Posts filed under “Legal”
Since the credit crisis began, I have frequently found myself in agreement with Paul Krugman. Not everything, but for the most part, especially on many major points, we are sympatico: He has been correct about Moral Hazard, about the folly of these many bailouts, about the advantages of nationalizing the banks. And, I suspect he is right that the economy would benefit (short term) from a bigger rather than smaller stimulus.
Where we part ways is on his criticism of Securitization. I simply do not see it as a proximate or even secondary cause of the crisis and collapse. It is a tool, and whether it is used for good or evil is a function of too many things beyond what its purpose is.
First, lets go to the professor’s Friday column, then see where we part ways:
“Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.
But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.
Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed . . .
A quick definition before proceeding further:
“Securitization is a structured finance process that involves pooling and repackaging of cash-flow-producing financial assets into securities, which are then sold to investors. As a portfolio risk backed by amortizing cash flows – and unlike general corporate debt – the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.¹
Under normal circumstances, securitization works fine. But the 1998 – 2008 period was filled with all manner of aberrational issues. Much of that era terribly skewed financial activity. Consider:
-Fed Chair Alan Greenspan took rates to 1% — so low as to cause an enormous credit bubble;
-The Fed refused to supervise/regulate the new “innovative” mortgage lenders. Hence, millions of ill advised loans took place;
-For most of history, credit transactions were based on the borrowers ability to sevice the debt (i.e., repay the loan); For a 5 year window (2002-07), that no longer mattered. What dominated the lending decision was the lenders ability to sell the loan to Wall Street; Hence, the lend-to-securitize model was born;
-These firms sold mortgages to Wall Street with an unconscionably short warranty: They guaranteed these mortgages would not default for a mere 90 days. This removed the lenders incentive to find qualified borrowers.
-AAA: The major rating agencies (Moody’s, S&P and Fitch) failed to perform their functions. These firms were wholly corrupted by their new business model of getting paid by underwriters, as opposed to the bond buyers. This pay-to-play model is little more than good old fashioned “Payola.” They slapped a Triple AAA rating on pretty much anything they could get a fee on.
-Without these AAA ratings, most of this paper could not have been sold to the various funds, central banks, and SIVs that bought them;
-Credit Default Swaps on the securitized products were wholly unregulated.
All of the above is painfully detailed in to Bailout Nation.
Do not forget that Securitization had been around for decades without major problems. And over the entire period of time in question, credit card loans, auto financing, and student loans were securitized without incident (other than expected cyclical recessionary downturns).
The same can be said about derivatives. Handled properly, they are tools that serve a function. Let loose with no regulation/supervision/transparency/reserve requirements, you have the making of a disaster . . .
We can even say the same about Mortgages. Would you draw the conclusion that because the lending industry made so many bad loans, that mortgages were the problem, and therefore we should do away with them? You have to look at the context in which the loans took place.
Securitization is no different.
Under normal circumstances, it works fine. And if we tweak a bit around the edges — make sure that securitizers cannot shed liability as easily as they have, and adjust incentive compensation away from the current hit & run style of faux profits but real bonuses, Securitization will work just fine.
The Market Mystique
NYT, March 26, 2009
1. Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford U Press, 2003, p. 103 via wikipedia
The AIG bonus hearings on executive compensation the current “bonus bill” is a sideshow that avoids addressing the lack of enforcement of existing law.
To the layman it appears, had the law (below) been enforced, we would get to the root of the problem. Of course Congress has no interest in reducing the lobbying dollars they can collect from firms that rely on those TARP dollars. They would rather pretend to be ineffective populists than effective legislators and responsible public servants.
Doesn’t anyone feel that we could get more accomplished if we enforced the following law?
Dan Greenhaus is at the Equity Strategy Group at Miller Tabak + Co. where he covers markets and portfolio theory. He has contributed several chapters to Investing From the Top Down: A Macro Approach to Capital Markets (by Anthony Crescenzi).
