Who Should Have Skin in the Game?

My friend Ted sent me comments from George Soros yesterday, where the old man opined on the proposal I discussed weeks ago from Barney Frank to ban 100% securitization.

First a quick refresher course: banks take loans and repackage them into securities such as MBS (mortgage backed securities) and then sell these new securities to investors. This makes the investor who buys the MBS the ultimate "lender" - they are providing the capital for you to buy your home. This also enables the bank to go and make more loans, as they have sold the risk on the previous batch of loans, and now have capital freed up. The negative effect of this is that it doesn't incentivize the banks to use stringent lending standards - because they have someone who is willing to take the risk for them.

My point is simple: that's how markets work! As I've said before, all securities transfer risk from a party who doesn't want it, to a party who does. The "security" in question could be a bond, an option, a stock, an MBS, a CDO, or something even more complicated. Let's get to Soros's comments:

To avert a repetition, the agents must have “skin in the game” but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement.

Soros is addressing the proposal which would require banks to hold 5% of the securitized products on their balance sheets, unhedged - as a way of ensuring that the banks have incentive to offer only securitized product with sound risk-reward profiles. It shouldn't be hard to see why this is hypocritical - why single out MBS? Why not force BankAmerica (BAC) to hold 5% of the outstanding stock in OpenTable (OPEN) - an IPO it recently underwrote? Why not force JP Morgan (JPM) and Morgan Stanley (MS) to hold 5% of the bonds they underwrote for Microsoft (MSFT)? I'll tell you why - because that's not how markets work - and we shouldn't single out MBS as any different. People are willing to buy OpenTable stock, people are willing to buy Microsoft bonds, and people are willing to buy mortgage backed securities. Buyers who fail to understand the product should not buy it - we shouldn't penalize the middle man for bringing together buyers and sellers.

My friend, Ted, highlighted these same points in an email he sent while debating the topic with a colleague of his. I thought his comments were clear and concise, and I'll share them here (emphasis mine):

In most cases, I don't think the lenders thought they were making bad loans. In some cases, that may be true. That's also irrelevant, though. If there is a person that wants the loan and a person that wants to buy the loan, it's not up to the MIDDLE MAN to say no. That's absurd. That's like saying when iVillage.com filed to go public in the 90's, Goldman Sachs would turn them down because of their view on the business. THAT'S NOT THEIR JOB. If the company wants to sell some stock to the public and the public wants to buy some stock, then we have a MARKET. Welcome to capitalism!!!!! If you want something else, move to Cuba or go back in time to Germany during WW2. This new law that Congress is passing that requires banks to hold 5% of the loans they issue is missing the point. Are they going to make the banks hold 5% of the equity of all IPOs? No!

If people are blindly trusting (which they should not be!) the ratings agencies to guide them on the valuation of these fixed income instruments, then it would make more sense (although still not a lot of sense!) to require the ratings agencies to hold the securities in question. Maybe the ratings agencies should be paid in kind - when they rate a security AAA - their $20,000 fee or whatever the number is should be paid in said security - but don't blame the underwriter - the guy enabling the capital markets to flow.

Comments

[Paul Amundsen:]

Maybe there shouldn't be a 5% requirement for the banks, but CDO's shouldn't be allowed to exist unless the insurer has cash on hand to match the obligation.

Jun 17 10:27 AM

[Kid Dynamite:]

well, another thing that doesn't make much sense is that someone is assuming that the banks didn't have enough interest in these CDO's.... isn't the problem the opposite - that they owned TOO Much of them?!?!? isn't that why the banks have massive losses!?!??

Jun 17 10:58 AM

[kebu77:]

How about a 5-10% requirement for loans the bank did not originate in-house (the bank's skin in the game as some assurance that their brokers (or other originators) have not been too "creative" in setting up their loan files...

Jun 17 11:20 AM

[biomedlives:]

The problem with IPOs as an analogy is that an IPO represents one security, which the buyer has a reasonable chance to analyze thoroughly. With an MBS package, the buyer has no chance to analyze the quality of the multitude of underlying mortgages. As the author points out, ratings agencies have not been reliable analysts of MBS packages If the institution selling the package keeps a piece of it, it gives the buyer some assurance that most of the underlying mortgages will perform.

