One of the not-sufficiently-acknowledged-in-the-MSM reasons for the current credit crisis is the sharp contraction of securitization, particularly of mortgages. Banks are balking at honoring LBO commitments because they can’t on-sell them as collateralized loan obligations, at least in the current environment. CDO new issues have pretty much halted, with only three deals this year (some might say that is a good thing). The would-be saviors of the housing market are all over Freddie, Fannie, and the FHA to guarantee more mortgages because the private paper pipeline isn’t moving enough product.
Some of these problems are more fundamental than others. The CLO market is likely to recover once Wall Street works off its very large inventory. CDO has become a very bad word and the product is unlikely to return except in a very modest way.
But the US has become dependent on a functioning securitization market; the alternative, of having banks hold the loans they originate, is straightforward but more costly (capital-related costs, not operating expenses, are the big reason). But if securitization does not recover, banks will have to devote more equity to good old fashioned lending at precisely the time when it is scarce. Not a pretty picture.
But Hank Paulson is a man with a plan, or more accurately, a plan to develop a plan. In a Bloomberg interview, he said that the Presidential Working Group on Financial Markets, is looking at how to remedy the securitization process — including Fed chief Ben Bernanke, SEC chairman Christopher Cox, and the head of the CFTC. Note that securitization is one issue in a list that includes the role of rating agencies, off balance sheet vehicles, and valuation. And Paulson also made clear that any proposal is “a number of months away” and that the markets needed to get through this period of turmoil first.
Um, what if Paulson has his priorities backwards? It may take intervention on the regulatory front, not the mere provision of ever-lower interest rates, to entice various players back into the water.
Let’s consider: Paulson and Cox are ideologically opposed to much in the way of intervention. Bernanke really is out of his depth in this area and will defer to the others. So this is a group predisposed to tinker, which is consistent with the minimal, more-symbolic-than-substantive moves that Paulson has launched to address the problem of large-scale mortgage borrower defaults and the near absence of traditional workouts.
Today’s Wall Street Journal MarketBeat had some worrisome commentary from Cox:
The SEC staff has been looking into possible ways to adjust U.S. regulations so there is less reliance on credit ratings, SEC Chairman Christopher Cox said….“If one were to seek to change the rules and laws concerning the special status of credit ratings for regulatory purposes you would first have to have a thorough appreciation of all of the consequence….
So how would the SEC substitute — and diminish — the regulatory reliance on ratings?
Mr. Cox said “one means of substituting … would be to substitute the current definition of the rating currently provided by the rating itself.”
What that means is that the SEC is considering ways of setting criteria that gets away from the ratings but focuses instead on the underlying concept. For example, for some rules the SEC could require bonds to be liquid and then develop some measure by which to sort them other than a credit rating, says one person familiar with the matter.
Mr. Cox last week said the SEC may consider proposing rules that would require rating firms to show the accuracy of past ratings and distinguish ratings of corporate and municipal debt with that of structured investments, such as securitized mortgages. Today, he said a rule proposal is not yet floating around and “we’re at least a couple months away.”
Require bonds to be liquid?. That is the most deranged thing I have heard in a very long time, and this presumably coms from someone within the US’s top securities regulator. It confirms what I have long suspected: that the SEC is preoccupied with the equity market and knows perilous little about debt.
A simple illustration: just about all corporate bonds are illiquid. That’s one reason credit default swaps are popular. Investors can use CDS to create synthetic corporate bond exposures, which unlike the underlying bonds, can be readily traded. But Cox would have us write off the corporate bond market.
And (in oversimplified terms), bonds are priced in spreads over Treasuries based on their ratings and maturity (or duration). Yes, if a bond is suspected as being worse than it really is, it will often trade as if it were rated lower. But the point is that ratings have been a key element in pricing precisely because they are a convenient shorthand for credit quality. Having non-rating ratings doesn’t appear a good direction of thinking; perhaps instead dethroning the role of ratings of individual securities among investors (for instance, pension funds face limits on the amount of non-investment-grade bonds they can hold) and instead replacing it with portfolio-wide notions of risk that are not ratings based might be a better avenue (what you want to avoid is what you have now with the monolines: large-scale sales forced by downgrades). But that would have to be accomplished by modifying the regulations of the various investors, many of which are beyond the SEC’s reach (and some rules are also codified in laws).
Similarly, Cos fails to mention of the most obvious problem, that of the conflict of interest post by having rating agencies paid by issuers, when their rating are allegedly for the benefit of investors.
Since this is a lame duck Administration, there is neither the time nor the will to come up with root and branch reform and knock heads to get it implemented. Instead, the aim, as with the Hope Now Alliance, is to have Potemkin reform, something that can be implemented with relative ease, so that the Republican presidential candidate has a soundbite come Septermber-early October.
Paul Jackson at Housing Wire observes that finding a way to bring back credit enhancement, which does not appear to get consideration by anyone in the officialdom, may be the most important element in the securitization equation:
While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.
For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.
Well, the bond insurers are on death watch, which does not bode well for the securitization market.