Interview with Joseph Mason: No True Sale with Prime Brokers, Hedge Funds

The failure of UK hedge fund Peloton Partners suggests to some observers that the masters of the universe at Goldman Sachs (NYSE:GS), by reputation Wall Street's most highly leveraged investment bank, may be next in line for a "mark to market" reality check. We hear concerns that the former GS bankers who ran Peloton used trading techniques commonly applied inside their former employer.

One reader asks whether commercial banks or broker dealers are most exposed in the latest chapter of the subprime fiasco, this one featuring impossible margin calls against illiquid collateral "owned" by hedge funds. Such an evaluation need focus on those ibanks - like GS - which have the most direct exposure to hedge funds. Start with the top-ten list of prime brokers.

The prime broker, after all, is the true owner of a hedge fund's assets via the financing relationship. As with a bank and a securitization, with prime brokers and hedge funds there is no such thing as a "true sale" because the hedge fund has little capital and the prime broker, as a result, ultimately bears all the risk. We've been writing about this issue for several years, but of course nobody paid attention to such nuances - at least until now.

In our continuing search for perspective on the global financial meltdown which began with subprime mortgage securitizations in the US, this week we talk to Professor Joseph Mason of Drexel University's Le Bow School of Business. Prior to joining Drexel in 1998, Dr. Mason was a Financial Economist of the Office of the Comptroller of the Currency, which charters, regulates, and supervises all national banks. In addition to teaching, Dr. Mason frequently consults for government agencies, research institutions, pension funds and corporations.

The IRA: You just returned from an overseas trip. What are the impressions of the US response to the subprime crisis among your foreign contacts?

Mason: I've been meeting with a combination of regulators, legislators, attorneys and investors. Worldwide, people are looking at the situation in the US and are asking "what did you people do?"

The IRA: So what do you tell them?

Mason: Well, they ask "Did you people really screw up that bad?" And my response is "Yes, we did."

The IRA: To what factors do you attribute the screw-up? Is this the end result of a gradual loosening of prudential and moral values?

Mason: The subprime crisis results from a growing arbitrage of regulations and accounting rules that got out of hand. Right now the situation is that regulators don't want to acknowledge the problems in the market because to do so is to admit that they missed these same problems, in some cases going back 30 plus years now. They can't admit the problems without admitting malfeasance. On top of that, it's an election year which really throws things for a loop. And then of course notwithstanding the fact that the regulators have egg of their face, the ratings agencies don't want to make any changes because, for them at least, this world is working just fine."

The IRA: The victims of the subprime crisis will not be very happy about maintaining the status quo.

Mason: No indeed. I have been meeting with some large pension funds outside the US, large state run pension plans with a lot of exposure and a lot of losses. As a group these funds are very angry at the inaction by the Congress, which held a few hearings last year but then followed up with absolutely nothing. Congress's treatment has been to wait and see if this crisis clears up because dealing with it directly is going to be very difficult.

The IRA: Well, to be fair, there is no one to talk to on Capitol Hill today, is there? Can you even think of a single member of either house who really understands finance well enough to investigate this mess?

Mason: No, none of them understand it. They understand that the problems are really big. But in a way, the congressional hearings last fall worked to the advantage of the ratings agencies. They called the legislators' bluff. They said, "This is so big, you figure out how to fix it." When legislators didn't know how they decided to wait and see if the crisis would blow over.

The IRA: When we worked on Capitol Hill two decades ago, there were giants among the members who not only understood banking and finance, but also had the resources in terms of staff and budgets to conduct real investigations. Nobody in the banking industry today is at all afraid of the Congress, even with the Democrats in the majority.

Mason: I make myself available to educate members of Congress on the basics, but frankly nobody really wants to know very much in terms of the details. This inaction and dysfunction in Washington is one of the reasons why some of the larger pension funds are thinking about starting their own ratings firm. You have alternatives such as Egan Jones, but they are too small serve the growing demand.

The IRA: We'll tell Sean Egan you said so. We have heard the same idea from a number of Street firms. Do you think that a public rating agency based on a utility model is the answer? Do we need a publicly owned rating organization that the issuers, and the Buy and Sell Side firms cannot push around?

