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As a freelance industry writer, I synthesize and provide opinions on topics relating to Structured Finance, Risk and Regulatory Reform. I am a former Rating Agency Analyst and a certified Financial Risk Manager (FRM). My rating agency experience focused primarily on Structured... More

    The turmoil in the mortgage markets triggered by liberal policies and lax lending standards is undoubtedly the origin of the financial crisis. Since the crisis, there has been a shift in the mortgage market. This shift, which exists both in the regulatory front and the demand-supply front, is poised to alter the industry. The article is focused more on the changes that are being proposed by the regulators to the mortgage industry and what the average consumer needs to comprehend to facilitate fiscally responsible decisions.

    The mortgage market classifies borrowers into prime, sub-prime and Alt-A categories. These categories differentiate the borrowers based on their credit quality. Despite the FICO credit score being an important parameter to ascertain borrower quality, it is rather ironic that the market, in the run-up to the meltdown, created huge incentives for borrowers with poor credit quality to become proud owners of expensive homes. This was partly driven by the booming securitized markets with investors seeking more of the MBS and its derivatives since they possessed attractive return profiles. In hindsight, there were large inconsistencies in the market with the homebuyers and investors having different goal sets and each was pursuing these goals hoping that their paths would never cross.

    The revival of the housing market is pivotal to economic growth. The financial regulators are now actively engaged in making proposals to reform the mortgage industry mainly with a view to dissuade the lenders and banks from bad practices. The proposals are being designed to facilitate safe lending while also ensuring and preserving access to financing for qualified home buyers. The difference now exists in how the market defines a "qualified" home buyer. The terms "Qualified Mortgage (QM)" and "Qualified Residential Mortgage (NYSEMKT:QRM)" are being referenced quite often in the realm of mortgage reform. The regulatory agencies have sensed an impending need to align these two terms. They are hoping to synchronize these rather complex terms in order that lenders make safe loans to borrowers that would ultimately perform well for the investors. The QM defined by the CFPB (Consumer Financial Protection Bureau), as required by the Dodd-Frank Act, was intended to set a minimum loan standard. It has a borrower's "ability-to-pay" provision that can be complied with by meeting specific underwriting standards. Its aim is to protect consumers from unsustainable loans. The QRM is intended to set a standard for loans placed in an MBS that have a low credit risk.

    In a preliminary proposal in 2011, a Qualified Residential Mortgage referred to those mortgages that had at least a 20% down-payment and no more than a 36% DTI ratio. Among other provisions, it excluded risky loan terms such as the no-doc loans, negatively amortizing loans and the interest only loans. The 20% down payment requirement lent itself to a lot of criticism owing to the term's propensity to limit access to credit for the average American thereby making home ownership a very tall order. With a view to promote responsible lending, banks and bond issuers that securitize these mortgage were required to hold 5% of the mortgages that are sold to investors.

    The proposal was recently revised to eliminate the down payment requirement and the DTI ratio was raised to 43%. Subsequently, the regulators expanded the risk-retention provision to apply the 5% requirement only to those loans that do not meet the underwriting standards to qualify for the QRM status. While the spirit of mortgage reform is much needed and appreciated, the course of these revisions may be indicative of a fragile legislative process. The critics of the revised standard opine that the risk retention rule has no meaning if it is going to exempt most or all the mortgages. If the need is to establish a strong linkage between borrower quality and risk retention by banks, these revised proposals could effectively be diluting this linkage. Requiring no down-payment and the softened risk retention rule has an increasing potential for the market to revert to the old practices. All categories of borrowers could start falling under the purview of a "Qualified borrower". Should things go awry, the market could once again face a preponderance of mortgage defaults. I believe, it is important to set standards that result in a visible positive transition in the functioning of the mortgage market. While everyone recognizes the need for major shift in rules and policies, efforts to expand the boundaries of the law to accommodate the needs of specific factions would undermine the purpose of reform.

