FDIC Proposes Tough-Minded Securitization Reforms; Industry Howls

As readers may know, the financial reforms proposed by the Obama administration barely deserve the name. The late-in-the-game efforts to rebrand the effort by putting Paul Volcker in the forefront and patch up one of the gaping holes, that the government is backstopping risky trading businesses (Goldman Sachs has issued FDIC guaranteed bonds) illustrates the typical Obama chasm between rhetoric and action.

So it was a pleasant surprise to learn that the FDIC presented a cogent and tough-minded plan for securtization reform at the American Securitization Forum. Surprisingly, I haven’t seen a write-up at my usual first stop for this sort of thing (Housing Wire) and a search of my RSS reader shows no posts on this “advanced proposal of new rulemaking” which was made public back in December.

This is clearly a topic of keen interest; an estimated 1000 people attended Michael Krimminger, Deputy to the Chairman for Policy at the FDIC’s presentation and follow-up panel discussion. I’ve been skeptical of various ideas to “fix” securitization, but this one would do the trick. And it will also have the effect inherent to any program to restrain profligate and irresponsible lending: it will reduce credit extension and increase costs to the industry. That’s a feature, not a bug. But many incumbents seem unable to accept that a return to healthy practices means an end to cheap credit.

Given all the attention to Volcker’s proposals, I’m amazed that this FDIC proposal has gone virtually unnoticed. Yes, Volcker is a big name and Krimminger isn’t, but bad mortgage lending, which took place primarily through securtizations, was at the heart of the crisis. How is this story not important?

In addition, this FDIC proposal supports two of my other pet theories. One is that it is possible for regulators to come up with effective reforms if they have the will. This is a cogent and well designed plan. Second is the FDIC is the only Federal banking overseer that takes regulation seriously (the SEC might have once upon a time; it might be possible for it to rebuild that skill. The Fed is beyond redemption here; it is dominated by monetary economists who not only don’t know what they don’t know, but also are unduly respectful of the wonders of financial markets. The FDIC, by contrast, is not overawed by banksters).

I’m at a bit of a disadvantage by not having attended the presentation; I’ve also read the FDIC notice and hope between it and the comments received from some people who did attend the panel that I am presenting the FDIC plan accurately.

The driving element is that the FDIC is proposing to change the requirements for a securitization to be treated as a true sale, meaning that when the originator sells the mortgages to a securitization vehicle (say a trust), the investors in that vehicle cannot go back to the originator for recourse. Banks also need a “true sale” treatment for accounting and regulatory purposes; otherwise, they’d have to report their interest in the mortgages on their balance sheets and hold equity against the exposure.

The FDIC proposed these major changes (these are high-level summaries; comments encouraged):

1. Mortgages must be seasoned 12 months before they can be securitized

2. The originator must retain at least a 5% interest in the credit risk of the assets sold

3. The interest of all parties to a transaction must clearly be disclosed, along with their fees

4. Re-securitizations (meaning CDOs) are not permitted (note a disconnect here; the e-mailed and verbal reports suggested they were banned entirely; the language at the FDIC website seems to indicate that they are allowed in limited circumstances, but any use of synthetic assets, meaning credit default swaps, in a asset-backed CDO is verboten)

5. Compensation to servicers will include incentives for loss mitigation

This is an elegant little list. I had been critical of earlier proposals that merely called for originators to retain a 5% interest as being too small an economic stake to change behavior sufficiently. But in combination with the 12 month seasoning requirement, it require the originators to bear a fair amount of risk. Indeed, as we have found out, a high proportion of the loans that went boom did so in the first year. This change would force banks to up their game considerably as far as borrower screening is concerned.

A reader provided additional detail:

The FDIC included various proposals to insure transparency for investors, including a requirement that all deals be arms length, to third party investors (no affiliates or insiders). They would exclude derivatives (excluding interest rate swaps) and would not permit re-securitizations. Provisions would mandate clear documentation, segregation of assets and documents, separate documents that specified the related parties role (ie a seller/servicer would have separate documentation for its roles for each function), clear descriptions of the capital structure with disclosure of all fees paid to any third parties to the transaction (including rating agencies), and ongoing disclosure about performance, modifications and advances.

