An Overdue Overhaul of the Securitization Industry

by: TraderMark

We're harsh critics of so many of the now government institutionalized bad practices in these virtual pages, so let me be the first to say if the following does come true - as reported by FT.com, I'll be the first to applaud.

  • The US Treasury is planning a sweeping overhaul of the securitization industry to require lenders to retain part of the credit risk of loans sold to investors and end the gain-on-sale accounting rules that helped spur the market’s boom. The overhaul aims to restore confidence in asset-backed markets and allow them to resume supplying credit to the economy without re-creating systemic risks. Securitization of assets – such as mortgages and credit card loans – accounted for about half of the credit markets before the financial crisis struck.
  • Under the plans being discussed, originators will be required to retain at least 5 per cent of the credit risk of loans packaged into securities and sold to investors. The 5 per cent rule – which looks set to be applied in Europe as well – would ensure that lenders have what investors call “skin in the game”.
  • The proposed elimination of “gain on sale accounting” would prevent financial companies from booking paper profits on loans – packaged into securities – as soon as they were sold to investors.
  • A Treasury spokesman said that while securitization had made credit more widely available, breaking the direct link between borrower and lender had “led to a general erosion of lending standards, resulting in a serious market failure that fed the housing boom and deepened the housing bust”.

We've spoken quite often of the disassociation between those who bear the risk and those who move the product in the financial world. This is not just with NYC firms, it goes all the way down to your local mortgage broker. When you are only paid on volume and not on performance, well you can apply that to your job or business dear reader... and figure out how it would eventually turn out. Your department or business would party for a while as volume exploded through the roof and everyone became wealthy off those faulty precepts. It would work like a charm .... prosperity on the surface while operations and financial degraded behind the scenes. Until said business collapsed on itself. We showed the daisy chain of fees specific to the mortgage game in [Jan 19, 2009: WSJ - Would You Pay $103,000 for this "Fixer Upper"?

Less than two years ago, Integrity Funding LLC, a local lender, gave a $103,000 mortgage to the owner, (step 1) Marvene Halterman, an unemployed woman with a long list of creditors and, by her own account, a long history of drug and alcohol abuse. By the time the house went into foreclosure in August, Integrity had sold that loan to Wells Fargo & Co., (step 2) which had sold it to a U.S. unit of HSBC Holdings PLC, (step 3) which had packaged it with thousands of other risky mortgages and sold it in pieces to scores of investors. (step 4)

Her lender, Integrity, was one of a flurry of small mortgage firms that sprang up nationwide during the boom, using loans from big banks to generate mortgages to resell to larger financial institutions. Whereas traditional mortgage lenders profit by collecting borrowers' monthly payments, Integrity made its money on fees and commissions.

At closing, on Feb. 26, 2007, Integrity collected $6,153 in underwriting, broker, loan-origination, document, application, processing, funding and flood-certification fees, mortgage documents show. A few days later, Integrity transferred the loan to Wells Fargo, earning $3,090 more, Mr. Rybicki says.

So chop, slice, cut, divvy and package (i.e. financial innovation) ... have the credit agencies slap a AAA, everyone collect a fee along the way (i.e. prosperity in a finance based economy) and we're all good. Just need to keep finding suckers to buy the snake oil and everyone wins. Except the end buyer.

And now since there are no suckers left and the shadow banking system has collapsed onto itself, we use the sucker (err, buyer) of last resort. Who? Go walk to the mirror and take a stare ... you're backstopping it all. At your next cocktail party you can proudly proclaim you are now supporting the entire shadow banking system via your taxpayer prowess. Until you realize so is everyone else at the party.

Frankly we would not need these lame credit agencies if people who ORIGINATE snake oil actually had to participate in its ingestion. Then the free market would really work, instead of using asleep at the wheel credit agencies 'stamp of approval'. When your own business is at risk, trust me... the mortgage broker, the NYC investment bank, the commercial bank.... will ALL be actually checking to see if people can (wait for it) PAY BACK the loan. Groundbreaking. Innovative. Retro!

And by now you know the traditional retort, to which I say - yes maybe to account for RISK we need to have HIGHER rates and nearly free money is not a birthright! That's how it works in normal systems. Or even ours pre-"innovation". Since you did NOT have to ACCOUNT FOR RISK, you could offer LOWER rates. But what happened? Our entire system imploded ... so is it really worth 50 basis points of savings in terms of a lower rate to sacrifice a few generations of Americans to pay for the bailout? Did we "come out better" in the end for that short term savings? I think not ... our collective financial obligations have now skyrocketed - but carry on with the tired lines that the lobbyists will be using incessantly to fight this.

  • Bankers warned that the new rules would reduce the incentives to package assets into securities, raising financing costs. “It is the beginning of the unwinding of the securitisation-for-sale model,” a senior Wall Street banker said. “By forcing lenders to keep part of the loans and scrapping ‘gain-for-sale’, the government will raise the cost of capital and put a dampener on the reopening of credit markets.”

The fact the mentality remains that the NYC crowd still believes they should make loans and yet take none of the credit risk shows you nothing has really changed in the mentality. And why should it - we've bended over front... err backwards for these fellas. It is bemusing at best that this is even a debatable point - what part of LENDER is not clear... "forcing lenders to keep part of the loans". You'd laugh if it were not so convoluted.

So I carry a little hope if this comes true - but it is just a proposal for now and by the time it runs through the gauntlet of lobbyists I expect loopholes the size of (insert bad joke here) to be spring loaded throughout any legislation. But at least it's a promising premise based on common sense. Rare.