Macroeconomic Stability and Securitization

The Financial Stability Oversight Board (FSOB) has released their analysis and broad recommendations for how to balance the costs and benefits of risk retention associated with securitization (here).  The issue I have blogged about before (here) is that we want banks to hold the risk of the loans they make so they have the incentive to lend wisely (see securitization and the recent subprime lending crisis)s; on the other hand, we want them no to hold this risk because if an economywide disturbance like a decline in national house prices leads to these loans all losing money, then the banking system can collapse (see the Great Depression).  The reason many underestimated the impact of the subprime crisis was that we thought securitization had removed many real-estate based loans from bank balance sheets.  In fact, they were off-balance sheet, but they were real liabilities for large investment banks.

 So how to balance the desire to insure banks and the desire to incentivize them?  The FSOB discusses many issues but I think misses the boat.  There is a simple way to do both.  Have banks hold all (or a lot of) the risk that their loans perform worse than average and have them sell off all (or a lot of) the risk of the average loan (both statements about loans in some class of loans).  There are many ways to do this.  One is to have the banks securitize little, but make them hedge their macro risk using an index of the performance of similar loans.  Another is to have them securitize and sell everything in bundles of many banks’ loans, but take the proceeds from the sale, place them in a common trust (that invests in say Treasuries), and pays out to each bank in proportion to how well its loans do relative to the rest of the banks loans.  In either case, each bank is incentivized to make good loans – if it does not, it makes less money – and yet holds no systemic risk that can take down the banking sector – if house prices for example tumble, either the hedges on the index pay off or the total sum of payments to banks from the trust is unchanged. 

 This seems so important, and so simple (at least in theory).

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Adverse selection and the Goldman Stuffed Suit

The SEC action against Goldman again has me asking whether the industry might not actually be better off with some serious regulation of adverse selection. Goldman sold an asset hand-picked to fail as if it were just the average security. The retail investors has lots of protection, and so does the consumer. Imagine buying a car, and then being sold one off the lot that the mechanic who just tuned the engine is betting will break down. And not being told this. If car dealers could do this, cars would be hard to sell (this is the model and application for which George Akerlof won the Nobel prize in economics). Adverse selection makes assets illiquid. The more disclosure is required in simple, transparent ways, the more easily assets can be traded. If Goldman can hide the adverse selection behind tens of thousands of pages of “disclosure,” surely it makes it harder for any bank to securitize?

And this need not be regulation. Why doesn’t some bank start a private initiative of this sort?  In the car market, dealers provide guarantees.  Suppose that one of Goldman’s competitors made a pledge and provided a money back guarantee on losses directly caused by a listed set of shady practices. Wouldn’t that that bank almost never have to pay off and wouldn’t it gain a huge amount of business? Is the industry colluding to keep things opaque so they all decrease liquidity and increase profits?  I thought innovations that provided greater liquidity were the source of securitization and the financial boom, but maybe not . . .

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Corruption, in Short, Still Seems a Small Part of the Problem

Housing prices and securitization, and their collapses, are the central causes of the Great Recession, and the debate now rages over their deeper causes and, related and more forward-looking, how to reform the regulation of financial markets to avoid future meltdowns without killing the goose that lays the Goldman Eggs.  The latest news is the extent to which plain old securities fraud seems to have played a role. The headlines have recently been grabbed by the SEC’s indictment of Goldman Sachs and their role in selling Abacus 2007-AC1 (e.g. here). This deal was for one billion dollars. This is a lot of money, but far short of the amount of the financial crisis. Remember, the total losses on sub-prime and alt-A mortgages in early 2008 given pretty bad scenarios were around 500 billion, an amount much smaller than that lost in the stock market decline following the internet boom in the 1990’s. The problem was the location of the debt instruments – hidden in banks and being held by all sorts of institutions that should have been holding only very safe assets. That and the cast that synthetic CDO’s seem to have been created with adverse selection in mind – picked to consist of the worse MBS and then sold as if they were the average MBS (see Pro Publica on the Magnetar CDO’s here). Some buyers did not check whether or not the dice were loaded.

But the important fact to keep in mind as the legal saga unfolds is that, so far, while one should always and everywhere prosecute securities fraud, this is chump change relative to the real causes of the financial crisis and should not be the primary focus of the new financial architecture. Although there is an important caveat. There may be many more instances of fraudulent sales of MBS. If this is the case, do we need to try to protect large financial institutions that manage other people’s money?  Are they really so unsophisticated as to get up and dance just because everyone else is? I hope not.

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Bairly Comprehensible

FDIC Chair Sheila Bair speaking on March 8, 2010 gives a pretty standard description of the crisis and lays out quite a good framework for reform. The piece is FDIC centered, so emphasizes the problems of too-big-to-fail, failures in securitization, and regulatory arbitrage. But she dances a contorted political dance, like so many in DC forced to bow before sacred words, and ends with

“ . . . unless economic incentives are also appropriately aligned, regulation alone will fail.”

Uh, what appropriately aligns economic incentives if not the governmentally-enforced rules of the game, often called ‘regulation’? I guess everyone hates regulation, and everyone loves “laws that protect the American way.” And we wonder why we get the divided government we do. (Maybe I just need another cup of coffee.)

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The Return of CMBS

The first new Commercial Mortgage Backed Securities in nearly two years were sold this week. According to press reports, the deal was heavily oversubscribed, and with the securities offering a weighted-average coupon rate less than 6%, hope for affordable commercial real estate finance is returning to the market. But does this deal really signal “normal” access to credit for commercial borrowers?

On the favorable side, the deal was the first new issue eligible for financing from the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF). The $400 million deal included $323.5 AAA-rated senior securities eligible for TALF financing. Surprisingly, the Fed reports that only $72.2 million in loans were requested to purchase these securities. Given the 15% required haircut, this implies that nearly three quarters of the AAA tranche were sold to investors that did not receive any preferential TALF financing. This suggests that demand for high quality securities exists and that government-provided below-market financing may not be as important to the CMBS market as first believed.

On the other hand, the structure of this particular deal was quite different than the typical pre-crisis CMBS offering. A typical conduit deal from a few years ago was backed by a large number of commercial mortgages diversified over a large number of different borrowers, regions, and property types. The tranching would have been complex, involving more than 30 different securities being issued with ratings spanning the entire credit spectrum. This week’s deal consisted of the securitization of a single, $400 million loan from Goldman Sachs to Developers Diversified Realty Corp (DDR). This single-borrower loan was backed by a portfolio entirely comprised of retail shopping centers. The underwriting of the deal was conservative, featuring a loan a loan-to-value ratio of 62% and a debt service coverage ratio of 1.44. This conservatism was mirrored in the tranching. The $400 million of securities were packaged into only three tranches, the lowest receiving an A-rating.

So while the DDR deal is undoubtedly a positive event for investors looking for new CMBS, the particular details of the securitization make one pause when considering the implications for CMBS-based financing going forward.

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