Saturday, February 6, 2010

Can the world be made safe for the return of securitizations?

Original posted in the NY Times by Floyd Norris:

That is a question of great importance to those like John C. Dugan, the comptroller of the currency, who say they believe that the banking system on its own is unlikely to have the ability to provide enough credit to sustain an economic recovery in the United States.

“We need a vibrant, credible securitization market to help fund the real economy going forward,” Mr. Dugan said this week. He was preaching to the choir — a meeting of the American Securitization Forum — but it is an opinion widely held in financial markets.

It is possible to question that thesis. Securitization grew as a way for banks to get around capital rules, not because of any profound desire by investors for such assets or any real unwillingness by banks to make the loans. But since it was more expensive to hold capital against the risk if the loans were not securitized, they were securitized. That also opened the market to new players, who neither wanted to, nor could amass, the capital to hold onto loans.

Together, those developments undoubtedly made mortgage loans less expensive for borrowers. That was welcome to politicians and to regulators, who wrongly thought that securitization had moved a lot of risk outside the banking system.

Then the whole structure collapsed.

If they have no way to gain capital advantages from securitization, banks might choose to make more loans anyway, and the economy could get by without securitization.

But there is no doubt that the banks have not fallen all over themselves to lend as it is, even with many billions of dollars in government-supplied capital. Something like 95 percent of the American mortgage market now depends on government guarantees, through Freddie Mac, Fannie Mae or the Federal Housing Administration.

At some point, that share has to decline drastically as the government steps back. And it is reasonable to think a securitization market could be part of the answer.

But how to do it? The old private securitization failed for a variety of reasons. Loan underwriting standards vanished in part because the people making the loans concluded they would profit from fees for arranging the loans, whether or not they were ever repaid. Regulators stood aside, thinking they had no power over many players.

Investors in the securitizations did not do their homework, either assuming that rising housing prices made such work unnecessary or that the quality of the loans was being policed by bond rating agencies, which were doing no such thing.

There are several essential elements to any fix. The underlying loans have to be of better quality. The investors have to believe that is the case and that they are being compensated for risks that were much higher than they previously believed. Another 30 percent collapse in home prices is unlikely, but it will be a while before anyone’s models deem such a thing impossible.

There are two ways being suggested to deal with the quality issue. Mr. Dugan favors using government edicts to set lending standards. Other officials want to find ways to use the market system to promote better lending.

The principle market-based approach now being pushed is called “skin in the game.” Force a banker to hold onto some part of the loan — and details of just how much, or in what form, are subject to debate — and he will act better.

In an interview, Mr. Dugan said he was not necessarily opposed to such rules, but he had a lot of doubt about them. First, there are accounting issues. The accounting rules are not clear, and even if they were, banking regulators like Mr. Dugan could allow the banks to deviate from them in computing capital. But the reformed rules do make it harder for banks to get loans off their balance sheets if they retain any stake in them. And capital must be held against assets that are kept on the balance sheets.

In his speech, Mr. Dugan said he thought off-balance sheet treatment was vital to getting the securitization market moving again, and that meant a “skin in the game” rule could be perverse.

“A requirement intended to improve the securitization market by improving the quality and trustworthiness of underwriting could significantly curtail the number of securitizations that are actually done,” he said. “And that, of course, could materially reduce the amount of credit available for housing or any of the other sectors that have traditionally benefited from securitizations.”

There was, he said, a simple question to be asked: “Instead of going at the underwriting problem indirectly through ‘skin in the game’ requirements, why not attack it directly?” Why not enact regulations to force lenders to lend responsibly?

He talked of requiring lenders to actually check income of borrowers, and to set minimum down payment rules. But he was vague on how low the down payments should be. The F.H.A. still requires only 3 percent, which may be too low, but raising it would be politically explosive.

Moreover, it is hard to envision rules that cannot be evaded by someone who wishes to do so. Bank examiners cannot check every loan.

There is also the real possibility of political interference. It is not hard to imagine a bank telling someone he could not get a mortgage because of a stupid government rule, and that person complaining to his congressman. It might really be absurd to deny that person a loan, but changing the rule could weaken it for others who might be less worthy borrowers.

The Federal Deposit Insurance Corporation is considering imposing some kind of “skin in the game” rule for securitizations, forcing a lending bank to hold on to part of the risk of default.

“We must have better loans,” Michael H. Krimminger, the deputy for policy to the F.D.I.C.’s chairman, Sheila C. Bair, said in an interview. “One way is to have regulatory fiat. That is important, but it is not sufficient.”

If the private securitization market is to be revived, would-be investors will have to be persuaded there are better safeguards. Such persuasion seems likely to include more disclosures, more time for investors to review loans before securitizations are completed and perhaps some rules to assure that mortgages are not securitized until the borrower has met several monthly payments.

Even then, it might be difficult to persuade investors to trust in loans made by lenders who are unloading all the risks on investors.

Mortgages are highly dependent on individual facts that are not easy for an investor to review. Is the borrower really responsible? Is the house really worth this much? It was mortgage lenders who bribed assessors to overstate the value of homes so the mortgages would go through. At a minimum, any new securitization system should take away that incentive from the lender.

The beauty of Adam Smith’s “invisible hand” is that it leads players to maximize the welfare of all by seeking to maximize their own welfare. But that hand is diverted in perverse ways if the player thinks it can profit from making a bad loan. A reformed securitization market may need to rely in part on bringing back that invisible hand.

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