FT:

The authorities plan to force lenders to retain part of the credit risk of the loans that are bundled into securities and to end the gain-on-sale accounting rules that helped spur the boom of the markets at the heart of the financial crisis…

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared. The proposed elimination of “gain on sale accounting” is to prevent financial companies from booking paper profits on loans – packaged into securities – as soon as they were sold to investors.

Banks would only be able to record income from securitisation over time as payments are received. Brokers’ fees and commissions would also be disbursed over time rather than up front, and would be reduced if an asset performed badly due to bad underwriting.

The US authorities also plan to stop credit rating agencies from assigning the same types of ratings to structured credit products that are assigned to corporate and sovereign

The proposal to change accounting and allow for clawing back of profits if a deal goes bad is probably far more meaningful than having banks retain 5%. 5% is simply not significant enough, in and of itself, to change behavior much.

However, there is an unrecognized contradiction here. The reason securitization became pervasive was both a real improvement in economics (bona fide cost savings per above) which were then compounded by efforts of banks to streamline costs further by scrimping on vetting loans (why bother if all you needed to on-sell the stuff was FICO scores and other simple metrics?). And the favorable accounting also was a considerable impetus.

Thus any activity that changes the incentives meaningfully will also reduce the attractiveness of the economics to banks. Some of this is salutary and necessary. The point is to discourage banks from selling dreck. But effective measures may reduce the size of the securitization market more than the powers that be anticipate. There may be no free, or even cheap lunches here. For instance, it might take a more meaningful retention (20%? 30%) to change originator incentives, but a proportion that lare would make securitiation a far more marginal activity and might require the move the powers that be are hoping to avoid, namely considerably more on-balance sheet lending.

Personally, I’d stick with the changes in accounting treatment proposed, but would increase liability considerably in the event of deficient due diligence and mis-selling (ie, burned investors could go after banks and rating agencies tooth and nail). However, it would take some effort and thought to come up with the right framework.

Sadly, the US seemed able to do that in the Great Depression. The provision of the securities laws of 1933 and 1934 were astute and durable. I wonder why devising good regulatory regimes has become a lost art.

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10 comments

  1. anon

    This always baffles me; saying securitizations are a problem is like blaming the car for an accident when someone was either drunk or not paying attention. Securitization is modern finance's greatest invention. It creates credit and liquidity by getting the right investor the right instrument. Reform shouldn't take much thought:

    a) make the underwriting bank unindenifiable for their underwritings down to the mortgage or loan broker. Meaning, you put crap in the portfolio and it defaults, you get sued and you pay.

    b) limit leverage on securitized pieces such much like Reg-T. Don't sell someone a Z tranche which was underwritten like crap and sell it to a fund with 40x leverage.

    c) make bond insurance illegal. It doesnt work and it gives issuers and buyers a false sense of security.

    d) make CDS allowable only by those who hold the asset to be insured.

    e) make all CDO's hybrid with the premium only reinvested in higher credit securities.

    That's all – financial market fixed. Stop complicating things people.

  2. Sergei

    I think another reason securitisation was cheaper than bank lending, in addition to the saving of return on equity and FDIC insurance premium, was underpricing of risk. The risks of loss turned out to be much bigger than assumed, which was not priced into both senior and mezzanine tranches, and investors were not compensated for taking such risks.

  3. pakman

    The reason why pre 2007 securitization lending was cheaper and hence more 'competitive' than traditional lending, is not because they have less cost ie, simple metrics like FICO scores…

    BUT BECAUSE THEY SIMPLY MISPRICED THE RISK.

    So simple why securitization is not coming back, all the metrics used to lower costs such as FICO, Credit ratings etc… Have now proven less reliable than the model suggests…

    Hence the information assymetry cost is so high as to render securitization as a whole uncompetitive.

    We here in Hong Kong (no bank failures so far) still has bankers hitting the pavement, going to factories, looking at buildings etc to vet borrowers.

    a banker's gut instinct vs a quant's model…

  4. RTD

    Forcing the originators to hold 5% of the securitized product accomplishes nothing. The big shock last fall was when the market discovered how much of the securitized products were still held on the IB's balance sheets; people thought all the risk had been offloaded but it hadn't been.