Jun 17 12:11 PM

[Kid Dynamite:]

biomedlives - what you say is correct, but it's no excuse! if the buyer cannot effectively analyze the product then... wait for it... HE SHOULD NOT BUY IT!!!!

just because BankAmerica keeps some of the loan on their books doesn't make it safe - as i commented above, the banks owned PLENTY of this crap - remember all the talk of "toxic assets" ???? i hate the argument that the banks keeping some risk is indicative to buyers that it's ok for them to buy it too - that's even worse!

Jun 17 12:16 PM

[Ned S:]

I'm no economist and I might have a bit of the detail wrong, but it seems to me that America decided lending out 10 times bank holdings wasn't enough so 50 times sounded better. And decided to offload the risk so it could make it lots more. Plus gobble up petrodollars and BRIC surpluses along the way and leverage them as well. And if that's not enough, well heck, the country can print whatever the shortfalls happen to be. It sounds to me like America is chronically debt addicted.

If one wants to say That's how the game works, that's OK, but do be aware that the game just could stop working quite so nicely as the patsies reduce their risk exposure.

As for having skin in the game - Why should banks care - The American tax payer will bail them out regardless.

Jun 17 07:59 PM

[Moon Kil Woong:]

A much better rule would be the anti-Goldman Sacs rule stating: Those that insure mortgage bonds, are a party to, or participate in insuring them may not short them or take a stake in which they will benefit from their failure or default. This would prevent Goldman from helping their clients (including themselves) cover their bad home mortgage bonds by asking AIG to issue CDS and then buy more CDS to effectively bet that they will default knowing full well AIG can't pay. It would also likewise prevent Paulson from making a cool $2 billion on the side by having his investment company likewise bet against home mortgages that GS was eagerly shopping around to get insurance on before they defaulted.

All in all the rule could be more simply written: No bank of financial institution or individual in it can knowingly defraud their investors, clients, the government (taxpayer), or the people they seek to insurance from for themselves or their clients.

Jun 17 10:30 PM

[biomedlives:]

Let's carry the train of thought further. On the basis that someone who can't analyze an investment product shouldn't buy it,...wait for it... there's virtually no one who should buy an MBS (and particularly not a CDO squared). Perhaps it's time for these packages to ride off into the sunset.


On Jun 17 12:16 PM Kid Dynamite wrote:

> biomedlives - what you say is correct, but it's no excuse! if the
> buyer cannot effectively analyze the product then... wait for it...
> HE SHOULD NOT BUY IT!!!!
>
> just because BankAmerica keeps some of the loan on their books doesn't
> make it safe - as i commented above, the banks owned PLENTY of this
> crap - remember all the talk of "toxic assets" ???? i hate the argument
> that the banks keeping some risk is indicative to buyers that it's
> ok for them to buy it too - that's even worse!

Jun 18 11:59 AM

[Kid Dynamite:]

@biomedlives: that's fine - no one is being forced to buy these products.

what definitely shouldn't happen is that people/funds/sovereign nations buy these products and then cry foul afterward because they didn't do their homework and had no idea what they were buying. call the ratings agencies incompetent - they were - but don't blame the middle man for matching buyers and sellers.


On Jun 18 11:59 AM biomedlives wrote:

> Let's carry the train of thought further. On the basis that someone
> who can't analyze an investment product shouldn't buy it,...wait
> for it... there's virtually no one who should buy an MBS (and particularly
> not a CDO squared). Perhaps it's time for these packages to ride
> off into the sunset.

Jun 18 04:36 PM

[Ned S:]

It's just a matter of perspective KD - One could also argue that what shouldn't happen is that the snake oil salesmen cry foul if their patsies find a way to tar and feather them and give them a ride out of town on a rail - Depends on whether one is a snake oil salesman or a patsy I guess? And on whether the fraud was knowing or more just a case of Willful Negligence.

It doesn't matter how one dresses it up to sound good for the snake oil salesmen, I sure get the feeling there's a degree of culpability from that end.

The unfortunate thing for America is that if one sees an investment product nowadays with Made in America stamped on it, I think even an American would have to wonder if it just mightn't be the equivalent of getting an email from a Nigerian who seeks assistance with a bank transaction?

