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.
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.