I don't get it (from Yahoo):
Securitization, or the packaging and selling of loans as
securities, has been blamed by critics for eroding lending standards in
the mortgage and other lending businesses.
A Treasury spokesman said the administration would propose
requiring lenders to retain 5.0 percent of the risk they securitize. A
bill to do this was approved in May by the U.S. House of
Representatives, but is languishing in the Senate.
Here's my guess. Securitization has gotten a bad name because banks originated loans with no incentive to be careful. So to keep securitization going, we have to force people to take a stake
But maybe we should have less securitization. This does not seem to be on the table. Why not? Could it be because some one has hopes of making money on it again?
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I'm not sure I understand the point of creating a security you can't trade. I'm no expert, but wouldn't this just create an incentive to securitize loans the bank planned to keep in the first place? I'm not sure I see a benefit here.
Wow. A whole 5%? I'm sure that the ability to get only 95% of the loans they make off their books will REALLY make those lenders think twice. Especially when you consider that the U.S. government is now in the habit of backing almost all loans. These politicians are really hitting this hard.
The only thing this and most of the regulations proposed will really do is increase demand for compliance officers and decrease productive activity.
Russ, I don't exactly understand why we should have less securitization. I know Arnold Kling doesn't like it either. ABS have been around for decades without problems and it seems to me that the recent bubble trouble had a lot more to do with problems in the underlying (bad loans) and the lack of due diligence on the part of the ABS buyers than it did with the asset class itself.
I always assumed that, at least in part, the amount of securitization was due to a) the presence of Fannie and Freddie (to take stuff off the banks hands and create the market), and b) a banking sustem riddled with moral hazard. Get rid of Fannie and Freddie and trim down on the moral hazard front and one might find less securitization.
One does not have to go beyond the first lecture of a corporate finance course to arrive at the conclusion that having the originators keep a stake is the sensible thing to do in this case. That this has to be government imposed only testifies to the financial incompetence of the last years.
Maybe I'm missing something but if the investment banks/banks who created these securities over the last many years had not retained some of them, they wouldn't be sitting on the losses they are. So, what exactly does this accomplish?
I suppose there is the possibility that they didn't retain any of the ones they created and instead loaded their balance sheets with issues from other banks, but that just doesn't make sense to me. Wouldn't they retain the ones they knew the best, i.e. the ones they created? If JP Morgan was afraid to keep the ones they created why would they trust the ones being created by Bear?
Another possibility is that the toxic assets were pieces they weren't able to unload before the bottom fell out of the market, but I fail to see how requiring them to retain some of each new issue would yield a different outcome.
This looks to me like a way to "do something" without really adressing the problem.
And what of the loan originators? They were the ones writing mortgages to anyone with a pulse, because there was huge demand for them to turn around and resell the debt. They were manufacturing poor-quality debt day and night, and were in the clear instantly.
What does having to hold 5% mean? Does that mean they can simply purchase a swap similar to how reserve requirements for banks are met today?
Joe,
You're exactly right. Many of the I-banks which underwrote the MBS and CDOs actually DID take positions in those securities which they underwrote. In fact, this is not an uncommon practice for underwriters and many exercise the option to take a position in those securities by exercising their greenshoe provision. And you're also correct that many of the underwriters were caught holding issues that they hadn't sold yet but for which demand evaporated. They already run the risk of "eating their own cooking" by virtue of underwriting these issues in the first place. But, the wording in the article implies that the loan originator will have to keep small percentage of the ABS on its balance sheet.
Still, forcing originators to keep 5% of their loans on their books is not a high enough percentage to matter. Forcing underwriters to hold 5% of the issue is inane. Not every security the I-bank underwrites fits into its proprietary portfolio. So the I-bank shouldn't perform an underwriting service when there is demand for a security merely because it can't take the risk of holding that security in its portfolio? That really would do something – it would raise the cost of underwriting. Higher costs, low benefits. Sounds like a government program.
I was discussing something elsewhere yesterday that I think plays a big role in the danger of these instruments.
When trading a commodity other than debt, the normal market mechanism of supply and demand regulates the price of the commodity. When something gets too expensive, people stop buying it.
That's not the case with debt. People look at the yield and say, I like it, or I'll take my chances elsewhere. The pricing pressure is in whatever market the underlying debt is funding.