Additional requirements with respect to mortgages would include a prohibition against advancing for delinquent principal and interest for more than 90 days and the affirmation that all laws related to the origination of the loans had been complied with.

From the FDIC perspective, all of these requirements seem reasonable – the FDIC has incurred substantial costs from failed banks (they estimated that they would see more failed banks this year than they did in 2009!) and lack of transparency, skin in the game, appropriate diligence and so forth were a big part of the reason for these failures.

One observer noted that a clever effect of this proposal was that it solved the problem of “what to do with rating agencies” by making them irrelevant (well not entirely so, some fiduciaries are required to consider ratings). The near or total elimination of CDOs would reduce the potential for mishap; the greater disclosure and improved originator incentives would reduce their importance in simpler structured credits.

The resecuritization restriction/ban is also crucial. CDOs are a bad product (and please do not argue otherwise; even the supposedly “better” high grade CDOs have hit the wall in truly impressive numbers; an examination of ratings histories also shows that the supposedly “better” 2004 and 2005 vintages have had impressive downgrades of AAA tranches) and ultimately a Ponzi scheme. CDOs were crucial in enabling subprime to get as bad as it did. Ironically, the equity tranche of subprime bonds could be sold (they got the overcollateralization and excess spread, so if a deal did OK, it paid back nicely and in a short period). The BBB tranche was unwanted, and the A and AA tranches has limited demand. So they were sold into CDOs.

Ah, but the lower-rated tranches of CDOs were ALSO unwanted (for reasons I discuss at length in my book, the equity tranche came to have buyers, for all the wrong reasons). So they got rolled into CDOs. and I don’t mean CDO squareds. Regular CDO permitted a surprisingly high percentage of “inner”, meaning lower-rated, CDOs tranches.

So all these undesired pieces of RMBS and CDOs kept being rolled forward into new CDOs. That ultimately required that the market for CDOs keep growing, a condition that would of necessity fail at some point.

The industry, predictably, complained bitterly at these requirements, muttering darkly that securitization would no longer be attractive and they’d have to fund mortgages with deposits. Well, a lot of mortgages DO remain on bank balance sheets, and they’d be subject to regulatory review if they stayed there. If the industry is saying we can’t have safe securitization, then maybe we can’t have securitization at all (it certainly isn’t acceptable to risk another financial meltdown to preserve securitization, but if that really is where things stand, we might need a phase-in to give the market time to adjust).

More comments from a participant in the session, who was very complimentary of Krimminger (he politely but firmly deflected self serving industry BS):

After the panel, the view from people in the industry i spoke to is that the government seems to be trying to do two conflicting things – 1. encourage banks to lend again and 2. make the process of securitization so onerous that there is no motivation to lend. everyone i spoke was frustrated and confused about the intentions of the government.

Why?

the proposed reforms actually address a host of issues that any rational investor or taxpayer would be concerned about. However, the result of these proposals would, potentially, make securitization so costly, that bank lenders would be better off keeping all assets on their balance sheet and funding them with deposits. Interesting, right?

The FDIC also noted that they would be issuing their own securities soon as part of their resolution of failed banks. While no time frame was indicated for such issuance, when the FDIC pursues this path, they can demonstrate how securitization should look under the new rules and set the standards for the process. Or perhaps they will learn that it is too expensive and they will modify their own rules to facilitate the process.

Yves here. The industrys’ reaction suggests the supposed magic of securitization was (perhaps with the exception of very high quality borrowers) mere hocus pocus. The reason securitization was cheaper than keeping loans on bank balance sheets was that it saved the cost of bank equity and FDIC guarantees. But those were buffers against risk. Those risks don’t go away when banks sell them, they merely get transferred. And a lot of additional costs were incurred in that transfer process (although, banks skinned down their borrower screening processes, so it isn’t clear if there was a net cost addition). Ultimately someone has to bear those risks, and those “someones” as in end investors, were fooled by a long bull market in real estate, into underestimating those risks.