Mason: No, I have a better solution that goes back to some work done by Charles Calomiris when I was at OCC. He was helping to develop the investor information system of commercial credit in Argentina at the time. What you got was more like a cooperative model where anybody providing credit in the system had to feed the information behind that credit into the system. You could work out a netting arrangement so that if you had an imbalance between contributors and drawers, then relying upon the information you could rebalance the risk and contributors could get paid. This could set the stage for an open source cooperative model.

The IRA: So you mandate public disclosure by all market participants for all exposures? If you want to play in the system, you have to meet the disclosure requirements. The vendors and major dealers certainly wouldn't like that.

Mason: I don't think such a system goes all the way to full public disclosure since ratings can still be "bought" from the open source repository. By having firms that actually own the investments generate the ratings you eliminate a lot of the conflict of interest. Furthermore, you reinvigorate the unsolicited rating challenges that helped keep the system incentive compatible in the pre-1970s era. The open source model allows competition in ratings and enables a re-rating process continuously to adjust risk pricing.

The IRA: That sounds like a Buy Side model. The cottage industry of analysts would serve the investor community and the major ratings agencies would serve the issuers as they do today. "Let a thousand flows bloom," as Mao said.

Mason: Exactly. You still have a Sell Side ratings function, but if a rating is put on a deal and then the Buy Side analysts put a different rating on the same deal, then the fiction is going to be pretty clear pretty quick.

The IRA: Well, in theory at least you would have completely transparent benchmarking of structured deals, for example. You would be able to compare different rating regimes in real time and the reverse engineers and consultants would do just that. You'd have a Zach's type survey model for ratings? So why didn't the US develop precisely this type of market from the outset? The academic community laid out the necessary conditions for a functional efficient market. Why did the regulators and the Congress let this model become so skewed? Or is it the natural evolution a democracy that the interests buy their way into a favored position?

Mason: No. Here's my take on it. When I joined the OCC in 1995, I focused on securitization as an area of research. Securitization was growing by leaps and bounds and clearly had safety and soundness implications. Nobody was collecting information on it. The general view of securitization was "loans are sold" and this process was viewed as a good thing. But I began to look at the fact that securitization was a funding mechanism for banks. It is the liability side, the funding side of banks, where you really are running into risk. Incidentally, the liability side is where mark-to-market accounting and fair value is getting into trouble, posting paper gains when liability values plummet in distress. We allow banks to fund themselves by selling securitizations into an illiquid market. If that illiquid market breaks down, then your entire bank intermediation system gets a hiccup.

The IRA: As today?

Mason: Yes. So back in 1995 I was looking at this rapid growth in securitization and I began to suggest to my colleagues at OCC that we should start to monitor the phenomenon. I got tremendous indifference. This was around the time of the Advanta failure. I knew that there were some things going on within the agency because this failed bank did not have any deposits and there was some uncertainty whether the FDIC would liquidate the bank or just leave it to the OCC. But more than the question of the receiver, the Advanta portfolio was so securitized and so heavily levered that nobody knew how to value the business. When the bank was sold to Fleet, it was transferred as a whole business securitization where the buyer simply bought a majority share of the trust.

The IRA: Again, the same situation we have today.

Mason: As I researched Advanta and other early examples of securitization it became clear that while we publicly toed the line about the validity of "true sales" when it came to securitizations, the reality was that these were anything but. Deals would sometimes run into legal problems - things like deals not accumulating sufficient reserves in the early stages to provide a buffer - which would be grounds for the deal to be called off entirely. While an intervention is a violation of the regulatory interpretation of true sale, nearly every time a securitization deal got into trouble the regulators would allow the banks to make collateral changes to these deals on the fly to make them work. This type of implicit recourse, especially in the world of credit cards and other types of consumer collateral, was the basis for much of my early academic research in the field.

The IRA: Directly contradicting the notion of a true sale. So is it fair to say that securitization deals never really close? The deals are just dynamically managed by the sponsor banks, who then claim not to control the securitization vehicle?

Mason: Securitization is all about keeping the assets off balance sheet but retaining effective control, usually through servicing. Ultimately, the FASB and the regulators have to get away from a dichotomous view of true sale. There have to be degrees of risk transfer. It's not the reporting that is a big deal - you can put the number on the balance sheet and, in a way, who cares: investors can decide to what extent they want to remove or reduce that number from their risk calculations. At the end of the day, what really matters is how much risk is transferred. My analogy for securitization is not risk transfer but risk distillation. In the old days, when banks kept the bottom first loss portion on balance sheet they kept all of the expected loss on their books. This is the point, by the way, of the 2001 regulatory ruling that required dollar-for-dollar capital requirements for residuals.