The instrument itself is completely decoupled from that market.
Investors just see this black box covered in coupons. These things of course sell at a pretty brisk pace. In order to manufacture another one, loans have to be made.
If pricing pressure is starting to dry up appetite for loans, then demand must be artificially stimulated, and one way to do that is to expand the market by making riskier loans.
I have always been under the impression that the point of securitization was to allow the law of large numbers to replace specific underwriting. Unsecured credit card lending can be very profitable..or at least it used to be, but default rates on securitized mortgages were badly underestimated and institutions were allowed to imploy insane leverage so maybe holding 5% will force a bit of due dilligence but it defeats the purpose which was to spread the risk and thereby play the odds. Why don't they just say no more 30:1 leverage and no more off balance sheet…all the rest is noise.
Why don't they just get rid of regulatory arbitrage opportunities that encourage banks to hold securities over whole loans for lower capital requirements?
Or perhaps they could stop running protection for the rating agencies, whose ratings of securities are used to determine capital requirements and are paid for by the issuers.
Are either of these being addressed? They seem like good places to start…
What's really scary about all of this is that I know, while they might not all be crooks, not more than a handful of Senators or Reps even remotely understand this stuff. Not remotely. Thus, the answer to me would seem to be to remove the safety net for banks and the huge moral hazard incentive, rather than tweak it with fingers crossed.
Investors just see this black box covered in coupons.
These ABS were not sold to mom & pop. They were sold to institutions which employ an army of fixed income analysts. If they failed to do the due dili or just didn't bother asking questions, then it's pretty hard to blame the black box.
If pricing pressure is starting to dry up appetite for loans, then demand must be artificially stimulated, and one way to do that is to expand the market by making riskier loans.
That doesn't make sense. Increasing supply in the face of waning demand neither increases demand nor drives up prices. The demand that was artificially stimulated was the demand for loans by making money cheap through the GSEs and the ridiculously low interest rates. The buyers of the pass-throughs demand yield. Since the prices were bid up and the yield for similarly rated new securities was at historical lows, investors "solved" the yield problem with leverage – which, of course, compounded the problem when the bubble blew. The thing about leverage is that there's no clear formula for how much is too much and how much is too little. simply arbitrarily choosing a number – 20:1 or 10:1 versus 30:1 – is meaningless. There are situations where 2:1 is too much and 30:1 is perfectly fine. If you forbid off-balance sheet items, they will find a way to do deals that are so murky and so opaque that off-balance sheet items will seem positively transparent. Who cares? They'll be bailed out anyway.
Basically, if you don't want the risks of banking and financial services, too bad. The best thing is let failed institutions fail. That's the only way to make them think twice about risk. This is all smoke and mirrors.
Pardon me, but I don't get it. Russ, you think securitization should be outlawed between free adults or free institutions? On second thought, I guess most issuers and buyers are not exactly free market institutions, but more like intensely regulated and even guaranteed (by the taxpayer) institutions.
I propose we let people or institutions dumb enough to buy bad securities, not read prospectuses, not do due diligence, buy things they don't understand or dumb enough to believe rating agencies or to trust people they don't know take their hits without a rescue.
Then maybe investment banks, commercial banks and rating agencies would again have some incentive to present themselves to the world as trustworthy both in their character as well as their balance sheet. Then there might again be securities we could trust. Of course we would also need a government that did not arbitrarily blow away confidence by wiping out bondholders ala GM and Chrysler. ]]]
I think we might be doomed in the short run as well as (ala Keynes) in the long run.
The demand that was artificially stimulated was the demand for loans by making money cheap through the GSEs and the ridiculously low interest rates.
The money was cheap because of leverage. Every time a mortgage was written, it was levered up 30x as it participated in new bond sales.
There was incentive to write new mortgages, and it involved huge profits.
My wording was clumsy. I should have said they needed to artificially increase the number of customers.
You have to admit, the pitch was pretty slick:
No money down, no credit checks, easy introductory rates. That satisfied the initial requirements.
Then, merely pointing out the huge gains in house prices even inside the introductory timeline, showed the downright reality of the possibility to flip the house for a profit, or to re-fi against the new valuation.
What I don't believe for one second is that nobody in the financial industry ever once considered what would happen if house prices stopped going up.