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28 comments

  1. Paul Tioxon

    FDIC Major Change #1. 12 months seasoning. Given the total disaster we are backing out of slowly but surely, 12 months seasoning is a good filter, establishing well understood and generally accepted mortgage underwriting guidelines. In good times, when people had to actually submit to underwriting. Let’s look at seasoning, coming out of an acute period of catastrophic proportions, of at least 24 months, the time it takes anyone to reestablish a good fico. After legislatively agreed upon cooling off period, the 24 months can go to 18, eg, when unemployment goes below 6%. Do not even think of a reduction to 12 months for something as trouble producing as securitization. Mortgages went from under a $Trillion to $4.5 per/yr in less than 5 years, from the end of the 1990’s. The rate of change is too fast to observe to regulate properly, and needs to be reduced to a human scale proportion of easily observable and measurable events that regulators can get their arms around.

  2. Jim

    Great post. Now I want two more things. Simple things.

    First, I want the no-call rule to mean the no-call rule. I can only wonder how many people would not have bought a sub-prime if they hadn’t been called by a focus grouped broker.

    Second, in countries many of these mortgage instruments are illegal. There is a reason for that. I have an MBA and it took me over an hour to fight the terms out of a couple guys I have listened to. It used to be that fiduciary duty for doctors, lawyers and bankers meant something. And saying, “Buyer beware” is not enough in these circumstances. These mortgages were too risky even for the people selling them. That is the real lesson.

  3. albrt

    Great post, and the first really encouraging thing I have heard since Obama appeared to go into acute phase dissociative identity disorder in the run-up to the state of the union address. Maybe Volcker is a decoy. Hope this gets picked up elsewhere.

    Of course, higher effective interest rates tend to dampen economic activity. But if “effective” interest rates were defined to include the eventual cost of all the fraud and malfeasance that went on last decade, we’d be getting a bargain with this proposal. There’s no way to dodge those costs in the long run.

  4. gordon

    So,how does this stack up against your view that “market-based credit” is here to stay (your post “Volcker Does Not Get It” 31 Jan.)? Wouldn’t eliminating CDOs fly in the face of that? Or are non-mortgage CDOs still OK?

  5. ozajh

    I’m not so sure that FDIC guaranteeing Goldman Sachs bonds is the best available example of “backstopping risky trading businesses”.

    Just sayin’. :-)

    1. Yves Smith Post author

      It lowers their cost of capital, How is overly cheap funding to a levered business not of benefit to trading operations, which use capital? I don’t understand your reasoning here.

      1. Yearning to Learn

        Yves, ozajh is making a joke highlighting the word “risky” and adding the smile. Goldman isn’t risky because they always win, either through skill or il/legal connections or both.

        MORE IMPORTANTLY:
        It is our DUTY to inform our ignorant Congressfolk about these things financial. Many of them are smart and even honest, but ignorant and thus awed into submission by the financial elite. The only ones who can fight this ignorance are those with knowledge, like you.

        Thus, I feel it is ALL of our duties to notify our legislators about this FDIC proposal. It’s the only way it might happen. Otherwise it will be over-ridden by a different ineffective lobby-initiated “reform” package.

        So please: all of you WRITE or even better CALL YOUR CONGRESSFOLK and let them know! I know I am (right now)

  6. a

    I’m not quite sure of your position on securitization now, Yves. I *thought* it was that securitization wasn’t going to go away, so it needed to be highly regulated. But, it sounds like this proposal may make secruitization so costly that no one does it any more (“the result of these proposals would, potentially, make securitization so costly, that bank lenders would be better off keeping all assets on their balance sheet and funding them with deposits”). So why not just call a spade a spade and ban securitization from the start?

    1. Yves Smith Post author

      That is the comment I got from someone at the conference, and that seemed to be more industry threat.

      First, this proposal applies mainly to mortgage securitizations. It appears auto and credit card securitizations will be treated differently. I probably should have been clearer re the focus on mortgages .

      Second, if the economic consequences are as dire as the industry suggests, this proposal will sadly be gutted or maybe phased in over five years. The issue is not the deposit funding per se; it’s that the banks would need a ton more equity to support the bigger balance sheets that would go with keeping rather than selling mortgages. Where will that equity come from, exactly? Even just warehousing them for twelve months has big balance sheet implications.