    To be more specific, if the zero down payment rule is here to stay in its final version, it is a huge victory for the home buyers. Putting aside the extensive lobbying that takes place which such reform efforts, the sense of accountability that the proposals are trying to enforce on loan originators and banks must also be extended to the borrowers in some form. Every facet of the mortgage market must assume responsibility. The home borrowers can assume responsibility by an external enforcement through a minimum down payment requirement that translates to making affordable and sustainable home purchases and by also making a conscientious alteration in their spending behavior.

    The government, since the crisis, has been introducing a flood of paper money into the economy to stimulate growth and consumer spending. This will eventually increase the likelihood of the consumers to take on more debt. While it may be unrealistic for the economy like the US to switch to a deleveraging cycle to combat such crises, it has become evident that escalating the debt spirals to unsustainable levels can be exceedingly damaging. It augurs well, therefore, to realize that "living within your means" could solve much of the problem.

    Sep 23 10:39 AM | Link | Comment!

    The financial crisis of 2008 has made it apparent that the market, at that time, was devoid of adequate oversight. While the markets were extremely innovative through the issuance of exotic financial products, most of us would agree that a liberal policy environment made these innovations possible. Five years after the crisis, the question that all facets of the market must answer is - Is financial innovation a deterrent for the marketplace and the economy as a whole?

    Innovation is definitely a hallmark of a progressive society. However, the financial innovations of the pre-crisis era were very obscure and less transparent to the investing public. The financial markets in the years leading up to the crisis were rife with innovative products. The innovations and the volume of product issuances drove revenues and profits for all the market players. With these innovations came the menace of rising opacity in the financial markets. Banks were competing to come up with more exotic products which became feasible through a conducive regulatory environment. The regulations on capital requirements for securitizations, governed by the SEC guidelines, permitted and incentivized the Investment Banks to engage in excessive off-balance sheet regulatory arbitrage.

    The regulators are now imposing numerous restrictions through reforms in order to mitigate any future turmoil in the market. The proposed reforms are primarily intended to increase the banks' capital requirements, under the international Basel III capital standards and the Dodd-Frank reform in the US. In the event of a future crisis, it is expected that the banks will hopefully have adequate equity capital to absorb large losses which would eventually serve as a protection to the tax-payers. While this is the primary driver for reforming the financial services industry, will these proposed reforms make innovation prohibitive for the banks and other non-bank financial institutions?

    Being an advocate for free market capitalism, I feel it would be detrimental to the markets if the scope for financial innovation is inhibited through onerous reforms. While, most of us would agree that regulatory oversight is necessary, can this be achieved by also preserving and encouraging innovation in the markets? While this may be an arduous task for the reform advocates and the government, it will only indirectly boost the economy that is on a path of very slow recovery. At this moment, we need policies and regulations that protect the tax-payers but at the same time create a regulatory framework that works for the market place to innovate new transparent products which in turn would meet the risk-return objectives of the investor base. The innovating entities must operate within the boundaries of the framework. When innovation involves sidestepping the regulatory restrictions, it can lead to potential crises in the financial markets. Harmonized stable markets can thus be created only when there is a reasonable and sustained balance between financial innovation and regulatory reform.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Aug 06 11:10 AM | Link | Comment!

    With the economy showing signs of recovery, the exotic financial products are springing back.1The demand for derivatives is once again growing as investors are trying to capitalize on the low interest rates. Notwithstanding the crisis, derivatives will continue to be useful and will serve as good hedging tools. The banks may continue to develop innovative products, even in a more regulated environment. At this juncture, it is important that the market entities take a step back to review the prevailing practices

    Being a former Structured Finance rating analyst of a leading Rating Agency in the years leading up to the crisis, I feel compelled to educate the readers on the intricacies of the market in the pre-crisis years. Since the financial crisis, I have been actively following the developments in the market and my efforts have been more geared toward studying the importance of risk assessment and its management. I have come to realize that the market, going forward, primarily needs a holistic view of risk tolerance. I am not writing this article with the intent of assigning responsibility for the crisis on any particular entity. However, as a former rating analyst, I consider myself uniquely placed to objectively present the idiosyncrasies of the market during this period. This should hopefully illustrate the importance of understanding risk to foster prudent investment decisions.