The IRA: So if you were SEC Chairman Christopher Cox, what would you be saying to the FASB right about now?

Mason: I would tell them that, at the very least, you need an accounting schedule that reports securitizations and the dollar value securitized. Second, if you could, you'd like to get some idea of retained risk exposure. Measuring this is tricky. Thirdly, investors need to be able to connect bonds sold in the securitizations with the other related bond and securities that provide their credit support. You need to know how much of a given deal your paper represents and how much of the rest of the deal supports your paper. Furthermore, the performance of related subordinate bonds can tell investors a lot about the expected performance of their own senior pieces. This can be done right now in the CUSIP system.

The IRA: If the revisions to the Shared National Credits survey ever get started, that might be a vehicle for aggregating this type of disclosure.

Mason: Exactly. If it addresses securitization of all types, exposures really, then that would be very useful.

The IRA: So rather that seeing the FASB do away with Qualified Special Purpose Entities and the like, as is now proposed, what changes do you propose?

Mason: The previous (2002) QSPE issue was really about eliminating SIVs and other similar vehicles that arbitraged the "primary beneficiary" rules, but it didn't impact straight securitizations. "Variable interest" rules need to acknowledge that there is no true sale, but acknowledge that there is some degree of risk transfer, even if that is not complete. Incomplete risk transfer is the middle ground that necessitates dropping the dichotomous "sold" or "unsold" position we have now. We have recently seen that the variable interest is more like an option: if we want to continue the business we support the deal and the variable interest is total and complete; otherwise, we allow the structure to fail. Basel II seems to be on a better track than FASB, requiring capital buildup as the option comes into the money - that is, as the securitization falters - to adjust for the increased value of the "variable interest."

The IRA: Speaking of dichotomies and middle ground, what would you do with fair value accounting? Is there a compromise position whereby exchange traded securities are subject to mark to market, but illiquid assets are not?

Mason: You need to show the quality of a price. Not all marks are equally valuable. Just because you have an exchange traded security does not mean the price is valid for valuation purposes. I want to see the liquidity behind a price quote before the premise behind mark to market is valid.

The IRA: Agreed. The classic academic treatments of market efficiency all required a high degree of liquidity as a necessary condition for an acceptable securitization model to functionally replace banks as intermediaries. .

Mason: Only a very small portion of the market has deep prices. Academics and regulators who sit in their offices think that all markets are deep. Get outside of the couple hundred most active stocks on the NYSE and the fallacy becomes apparent.

The IRA: Well, that suggests that most securities traded today should not be subject to fair value accounting. Is it fair to say that fair value accounting was a bad idea?

Mason: It is a good idea, but like many good ideas it is difficult to implement. You can't just say, well, here's the price without thinking about the quality of that price or what is meant by the price. You have to define your terms. And this also is the problem with ratings. We never defined the terms so that we know what a given rating means. So, we are stuck regulating fair value accounting or ratings based upon concepts which are ill-defined and the vague regulatory regime sets the stage for more regulatory arbitrage. This will happen quickly with fair value/mark to market unless we define our terms very carefully.

The IRA: So what is to be done? The carnage is awful.

Mason: I don't think the carnage is that awful. Do you mean the level of losses?

The IRA: No, for us fair value is offensive in two ways. First, we are seeing a lot of very talented executives immolated by reporting paper losses due to fair value accounting, losses on assets which are not impaired. Second and more important, this standard is confusing to investors and this confusion will only grow with time as gains are taken on these previously moribund assets If this rule does not make company financial reporting more clear, then why are we doing it?

Mason: The carnage is coming from hiding asset values and exposures, not from reporting them. Again, it comes down to simple definitions. It could be more appropriate to have a standard that is a 30-day average look-back price for a structured security that is traded at least half of those days. This is the type of reporting definition that can help separate securities which are eligible for fair value treatment and those which are not.

The IRA: It sounds like the SEC has to either compel the registration of all securitized assets or find some other way to achieve the price transparency that is consistent with the levels of market liquidity that investors expect and that make fair value accounting practical. Is that fair?

Mason: The SEC has a very tough job ahead of it. They need to be at least as creative as the Street but they are bleeding talent and they don't pay enough to attract and retain good people. The Street is so far out in front of them in terms of creativity that the regulators almost always end up behind. Same with the bank regulators. They cannot compete with the banks in terms of compensation or talent.

