Posts filed under “Regulation”
Regulatory Malfeasance and the Financial System Collapse
by Joseph R. Mason
April 14, 2009
Kotok comment: we are pleased to forward this guest commentary by Professor Joe Mason. In it he outlines ways in which the securitization process went awry and led to the financial crisis we have been experiencing. Joe notes some of the warnings. He also furnishes a link to his recent paper on mortgage servicing which we have read and recommend to our readers. We thank Joe for permitting us to share this missive with our readers.
Joe Mason wrote:
Greetings from Rome! While I look forward to the Banca d’Italia’s program on “Financial Market Regulation after Financial Crises,” on Friday National Journal features correspondent Corine Hegland published a rather scathing account of risk transfer in securitization entitled “Why the Financial system Collapsed” (available at http://www.nationaljournal.com/njmagazine/cs_20090411_7855.php) If anyone wonders why regulators did not recognize the growing problem of risk on bank balance sheets over the past decade, this article is a good starting point.
Ms. Hegland begins by explaining to readers the distillation process of securitization. In short, when a securitization throws off a preponderance of risk-free debt in the form of AAA-rated securities, there must be a complimentary – albeit smaller – proportion riskier lower-rated securities that absorb the losses. In February 2007, I asked “where the risk went?” As I knew back then and Ms. Hegland clearly describes in her article, the risk never left the originating institution (the sponsor), typically a commercial bank.
Think of the problem this way. If a bank sells a pool of loans with an expected loss rate of two percent, they can’t really sell the two percent. They could discount the price, but that is just taking the two percent loss now rather than later. But if losses turn out to be less than two percent the bank made a bad deal. So the bank usually prefers to keep the first loss piece – called the residual. Hence, the expected loss is retained.
While I have written about this previously, Ms. Hegland does an incredible job of describing the degree to which regulators knew about the problems with risk transfer and willfully looked the other way. Ms. Hegland not only shows how regulators memorialized such practices in regulatory rules, moving away in 2004 from requiring a transfer of a “majority” of risk to merely requiring a structured finance arrangement to transfer “some” of the risk.
Where the article really gets fun is where it cites explicit warnings by none other than Fannie Mae and Freddie Mac that such relaxed standards would indeed result in a shell game, where partial or nonexistent risk transfer would cause a financial crisis. In the words of Freddie Mac in response to notice of proposed rulemaking in 2001 (as published in the National Journal), such practices would encourage banks “…to structure securitizations that reduce their capital requirements to a fraction of what they would otherwise be required to hold, even though the risk exposure remains the same. The results could be a net reduction in the amount of capital in the banking system to protect against credit risk.” Fannie Mae said even more clearly back then, “There should be equal capital for equal credit risk, regardless of the form in which the risk is held.”
While Ms. Hegland’s article is a good jumping off point for many who are just now learning about securitization (and perhaps trying to structure bailout programs for the large institutions who took advantage of the perverse regulatory rulemaking), it is still just an introduction. The next step lies in better understanding the terms and triggers of securitizations to recognize perverse incentives apparent in selling the AAA securities but keeping the risk, while also servicing the loans. My recent paper, “Subprime Servicer Reporting Can Do More for Modification than Government Subsidies” (which just made the Social Science Research Network’s Top Ten download list for the Financial Economics Network Professional & Practitioner Paper Series, available at http://papers.ssrn.com/abstract=1361331) shows that while securitization deal terms that require servicers to hold residual stakes can properly align incentives in steady state market environments, they can create perverse incentives when markets are in free-fall. Right now, therefore, a preponderance of servicers are using any means necessary – including modifying loans whether borrowers can pay or not – to keep securitizations in which they hold residual and junior bond stakes away from triggers that can move their own investment stakes from first in line to last in line.
