Are the New Securitization Regulations Workable?

Binyamin Appelbaum has details of the new regulations surrounding securitization, and it all looks incredibly unworkable to me, especially the central plank:

Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security…

The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment.

What on earth is a bank’s chief risk officer supposed to do with an edict that she cannot hedge a certain chunk of the bank’s balance sheet? I can see that she might not be able to explicitly create a synthetic CDO to bring that idiosyncratic risk down to zero. But if a bank has exposure from securitizing credit-card receivables, say, or commercial real estate leases, or student loans, or residential mortgages, then similar risk will reside elsewhere on the balance sheet, and the bank will — and should — just reduce the amount of that risk instead. It has the same result, from an all-over risk perspective, and the new regulation is rendered utterly toothless.

As for the idea that the ratings agencies should make it clear that ABS aren’t corporate bonds, well, as Agnes points out, that’s pretty silly: I think everybody knows that by now. The problem is that if there’s a separate second scale for ABS (and maybe even a third scale for munis), no one will have a clue what the new ratings are supposed to mean. It would be a bit like being given two apples, and told that one costs 15 foos while the other costs 17 bars.

I would rather encourage the ratings agencies to try and make credit ratings as laterally comparable as possible, and to try to set ratings so that you don’t have the enormous default-rate discrepancies that exist right now between different asset classes. Investors could then judge for themselves the degree to which the ratings agencies had succeeded.

My fear is that ratings agencies might start issuing separate credit ratings for munis, which will be considered much safer than the equivalent credit ratings on corporate bonds, just as a wave of muni defaults is about to hit. In general, the key here is to decrease the importance of the ratings agencies, rather than trying to regulate them on the grounds of how important they are.

But a couple of the proposals make sense: paying originators of securitized loans gradually, over time, for instance, rather than up-front when the loans are securitized; or standardizing contract language in the ABS market to make such securities easier to compare to each other. They just won’t make an enormous amount of difference.

Comments

[Mad Hedge F...:]

Isn't there anything else better on TV? How about Antiques Roadshow? Ho hum. Another day of financial reform debate. Another day of closing the barn door after the horses have bolted. Please stop scratching your fingernails on the chalkboard, will you? What has the market come to? The volatility index (VIX) spikes 7% in one day, and we only get a 187 point drop in the Dow. It’s getting so you can’t even get a decent crash going. Thank goodness I’m not a Master of the Universe anymore. Life in that industry is about to become incredibly boring.

Jun 16 05:39 PM

[KirbyJF1:]

Felix says

Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security…

The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment.

Felix


If the bankers don't want the risk, maybe they can store the cash in the bank Valts, buy Treasuries or other government bonds and let other banks take the calculated risk. Either that or the loans they originate better be underwritten with the same criteria that they give to all the other loans they keep for their own portfolio's. This old Wall Street Bankster mentality of sticking the next guy with the problem has to be quashed. In the old days before your time the Wall Street Banksters were Partnerships & the Risks were considered first before trying to get some snot nosed kid a few million for sticking it to the public

Kirby

Jun 16 08:33 PM

[nobby73:]

So, what is being said is that the banks must retain 5% of the notional of any tranche of securitization. This might make sense rather than stuffing the equity tranche (the riskiest) in the bottom draw and they will not be allowed to hedge, i.e. synthetically sell this, though with the muppets at AIG out of the game, there would not be many buyers. It seems quite sensible to me, the originator should have some chips left on the table.

Anyway, the banks won't worry too much, they know they will always be able to sell the positions to the Fed once they turn nasty...

Jun 17 10:09 AM

[tlsc:]

1. re the retaining 5% of the notional of any tranche of securitisation - what's the reasoning behind this idea? is it to keep the bank honest so that it shares the risk of the tranche with the investor? caveat emptor - buyer beware - is a principal of business. what is the root issue - i think that the root is to ensure that complex product should not be sold to unsophisticated investor. that's where the risk assessment comes in. the seller should be made responsible for ensuring that the investor is able to understand and had understood the product sold, and that bar should be high eg if the financial institution sells a product to a mum on the street, the assumption should perhaps be that the buyer has little knowledge, and the burden of proof is on that financial institution to prove that the buyer did understand the product. such a law would, for example, help the numerous HK and Singapore buyers of the Lehman mini-bonds which included embedded CDO tranche.

in addition, not allowing a bank to hedge a risk is simply dumb. risk should naturally go to the entity that is best able to accept and manage the risk. again one has to look at the root cause - eg AIG sold protection on ABS, accepting the risk, the problem is no regulator was monitoring AIG in this area of its business, and that is the root cause. hence the systemic risk regulator is a great idea, however, it is unlikely to go far - likely to be watered down in the politics of the day - and it requires co-ordination of global centers regulators. what are needed IN ADDITION to the systemic risk regulator is to ensure, among others, (a) outside auditors are able to assess risk (b) robust and strong accounting standards (c) internal risk management which is not only independent of the day to day management but also consistent across the financial companies (d) strong BIS and capital regulations, and ensuring that the sign post does not shift eg in the current crisis, other forms of Tier 1 like hybrid capital and equity linked capital instruments are treated not as capital and core common equity is the seemingly only acceptable capital.

2. re the requirement that rating agencies do not treat ABS like a corporate debt. think about it, an SPV, is like a corporate with only a single business with a pool of assets, and issues debt and equity (ie the equity tranche is treated as equity). regulators need to again go to the root cause - which, i think, are the robustness of the credit rating methodology as well as the internal conflict of the rating agency - on one hand to rate the instruments and on the other hand, to get paid. too often, the structurer of the ABS would shop among the rating agencies to get the best rating possible - and this should perhaps be stopped. in addition, among others, (a) rating agencies should be required to split the business of rating and payment, similar to accounting firms which were required to split advisory and auditing, (b) regulators themselves must not be overly dependent on ratings in their various testings which gives the wrong impression to investors.

Jun 17 02:37 PM