It's about as likely as inventing escalators that only go up, and nobody ever thought about one that goes down.
I have to agree with everything K Ackermann says in this… What "caused" the issue was not that people are allowed to hedge, but that a lot of the underlying asset defaulted.
But these things have an incredible way of self-regulating. Look at the insurance market. You can't buy 20 million in disbility insurance unless you're worth 20 million. Stake in the game or not, no-one is going to let you hedge that much. Same with life, health, and any kind of insurance that exists.
The way the insurance industry manages this is by ensuring that you will be insuring against real or potential loss, and not for gain, because that skews the odds.
The same applies here. Over the next year or two, if we can stop people from getting their grubby hands in the way, the buyers and providers will work out a way to make sure they don't get in this mess again. In the case where you are hedging without a deliverable underlying asset, it's likely along the lines of ensuring that there is a real risk that is being hedged.
People would rather not lose money. They also don't like being in Obama's pocket. We just have to make sure that the people who have the greatest incentive are the ones that put the controls in place. That's not the government, no matter whether you think they are doing it for our benefit or theirs.
Cheers, that's a great point about hedge vs. profit.
It has taken years to work out a pecking order of claims against assets in a bankruptsy. A standard step was for creditors to avoid bankruptcy by devising a new plan for the company to get back on track. This has been done countless times to great effect.
As it now, by holding swaps, it can be very profitable to root for bankruptcy instead of a restructuring.
Everything about that seems wrong.
If something is regulated, then it's behaviour becomes more regular, predictable, and smooth.
What the government calls "regulation" deserves no such name.
Nassim Taleb is on record saying we don't need these complex financial products and many of them should be banned.
Well, if Nassim Taleb thinks so, then by God, I'm convinced.
muirgeo,
From what I can discern, Nassim Taleb disagrees with you about almost everything except this issue. Why should it matter to you what Taleb says about complex financial products? You clearly think he is wrong about almost everything.
muirgeo,
From what I can discern, Nassim Taleb disagrees with you about almost everything except this issue. Why should it matter to you what Taleb says about complex financial products? You clearly think he is wrong about almost everything.
The risk is that buyers of securities meeting this new standard will assume that the securities have an implicit state guarantee and thus will not take the risk seriously. We need the strongest possible check on Congressional authority to bail out creditors, something like a constitutional amendment. A limit on Congressional authority to impose credit on taxpayers would be nice too. And then free banking.
Needless to say, I'm not holding my breath.
The money was cheap because of leverage.
That's one reason – also the money was cheap because interest rates were too low. Note that mortgages were not a new product but suddenly you didn't have to put 20% down or prove income anymore. The government encouraged this by allowing Fan & Fred to significantly increase the amount of alt-A and subprime mortgages they buy. This, in turn, gave lenders every incentive to write more of those mortgages.
The only reason the lenders needed to increase the number of customers is because there was the ultimate lenders (the buyers of the "black box with coupons) were willing to lend. That willingness was exhibited by professionals – not Mom & Pop who didn't know how to do due diligence. The fact that these sophisticated investors didn't do due diligence doesn't mean the black box was faulty. They got the product they demanded.
You have to admit, the pitch was pretty slick:
No money down, no credit checks, easy introductory rates. That satisfied the initial requirements.
Did that pitch work on you? It didn't work on me. You seem to imply that we have to idiot proof mortgages because some dumb would-be house flippers are willing to take all kinds of risks to satisfy their greed. You also imply that the loan originators are so clever that they outsmarted I-banks and hedge funds as well as Mom & Pop. You don't think the average house-flipper came to think prices are ever increasing and house-flipping is riskless without the help of lenders? You really underestimate the stupidity of some people.
What I don't believe for one second is that nobody in the financial industry ever once considered what would happen if house prices stopped going up.
You shouldn't believe it. I remember sitting around with a group of people all scratching our heads. But, you won't hear about us because we didn't get into trouble, didn't receive TARP and personally didn't buy houses when they were over-valued because prices will "go up forever". That has nothing to do with anything. Lenders in competition for market share will lend on whatever terms they need to in order to compete. The buyers of the ABS will do what they have to do to chase yield. The housing market was heading up, so they were piling in. No amount of regulation will ever change those incentives – at least not without creating much worse problems.