      1. a

        Well ok. But I think you’re caught between a rock and a hard place, myself. Regulation lowers risk but adds cost. Maybe you can add the right regulation to lower risk enough without adding too much cost, but I see no reason why one should expect this to be a possible solution to the equation. Since securitization necessarily loses information, it seems more plausible that any solution via regulation either doesn’t lower risk enough or makes it too costly to do securitization at all.

        1. Siggy

          TBTF needs to be erased from the lexicon. Forcing lenders to have higher levels of equity and to exercise genuine due diligence and to limit securitizations to the pool in hand and no further would force the change on this market that needs to occur.

          At some point, by rational action or reaction to catastrophe, this business of trying to borrow our way to prosperity has to cease. What the FDIC is proposing is a step in the right direction. The orginate to distribute model is the devil’s playground that needs to be eradicated.

          If anyone thinks that CDO’s are a way to disperse risk, they are seriously retarded. You don’t need a computer to understand that a CDO represents the concentration of risk.

          1. a

            Just to be clear, I think the solution is to ban securitization, myself. So I’m fine with putting in regulation which is so onerous that it kills securitization

    2. Chris

      I think the point is to clean securitization up to the degree that organizations who aren’t backstopped by the government might consider buying said securities. Without the ability to have the taxpayer pick up your losses, and knowing what we now know, would you ever consider buying one? I wouldn’t, unless measures like the FDIC proposes were implemented (and even that would only be a starting point). If a product is so flawed that only the TBTFs will buy it, it deserves to be shut down.

  7. jake chase

    sounds like lipstick on the pig. retained equity of 5%? who takes the rest, Fanny and Freddy? Only idiots will buy securitized mortgages going forward. How do you feel about holding them in your own portfolio? This is a prelude to taxpayer supported mortgage drek. Why involve banks at all, just so they can book fees?

  8. dlr

    This looks to me like rearranging deck chairs on the Titanic. What good is a 1 year holding period with all of the ‘introductory low rate’ adjustable mortgages?, and the ‘pick a pay’ mortgages? , and the ‘interest only’ mortgages, and the ‘negative amortization’ mortgages?

    In the S&L crisis there were plenty of people were willing to make crazy loans even when they had to keep the loans on the books, because they had a very short term point of view. They were basically looking to loot the banks of assets. They didn’t care what happened to the bank long term.

    Surely that is also the mindset of the traders and managers at large banks (naming no names, but rhymes with (GoldmanSachsMorganChaseMerrilWachoviaLehmanBearSternsAIGWellsFargoCitibankBankofAmerica) with their ‘break the bank’ sized stock options and bonuses and reckless, irresponsible behavior. Or should I say with their ‘LOOT the bank’ sized stock options and bonuses and reckless, irresponsible behavior.

    These rules won’t change those mindsets. They will figure out how to game them in about 20 seconds flat.

  9. doctoRx

    The 12-month rule can be gamed numerous ways. Here’s one:

    Create a 1//29 type of 30-yr mortgage. Year 1 has a teaser interest rate if any at all. Since there is essentially no principal repayment in year 1 on a 30 yr mortgage, voila! Every mortgage is good for 12 months. Month 13, though, is another story.

    There are numerous other ways around this.

    Also, the 5% rule is BS. Here’s mathematical proof:

    Let’s say the originating bank (and, indeed, who needs banks involved?) officially values the mortgage at 100 cents on the dollar but believes it’s only worth 80 cents. If it only has to keep 5%, then its expected loss is only 1 cent on the dollar. If it makes more than that in profit margin, it has a net winner.

    IMO the only solution is to get the government (you and me) out of making mortgage debt sacrosanct. If someone out there wants to own a house vs. renting or living in a cave, and wants credit to do so rather than paying cash, what do I care? Let private industry handle the whole deal start to finish. Don’t take the risk that exists today of national bankruptcy.

    From a policy standpoint, talk about malinvestment. We may go bk as a society because of granite countertops!