Shrewd investors know that if mortgage pools perform well, those junior stakes are repaid in the first few years of the deal. If, on the other hand, mortgage pools perform poorly, those junior stakes go to last in line after everyone else is completely paid off. So while nobody in policy circles wants to talk about it, tranche warfare has erupted, with senior investors fighting junior investors to maintain credit enhancement that protects senior investor value as junior investors who control the servicing are delaying inevitable delinquencies and losses – the key measures of pool performance – through various strategies including modifying anything that moves, delaying the sale of foreclosed homes, and even inside dealing in home markets to prop up reported sale prices.
In summary, financial markets are a long way from fixed. Policymakers need to take advantage of calm markets to work on reform, so that we will have fewer panics in the future. Otherwise, we are destined to keep repeating the same panics over and over.
Joseph R. Mason – Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information: firstname.lastname@example.org; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on http://www.rgemonitor.com/financemarkets-monitor/bio/626/joseph_mason.
Looks like an interesting panel — anyone near D.C. on April 15 should consider going . . .
10:10 a.m. — Panel One: Current NRSRO Perspectives: What Went Wrong and What Corrective Steps Is the Industry Taking?
- Daniel Curry, DBRS
- Sean Egan, Egan-Jones Ratings
- Stephen Joynt, Fitch Ratings
- Raymond McDaniel, Moody’s Investor Service
- Deven Sharma, Standard & Poor’s
11:30 a.m. — Panel Two: Competition Issues: What are Current Barriers to Entering the Credit Rating Agency Industry?
- Ethan Berman, RiskMetrics Group
- James H. Gellert, RapidRatings
- George Miller, American Securitization Forum
- Frank Partnoy, University of San Diego
- Alex Pollock, American Enterprise Institute
- Damon Silvers, AFL-CIO
- Lawrence J. White, New York University
12:30 p.m. — Lunch Break
1:15 p.m. — Panel Three: Users’ Perspectives
- Deborah A. Cunningham, Securities Industry and Financial Markets Association
- Alan J. Fohrer, Southern California Edison
- Christopher Gootkind, Wellington Management
- James Kaitz, Association of Financial Professionals
- Kurt N. Schacht, CFA Institute
- Bruce Stern, Association of Financial Guaranty Insurers
- Paul Schott Stevens, Investment Company Institute
2:45 p.m. — Panel Four: Approaches to Improve Credit Rating Agency Oversight
- Richard Baker, Managed Funds Association
- Jörgen Holmquist, European Commission
- Mayree C. Clark, Aetos Capital
- Joseph A. Grundfest, Stanford Law School
- Glenn Reynolds, CreditSights
- Stephen Thieke, Group of Thirty
The roundtable is expected to end at approximately 4:15 p.m. with concluding remarks by Erik R. Sirri, Director of the SEC’s Division of Trading & Markets.
In the fall of 2006, Congress passed the Credit Rating Agency Reform Act, providing the SEC for the first time with authority to supervise credit rating agencies. Using this authority that became effective in June 2007, the Commission has adopted two major rulemakings, has conducted an extensive 10-month examination of three major credit rating agencies, and has several pending proposals to further the Act’s purpose of promoting accountability, transparency, and competition in the rating industry.
I mentioned the “cult of equities” earlier this morning; An article in the Atlantic on the Cult of Finance is making the rounds: The Quiet Coup. I found it very similar to Bailout Nation. If this sort of stuff floats your boat, then you will love the book — it gets much more granular than…Read More
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…Read More
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
NBR’s Darren Gersh talked with Jim Chanos, President of Kynikos Associates. He asked the legendary short seller for his take on investment opportunities in this market. A portion of the interview aired in tonight’s program. You can watch the extended version here. Just click the image below. (You need Flash installed to watch.)
click for video
Avinash Persaud, founder and Chairman of Intelligence Capital, discusses regulatory solutions that would avoid this happening next time: Lending to a Credit Rating
The credit rating section begins at ~22 minute
Gresham College, Running time 51 min 45 sec
One of the puzzles of the 2007/8 credit crunch is how a relatively small loss of capital in a tiny market segment was transformed into a global financial crisis costing close to $1 trillion and sending the world economy into slowdown.
Key players in this tragedy are a set of legal and accounting principles that are well-meaning, but turn financial hiccups into liquidity black holes.