    I agree with the above posters about bond insurance (and insurance-like derivatives in general) and the underpricing of risk. The two are intimately related. The interest rate/return of an investment is supposed to account for risk. The use of bond insurance and CDS distorts this mechanism. It also concentrates risk in entities that are unlikely to be able to pay claims in the event of a systemic event, thus making the whole thing one big false sense of security.

    –RueTheDay

  5. Voislav

    I have to agree with pakman here. It's retarded to say that abandoning securitization will increase the cost of lending. The only reason lending was so cheap was that there was a sucker (read AIG) willing to insure these things at ridiculous discounts and relieve banks of responsibility of holding sufficient reserves to cover this.
    If AIG was forced to hold reserves to cover potential losses, derivatives wouldn't have been so cheap and there would be no mess. One of or another someone will have to be forced to retain sufficient reserves to cover potential losses, whether it's the banks, insurer or the exchange (if it's created). When this is rammed down their throats, guess what, conventional suddenly doesn't look so bad, since it cuts out the insurer/exchange middleman.

  6. redst8r

    @Anon: agree with your "fixes" for securitization. Wrap them up and voila' we have on-balance sheet lending.

    Agree also with all prior comments that cheaper lending was due to mis-priced risk as well as greater leverage of given capital.

    The effort to regulate away the problem is different only in the party being held responsible. Instead of AIG's CDS we'll have the regulators (sure to fail) promises.

    Honest, they are from the government and they are here to help us.

  7. tj

    as is often the case with regulatory reform, these ideas miss the big point: no one (other than the governement) wants to buy securitized bonds.
    lots of people would seel the bonds with these or other rules – gain on sale was not used by many securitizers – and this had no real impact.
    with the credibility of the rating agencies completely destroyed, and the ability to price and understand risk undermined, why would anybody invest in the bonds?

    how can the appropriate level of risk be determined? what is the right price for a pool of MBS?
    no one knows and no one has proposed a method for determining it.
    as a result, there is only one real buyer – the fed.
    as a 20 year participant in this market, i don't see securitization ever coming back. if it is going to, it will need a real system of evaluating and pricing the risk in the bonds so they can be understood and traded. this is unlikely to come from the government and, as far as i can see, it is unlikely to come from the rating agencies.

  8. Anonymous Jones

    Parkman beat me to the punch. Securitization's benefits are mostly theoretical at this point. There is no proof that the transactions costs, information asymmetry, and agency problems are outweighed by the supposed cost benefits of avoiding bank regulations and FDIC premiums. This is classic economics (theory trumps reality) by ignoring transactions costs. Yes, securitization sounds terrific in theory. I was enthralled with the idea a decade ago. I'm back to reserving judgment for now.

  9. jerrydenim

    ANON: "Securitization is modern finance's greatest invention. It creates credit and liquidity…"

    Please explain why this credit and liquidity is so awesome if it just leads to an asset bubble? What was so bad about the old classic model?

    Profit = make a worthwhile loan to a credit worthy entity, recoup interest plus principle. Vs. Profit= make stupid loan to uncredit-worthy individual for overpriced asset, sell loan to some other sucker, make 10 more bad loans.

    Decoupling credit risk from lending can never result in a good outcome. I do agree people should quit complicating things, ban securitization altogether and be done with it. It serves no useful purpose.

  10. Mark

    ANON: "Securitization is modern finance's greatest invention. It creates credit and liquidity…"

    Securitization is an OK idea at best, but the quote may be correct. Regardless, securitization will probably remain in a slump for a while. Arguably, modern finance has done more harm than good.

    The other points are amazingly ignorant — they focus on side problems and are wrong. There are too many to criticize, but one good one is making banks responsible for crappy loans. If we did this, banks would have no incentive to securitize.

    Anonymous Jones and several others make good points about a handful of securitization's many weaknesses.

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