    As a professionally competent analyst within the group, I was viewed as one capable of analyzing complex and intricate CDO transactions with ease. I rated several hybrid CDOs that often times incorporated abstruse features, which were quite frankly, interesting to analyze. The increased risk appetite of the investors and the positive market sentiment encouraged the banks to come up with more complex derivative products. The period was marked by intense brainstorming sessions within the group. Everyone involved in the rating process was trying to get a grip on the features and their impact on the transaction "deal", in order to suitably incorporate them into the analyses. At this point, I wish to elucidate a few of the qualitative features that increased the complexity in rating these products, particularly the hybrid asset-backed CDOs:

    1. A large proportion of the CDOs' Collateral began having synthetic references in the form of CDS (credit default swaps). While this was widely prevalent even in the past years, the transactions leading up to the crisis predominantly referenced sub-prime mortgage backed securities. The ease of having assets in the portfolio without physically owning it and with no constraint on the notional amounts had become increasingly appealing. In order to account for the credit risk and the liquidity risk, these hybrid CDOs needed liabilities in the form of super-senior swap arrangements or note purchase agreements through a variable funding note. These agreements, while trying to shield the deal from having to take huge losses, were intended to also give regulatory-capital relief.

    2. The Issuer (the seller of protection) serviced its obligations on these swaps through the use of "eligible collateral" that took the form of GIC (Guaranteed Investment Contracts), TRS (Total Return Swaps), Repos, other highly rated liquid assets that also included triple-A rated structured finance obligations or a combination thereof.

    3. Sometimes the deals also comprised of a percentage of "synthetic shorts" where the Issuer, under this arrangement, was the protection buyer. The primary motivation for these types of securities was to partially hedge a long exposure. The deals even had naked (uncovered) shorts wherein the portfolio did not include any long credit exposure to the reference entity. This was intended to mitigate the overall credit risk associated with the long or cash portfolio. However, if the swaps have unintended consequences the deal could get over-leveraged.

    When one is evaluating a deal with all of the aforesaid features, which are only a few of the many, their aggregate impact further augments the complexity of the transaction. For a rating analyst, the analysis typically involved extensive review of swap agreements/confirmations in addition to the deal documents. The combined effect of multiple swap agreements to a transaction of this nature cannot be underestimated. The transactions also had complex cash-flow mechanisms "waterfalls" which needed be explicitly modeled in accordance with the agency's methodologies, while simultaneously accounting for the qualitative features. The robustness of the market necessitated appropriate methodology changes at the agencies. However the crisis has made it apparent that these changes did not totally account for the inherent risks in these securities. This could partly be attributed to the absence of sufficient historical data pertaining to the market at that time.

    The ramifications of these transactions on the market players, given their interconnectedness, have been humongous resulting in the financial crisis. The core of the crisis has only led us all to believe that the risks associated with these kinds of securities demanded a more in-depth understanding by the market.

    The rating agencies have understandably been under intense scrutiny by the market. Numerous other entities will also need to take responsibility for the fallout. As the growth in the Structured Finance market became rampant, the incentives for various players in the market started to get misaligned. As far as the rating analysts are concerned, there has always been a demand to churn deals out expeditiously. The analysts were rating a plethora of transactions prior to the crisis. These complex transactions were often tailored to meet the risk-return objectives of a specific class of investors that ironically possessed limited knowledge regarding these securities. To a certain extent, the proliferation of these complex transactions is consistent with over reliance on the rating agencies. Over-reliance without adequate fundamental analysis by the users can be detrimental. In order to make wise investment choices, the ratings need to serve as a complement to multiple data sources.

    The past few years since 2008 serve as abundant history, making it imperative for all concerned to take necessary actions to prevent such crises in the future. Regulators are making efforts through reforms to mitigate any potential crisis. The rating agencies need to continually review, revise and communicate their methodologies explicitly to the market. While there may not be a panacea for systemic risk, the effective way to mitigate risk will be through integrated efforts and cooperation among various market entities (structural, analytic and regulatory).


    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Jul 11 11:57 AM | Link | 1 Comment
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