    1. DownSouth

      doctoRx,

      You operate on three assumptions:

      1) Bankers are just too smart and there is no humanly possible way to regulate them or their practices. (In this you are joined by dlr above)

      2) Laissez-faire doesn’t pose a threat if bankers are made to suffer the consequences of their own actions

      3) Bankers who engage in imprudent and risky behavior should not and will not be bailed out when they get in trouble.

      My problem is that I see little empirical evidence that any of these assumptions are true.

      1. Siggy

        The your seeing what happened. And rigthly so. Go a bit further Laissez-faire is a curious point of view in terms of political economy. It never did work and it never will. A functioning society requires rules. So, lets us have some rules. The proposed FDIC rules are hardly the last word, they are, however, a politcally reasonable start.

  10. RueTheDay

    I have a question:

    If ALL forms of “credit insurance” (not just CDS, but also guarantees by GSEs, monolines, etc.) were eliminated, would there still be a viable market for securitization?

    I have a hunch the answer is either no or “only a very limited one”.

  11. meli

    Yves, you’re on fire today! Great post. The only thing that I don’t see addressed here is some sort of standardization of securitizations. In addition to protecting the taxpayer who bails them out, we need to build in some sort of protection for the ultimate investor, and that protection needs to include some sort of mechanism to ensure that the end security is comprehensible.

    (What I’m remembering here are the securitizations with little quirks in them that were designed to detonate under certain conditions that were very unlikely to be picked up in any analysis short of completely reverse engineering the deal. That nonsense has to stop.)

    Industry will howl that they need to be able to adapt to changing circumstances, and I’m ok with that, but they should have to submit new structures to some regulatory agency which gives it a stamp (formerly the rating agencies and a very bad choice.) That agency has to be able to reverse engineer the deal and the ability to price it has to become public through some mechanism. That will slow down the process somewhat, but so be it.

    The reason this is so important is the same reason I disagree with Jake. Lots of people who are not idiots will invest in these going forward for a simple reason: they have to invest in something. For demographic and a whole host of other reasons, the pools of money in pension funds and insurance companies are so large that they have very few places to turn without completely trashing markets. The US real estate market is a perfect place for that, but there need to be rules.

  12. Mindrayge

    There was an article back in December (I believe it was in HousingWire as part of a preview of an upcoming magazine article) where one of the proposed requirements was that existing securitizations would have to prove that the origination of the mortgages complied with all laws and regulations in effect at the time of origination.

    In the FDIC release it is this set of questions in soliciting comments:

    Should all residential mortgage loans in an RMBS be required to comply
    with all statutory and regulatory standards and guidance in effect at the time of
    origination? Where such standards and guidance involve subjective standards, how will
    compliance with the standards and guidance be determined? How should the FDIC treat
    a situation where a very small portion of the mortgages backing an RMBS do not meet
    the applicable standards and guidance?

    From that article there was a quote (I really wish I could find the link to this thing) that commentary received to date indicated that (paraphrase) “it would be too much of a burden on the banks to do it”. And the effective approach recommended is to grandfather such loans as if they had been in compliance with all laws and regulations even though we clearly know by now that isn’t the case.

  13. bena gyerek

    1. Mortgages must be seasoned 12 months before they can be securitized

    don’t like this. too much scope for gaming, per the previous comments. not an efficient solution, if higher capital costs are truly prohibitive

    2. The originator must retain at least a 5% interest in the credit risk of the assets sold

    would prefer more like 10%. should be explicitly a vertical slice (i.e. not a horizontal slice like equity or super senior, as it would screw up the originator bank’s incentives). this is not just a question of the originator being incentivised not to stuff the cdo with shit. it is also about having a key investor in the structure who will always be their to help manage the borrower relationship when things go bad. synthetic hedging of their position should be banned.

    arguably the same solution should apply in all cases of corporate governance – i.e. feel free to disperse 90% of any horizontal slice of an entity’s capital structure (debt or equity), but have one or a small group of key investors retain the remaining 10% so that they can maintain a close working relationship with the borrower/issuer. this should apply to bonds and shares too. the key investors are on the same footing as others as far as economic return and voting rights go, but have a more privileged position in terms of information, yet also heavy restrictions on their ability to increase or decrease their stake. key investors would also have a fiduciary obligation to other investors. just a thought..