The IRA: What is your outlook for the future of securitized markets?

Mason: We need to think hard about these issues, apply some talented minds to the problems and not get lost in the details of a given type of assets or instruments. We need to think in broad terms about the type of market we want to see develop. When you do that you can see the evolution of the marketplace pretty clearly. So, for instance, if you look at the progression from RMBS to SIVs and then auction rate notes as banks looked for shorter and shorter term funding. Didn't regulators see this evolution? Don't they realize that at some point the yield curve is going to turn and whoever gets caught when the yield curve turns is going to lose? I was very surprised to hear Ben Bernanke tell Congress that the Fed is not in the business of telling banks not to invest in something.

The IRA: I thought that was the Fed's job. This is an issue which has bothered us for some time. The regulators as a group seem to have lost the will to regulate, to confront the industry when they go too far and say "No" in a loud, very public way to unsafe and unsound activities.

Mason: The Fed has always been horrible regarding safety and soundness, considering themselves central bankers instead. The OCC, however, is also supposed to regulate for safety and soundness and check the industry's creativity. Under Comptroller of the Currency John Dugan there is nothing there at all, nothing. Previously, for example under Gene Ludwig, more tough-minded regulation prevailed.

The IRA: Ludwig is not afraid to tell people no.

Mason: He was also not afraid to go to the Supreme Court five times on deregulatory rulings, which says a lot for what Ludwig did for the banking industry. But on the other hand, if you went so far as to violate safety and soundness principles, he would say no. I think that is the right balance; to go to bat for the industry when it makes sense, but not put up with nonsense. Unfortunately, examples like Ludwig are far too uncommon in the regulatory world. The OCC is the chief safety and soundness regulator in the US. If I am looking to lay blame for what happened with securitization, then you must look at the OCC. Even under Ludwig, the OCC still missed the development of structured finance.

The IRA: So imagine it's November and President-elect Obama has called you with Attorney General designate John Edwards and Treasury Secretary designate John Corzine on the line, to ask for help. The private label securitization market is now down to less than $1 trillion from $3 trillion at the start of 2007. What do you tell them?

Mason: The key issue is transparency and giving investors the information they need to assess risk and figure out where the losses are. By continuing to paste over and conceal this information, we just persist in lying to investors and the investors know that we are lying to them and they just hang onto their money. Thus no liquidity in private label securitizations as people flee to the safety of GSE and Treasury paper.

The IRA: What is the outlook for litigation regarding securitization? We know you are hearing from a number of potential claimants. Have you been following the Truth in Lending Act litigation against Chevy Chase Bank in the Seventh Circuit?

Mason: No, there are just too many different things happening to follow all of the action.

The IRA: A trial lawyer in Milwaukee brought a class action lawsuit on behalf of some subprime borrowers of Chevy Chase Bank FSB in 2005. In January of 2007, the trial court granted summary judgment to the Plaintiffs, setting off the alarm bells in Washington. The banks cannot hide behind the OCC and federal preemption on TILA claims. Now the case is on appeal to the Seventh Circuit and the ABA has filed an amicus brief, but the findings of fact seem pretty clear. If the ruling by the trial court survives appeal to the most conservative, pro-business federal appeals court in the US, some 7,000 borrowers could be eligible to seek rescission of interest paid from Chevy Chase. The trial lawyers will have a template to use to attack the entire mortgage industry. We understand that the Plaintiff's counsel has three more cases lined up against other lenders.

Mason: There are a lot of loans out there that are not suitable, plain and simple. There are going to be claims for suitability on the borrowers' side and those will also be relevant for investor lawsuits. There are already suitability claims brought by investors. The disclosure rule hurt investors' ability to value deals. A large investor commented recently, "Before we bought the deal, we got this tape of information with LTVs, FICO, loan amount, geographic information. But after we bought the deal, we got the loan docs, which clearly demonstrated unsuitable lending. But then we already owned the loans." The investor took the documents to a due diligence provider who ran a sampling of the loans and from the examination it was clear that a lot of the loans didn't conform to the lender's underwriting guidelines. The income information did not make sense compared to the occupation and the geographic location. Either there was a great deal of fraud or a lot of the loans were just not suitable for the borrowers. Either way the loans were not written to a reasonable suitability standard and the quality of the pool was potentially misrepresented. Attorney General investigations and private claims by borrowers will eventually reveal the extent of such practices.