This is his most recent commentary:
Suspending Mark to Market Remains Unlikely
Decreasing transparency has never, and will never, be the answer
MARCH 18, 2009
I will reserve comment about the proposed changes/amendments/guidance regarding FAS 157 until such adjustments are implemented, but I wanted to make a few quick observations regarding FAS 157 and related topics:
To begin with, FAS 157 does not establish the concept of fair value accounting. Companies have been
reporting assets at fair value for years. What FAS 157 did was establish an outline for how companies
should value assets through the Level 1, 2, 3 system with Level 1 assets being the most accurately valued and Level 3 being the least accurate, the so called “mark to model” assets. Suspending that system would, in my mind, unquestionably increase market uncertainty by increasing management input with respect to the valuing of assets. How in the world anyone thinks reducing transparency, which is absolutely what would occur, is a good idea is beyond my understanding. I do not subscribe to the belief that the perceived lack of transparency now, the effect of distressed markets, excuses further reductions in transparency by removing the guidelines, outlines and disclosure requirements as laid out in FAS 157.
Secondly, I also do not subscribe to the belief that somehow these assets are not being priced to their “true” value. While there is certainly some temporary impairment due to market volatility and perhaps some underpricing relative to hold-to-maturity value as we believe it to be today, the fact remains that an asset trading at a significant discount to its true value would attract buyers in larger numbers than we’re seeing. The truth is that these assets are not seeing the interest they otherwise might be for a variety of reasons, not the least of which is that the “true” value of these assets are in contention right now. Could the value be higher than, say, 30 or 40 or 50 cents on the dollar? Sure. But I don’t know that and with high levels of macroeconomic uncertainty hanging over our heads, I believe that many market participants are staying away for fear of incurring losses on these positions.
Why does the US taxpayer have to guarantee every single transaction done on Wall Street? Since when is that our obligation? If the taxpayer is on the hook to bailout systemic risk, then don’t they have the right to prevent that systemic risk? Or alternatively, reserve for/insure it? I keep hearing that Wall Street must…Read More
It looks like the FASB is in full retreat on fair value accounting. Below is an artifact from the period we published today in The IRA. Author is a very well respected analyst who worked for the Fed in the 2007 period and tried to sound a warning about the supervisory implications of a FVA regime. I am going to do a victory lap at AEI today when we convene the latest “Deflating Bubble” session. – Chris
March 17, 2009
The following article on fair value accounting (“FVA”) was authored in May 2007 by a researcher who at the time worked for the Federal Reserve System. The paper, which was not approved for publication by the Fed Board’s bank supervisory staff, outlines some of the issues in a transition to FVA, issues that have turned out to be critical. Many of these issues now may be obvious to students of financial institutions and the general public thanks to the financial crisis, yet two years ago the paper was dismissed by the Fed’s staff in Washington. To us, the story around this article provides yet another example of how the intellectual closed-mindedness of the Fed’s Washington staff results in bad public policy.
Some background for context. The Fed and other bank regulators historically did not push back on supervised firm accounting “choices” or otherwise second guess the external auditor on valuation issues for financial firms. That is, if a financial firm could get its paid accountant to sign off on a choice of valuation methodology — choices which in many cases are based purely on “stated intent” at the time to hold an asset for sale or to maturity, then the paid regulator at the OCC (figure roughly 50 examiners for each too-big-to fail bank) and its more poorly staffed step-brother, the Fed (roughly 7 examiners per TBTF bank), would simply accept the decision without question or review.
During the bubble years, the author and other members of the federal bank supervisory community fought internally and with the banks against apparent inconsistencies in accounting choices — for example, the same large bank would put a big chunk of liquid exchange traded equites that turned over frequently into AFS, while putting illiquid slow-to-turn distressed debt in trading. Most regulatory accountants, though knowledgeable and well meaning, were in some sense lazy, as they felt it much more important to maintain GAAP and regulatory accounting parity, then it was to have more correct reporting based on actual facts and behavior.
Joe Nocera had a brutal — and brutally honest — column today. He essentially states that the Madoff victims were willing accomplishes through their own naivete and bad judgment. “And yet, just about anybody who actually took the time to kick the tires of Mr. Madoff’s operation tended to run in the other direction. James…Read More