    3. The interest of all parties to a transaction must clearly be disclosed, along with their fees

    disclosure is almost cost-free. no excuses for not having 100% disclosure of everything to do with the issuance structure. this should be a rule applying to all financial transactions of any description anywhere in the world.

    equally important however is the issue of complexity. many years ago i worked on an otc repo of various abs securities for one bank client. it took a group of three of us (reasonably experienced, albeit junior capital markets muppets) a whole week to review the docs for 20 abs transactions and populate a grid of basic risk-management questions so we could decide what to accept. fdic should therefore require a simplified and (most importantly) standardised “key risks” document be produced for every securitisation, so they are easy to compare. non-disclosure in the key-risks of any material risk would invalidate the sale, nws what is stated in the full documentation and how sophisticated the investor is.

    there should also be a requirement to provide a randomly selected structured sample of underlying loan documentation.

    4. Re-securitizations (meaning CDOs) are not permitted (note a disconnect here; the e-mailed and verbal reports suggested they were banned entirely; the language at the FDIC website seems to indicate that they are allowed in limited circumstances, but any use of synthetic assets, meaning credit default swaps, in a asset-backed CDO is verboten)

    i agree that “resecuritisation” should be banned, where this means cdo squareds or synthetic cdos, or anything where the underlying isn’t a loan or a corporate bond or some other direct debt obligation of the ultimate credit. the major failing of securitsation is that it negates the relationship between borrower and lender (both at the origination stage and at the workout stage).

    not sure what you mean by “cdo” here. i understand a cdo as any debt securitisation that is risk-tranched. as far as tranching go, they should simply require that investor capital requirements and rating agency methodology should always be based on the most conservative (highest expected loss) correlation assumption for any given tranche. that requirement of itself would probably have prevented 90% of past tranched cdos.

    5. Compensation to servicers will include incentives for loss mitigation

    servicer / manager fee should also be linked to a vertical slice of the portfolio (i.e. no upside “performance” fees, or other leveraged bullshit for managers; some real downside on fees for servicers so they don’t fall asleep at the wheel)

    1. Yves Smith Post author

      Bena,

      In context, CDOs meant ABS CDOs, or asset backed securities CDOs, and those are resecuritizations.

      Moreover, I have never seen the literature treat RMBS or CMBS as a CDO. CLOs, however, are CDOs.

  14. Alfred

    This is to rescue the system not to destroy/change it. The changes that Dodd and Frank will push through Congress and the President will sign into law will be changes on the margin at best. If a lender lends money it SHOULD BEAR THE RISK of loosing all of it (not 5%). That gives the required incentive to do prudent risk management. Imagine a world like this and anticipate new frugality and than imagine an 80 year old guy coming back from retirement making the only sensible logical suggestion in this financial hockus pockus so far. What’s more honorable Senators deliberately confusing the issue as if they are first semester MBA students without a clue about real market risks. Or just think about Obama’s laevish budget proposal.
    This is a rescue operation.

  15. radicalized

    Why are you amazed? If it is good for the people and thus bad for the bankers, it will be ignored. If it develops any momentum and looks like it might be implemented, it will be gutted. Just look at Volcker’s antics as an indicator. Any attempt at reform will be countered with some kind of deceptive move on the part of the military/industrial/financial complex.

  16. Anonymous Jones

    I know it’s been said a lot in this thread, but this was just a great post. One of the best ever. Positive and packed with great analysis of a potential solution.

    I think what a few detractors are missing on the 12 month seasoning rule is that there will be rolling package of loans on the books of any lender for 12 months. Don’t think about this as a tree but as a forest. Examining the effects of making one loan because it has to be on the books for 12 months is *not* the same as examining the effects of having an entire rolling portfolio of such loans on the books in any 12 month period. This will likely be a significant impact on the balance sheet of many lenders and will definitely increase fear about the consequences of “it” all hitting the fan again.

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