Jun 18 07:57 PM

[Philip Gvinter:]

I have to agree with Ned and Biomedlives. The very concept of a middle man with no skin in the game is a part of the problem here. This would not apply to banks and lenders who got caught holding the bag on several months of inventory of in some off balance sheet SIVs but would totally apply to GS, MS and originators like AHM and New Century. When one feels that he is in a position of limitless profit and zero risk than one is encouraged to do unethical things. We cannot allow this to continue. The very existence of such middle men is what breaks markets. Furthermore the difference between underwriting an IPO and selling MBS is that the underwriting of the IPO carries certain representations and levels of due diligence which are outsourced to the rating agencies or simply not performed in the MBS creation process.

The best idea I saw here was to compensate the rating agencies by paying their fees with par value sections of the debt securities that they rate rather than with cash. I get the feeling that a much higher level of due diligence on the part of the rating agencies would immediately become the norm.

Jun 21 11:22 AM

[Kid Dynamite:]

blaming the middle man would be like blaming your realtor when you buy a house that goes down in value... i just don't think like that.

the problem is that the people buying all these toxic assets let their own greed cloud their due diligence... buyers (of assets, MBS, etc) need to be responsible for their decisions!

more on this here:

fridayinvegas.blogspot...


On Jun 21 11:22 AM Philip Gvinter wrote:

> I have to agree with Ned and Biomedlives. The very concept of a middle
> man with no skin in the game is a part of the problem here. This
> would not apply to banks and lenders who got caught holding the bag
> on several months of inventory of in some off balance sheet SIVs
> but would totally apply to GS, MS and originators like AHM and New
> Century. When one feels that he is in a position of limitless profit
> and zero risk than one is encouraged to do unethical things. We cannot
> allow this to continue. The very existence of such middle men is
> what breaks markets. Furthermore the difference between underwriting
> an IPO and selling MBS is that the underwriting of the IPO carries
> certain representations and levels of due diligence which are outsourced
> to the rating agencies or simply not performed in the MBS creation
> process.
>
> The best idea I saw here was to compensate the rating agencies by
> paying their fees with par value sections of the debt securities
> that they rate rather than with cash. I get the feeling that a much
> higher level of due diligence on the part of the rating agencies
> would immediately become the norm.

Jun 22 02:00 PM

[Philip Gvinter:]

Well I think that there is a big difference between a realtor and the rating agencies. The rating agencies are more akin to an appraiser. The appraiser provides a document showing the current value in the area and area trends. He has a duty to perform the work honestly and to do due diligence on his sources. In the case of the appraiser that just means to cite where he got his data. In the case of the rating agencies there was no due diligence. Blaming the realtor is like blaming the trading desk. I don't believe in that but I do believe in holding the rating agencies to a slightly higher set of standards. They should have been required to review the underwriting standards for the pools of loans. They in fact did do this they admitted that they had erred in their ratings after the portfolios began to deteriorate.


On Jun 22 02:00 PM Kid Dynamite wrote:

> blaming the middle man would be like blaming your realtor when you
> buy a house that goes down in value... i just don't think like that.
>
>
> the problem is that the people buying all these toxic assets let
> their own greed cloud their due diligence... buyers (of assets,
> MBS, etc) need to be responsible for their decisions!
>
> more on this here:
>
> fridayinvegas.blogspot...

Jun 22 06:13 PM

[Kid Dynamite:]

philip - in my opinion, if we're going to fault anyone, it's the ratings agencies, who were guilty of gross negligence - not the "middle men" - the securitizers who brought together lenders and borrowers who were each driven by greed.

i was comparing the realtor to the wall street firm selling the securitized product...

i think we are basically agreeing with each other

Jun 22 09:57 PM

[Philip Gvinter:]

Yup totally agree. This is why I said that the rating agency should be paid with a piece of the security rated rather than cash. This would quickly re-align their interest and encourage them to do due diligence on the securities they rate.


On Jun 22 09:57 PM Kid Dynamite wrote:

> philip - in my opinion, if we're going to fault anyone, it's the
> ratings agencies, who were guilty of gross negligence - not the "middle
> men" - the securitizers who brought together lenders and borrowers
> who were each driven by greed.
>
> i was comparing the realtor to the wall street firm selling the securitized
> product...
>
> i think we are basically agreeing with each other

Jun 23 09:04 AM