The IRA: We may very well see some institutions threatened with insolvency due to litigation. How do you keep the Congress from doing something really stupid as the situation in the banking industry gets more and more problematic?

Mason: Ultimately, the culprit is the underwriting standards, not the litigation. But the legislative risk is a threat to the entire industry. In this election year, the biggest risk is for the Congress to try to build lawmakers' "legacies," whether it is through a Home Owner's Loan Corporation or a mass loan modification plan. We have to come to terms with the reality that a home mortgage interest deduction is the wrong way around and needs to be reversed into a mortgage equity tax deduction. And on top of that come to terms with the fact that federal housing policy has reached its natural limit.

The IRA: How so?

Mason: In the 1970s, during the stagflation era, we learned about the natural rate of unemployment. When you try to push the unemployment rate below the natural rate, you get perverse economic effects. This time around we are learning about the natural rate of home ownership and that when you push the rate above that level, you are going to get perverse housing market and economic effects. The appropriate target homeownership rate is not 100%. We already have the highest home ownership rates in the world. We need to tell the Congress to quit trying to buy votes through housing policy.

The IRA: So how do you react to the removal of the caps on the GSEs? They clearly don't have enough capital to grow their portfolios. Should Fannie Mae (NYSE:FMN) and Freddie Mac (NYSE:FRE) simply concentrate on securitization?

Mason: As they do more securitization they provide guarantees and create more risk on the same capital. Some GSEs are offering unsecured loans to help keep borrowers out of delinquency for the next several months, skewing GSE delinquency numbers downward in the short term. From a broader policy perspective, the GSEs were put in place to increase mortgage market liquidity. Liquidity is not a problem in the middle of the market, it is a problem on the edges. We need to remove the government monopoly from the middle of the mortgage market and stop the socialization of the housing finance sector through expanding the mandates of the GSEs, HUD, and FHA, and building new agencies and GSEs. Nationalization embeds political interests and pushes the goal of creating a stable liquid private market further down the road.

The IRA: So if the safety and soundness regulators put greater limits on private housing finance, particularly jumbo and subprime mortgages, then the entire mortgage sector will end up being dominated by the GSEs?

Mason: If the middle of the market dominated by GSEs expands while regulators push private lenders out of the fringes the ultimate result with be greater GSE dominance. The comment I just published on the National Homeownership Strategy - which was prepared by the Department of Housing and Urban Development under the direction of Secretary Henry G. Cisneros in response to a request from President Bill Clinton - clearly documents how the GSEs and HUD actively worked to push up the rate of home ownership in the US by selling mortgages to those without savings to make down payments or income to make monthly payments. I can't help but think that more government interference will not be beneficial.

The IRA: So then maybe it was President Clinton too, and not only former Fed Chairman Alan Greenspan, who is responsible for the subprime crisis! Thanks Joe.

Comments

[jjason]

My comment is, well, I don't have a comment. The Professor lost me when he started talking about Argentina. Then I just went down to the comment box to say you guys should send this article to Senator Chris Dodd. Barney Franks probably won't understand it. Maybe Henry Paulson will. When I did my MBA in 1974 they started teaching ethics in business schools and law schools. Too bad the lawyers in Congress didn't study ethics and economics.

[GingerYellow]

It sounds like he's proposing the US move closer to the European model of IFRS and Basel II. Most European securitisations involve the originator retaining the first loss piece and accounting for it to the extent that it represents the risks and rewards of the assets. Also any under Basel II implicit support to a securitisation is harshly punished - all existing securitisations are treated as unsecuritised assets for capital purposes and you can't get securitised treatment for future deals in that asset class for at least five years. That's what happened to Egg in the UK when they repurchased a bunch of delinquent receivables from their credit card master trust.

There has been a lot of mud thrown at securitisation in general that would more properly directed toward abuses of securitisation and the people who carried out and condoned those abuses. It's entirely possible to have a securitisation market that doesn't create perverse incentives, as long as investors and regulators are vigilant to ensure that lenders and structurers act responsibly.

"Thirdly, investors need to be able to connect bonds sold in the securitizations with the other related bond and securities that provide their credit support. You need to know how much of a given deal your paper represents and how much of the rest of the deal supports your paper."

I'm not sure what he's saying here. It's not at all difficult to find out how much subordination you have - it's in the offering circular, in the marketing materials and in the pre-sale report.