Since nobody is being held responsible (sued for millions and going to jail) for the 100% of the securities that went haywire they now think that they can solve it by holding the banks responsible, to themselves, for 5% of these securities. What happens if some of these 5% stakes go wrong?… banks have to charge higher rates…What happens if too many of these 5% stakes go wrong?… taxpayers have to pay. Sheer madness.
One problem we all confront is that asking for “some skin in the game” is that it is such a cute statement that all politician regulators and commentators love it.
And then of course I subscribe 100% to the questions posted by Dave above
Ten principles for a Black Swan-proof world
http://www.fooledbyrandomness.com/tenprinciples.pdf
6. Do not give children sticks of dynamite, even if they come with a warning . Complex
derivatives need to be banned because nobody understands them and few are rational enough
to know it. Citizens must be protected from themselves, from bankers selling them “hedging”
products, and from gullible regulators who listen to economic theorists.
"Citizens must be protected from themselves, from bankers selling them “hedging”
products, and from gullible regulators who listen to economic theorists."
This is the justification for the nanny state. The same logic applies to smoking, drinking, etc.
No thanks.
Telling: The American Securitization Forum, my trade group, is having next year's event not in Vegas or NYC, as ususal, but in D.C.
I don't understand how Nassim can go from saying that regulators and government officials that screwed up should not be allowed to continue "driving the bus", but then goes on to say that citizens need to be protected by themselves.
I have not read his books, but from every article of his I have read I get the sense that he is not a terribly clear thinker, or at least has not fully thought through his ideas.
Sorry, should be "that citizens need to be protected FROM themselves," not "by".
It's amazing to see people who claim to be all about market mechanisms talking about the value of financial instrument that are designed to avoid market mechanism by being so complex almost no one knows their value or how to price them.
As far as I am concerned Wall Street should be able to design as toxic of products as they lke as long as two conditions exist.
1) They have no direct ties to our treasury.
2) In every financial instrument in which they exist they should be labeled so like ingredients on a container of food are labeled.
When people realize an investment product has the equivalent of 100 grams of trans fats and cyanide as well they will not allow them into their investment portfolios.
Then the products can be traded by the Bernie Madoffs and his rich clinets all they want.
Recommended viewing is the latest edition of Frontline. What a display of the pathetic nature of the typical big bank CEO. These people who live just to make money are to be pitied if only they weren't destroying the lives of so many others.
In a truly free market, if financial instruments are so complex that almost no one knows how to price them, then almost no one buys them, but of course, our markets, particularly our financial markets, aren't remotely free.
Fat chance. The capitalists don't want that much freedom.
The following label is sufficient.
"This financial instrument has no state backing whatsoever, and any post facto state backing of it is a constitutionally impeachable offense. Buy at your own risk."
So 1 and 2 are redundant.
The reason WaMu went bankrupt is because it held on to so much of it's bad risk …
Mortgage originators in OC, California were leveraging at 41-1.
That's a problem.
Only a free market can develop rational mortgage securitization programs. The government should simply get out of the way. Regulation inhibits the market's need to learn from mistakes and be creative.
It's amazing to see people who claim to be all about market mechanisms talking about the value of financial instrument that are designed to avoid market mechanism by being so complex almost no one knows their value or how to price them.
If a fool like you doesn't understand anything more complex than the cheese sandwich his caretaker prepared for lunch for him, I'm not deeply troubled by that. Just because you're too stupid to understand these products, doesn't mean that others are as well.
"Just because you're too stupid to understand these products, doesn't mean that others are as well."
Posted by: Methinks
You talking to me or Nassim Taleb???
41:1? Ouch!
It goes to show that rational is totally subjective.
You talking to me or Nassim Taleb??? – Yasafi (pretending to be DiNiro)
If the shoe fits…
I did notice, when you cut and paste from others' comments, that your and you're are used correctly in your posts.
Okay, it may be a few years since my finance and economics degree but why should the securitizers hold onto the risk?
Surely some due diligence from the people buying the risk would have created a fair market where the risk was priced appropriately?
Surely some reasonable regulation would have stopped institutions using risky, securitized products as collateral for taking on board new debt?
And, my main problem in this whole thing, where were the non-executive board members whose sole purpose in their $100k+ 1 day per week job is to safeguard the shareholders' equity by stopping the board from taking dangerous risks?