Wednesday, March 3, 2010

Vanilla Options for Securitization

Original posted on Rortybomb:

We’ve done vanilla options for derivatives, and vanilla options for stakeholders. Let’s do another. Let’s look at another piece of reform that is necessary that involves having mandated transparency, clean rules and good information do the work of fixing the financial system, and that is Chapter 8 of the Make Markets Be Markets Report, Josh Rosner’s Securitization: Taming The Wild West.

Josh Rosner is Managing Director at the independent research consultancy Graham Fisher & Co, and called the financial crisis perfectly. Here’s an interesting interview with him. Here he is with “Housing In the New Millennium: A Home Without Equity Is Just a Rental With Debt”, calling the problem in June of 2001. Here’s CNN’s writeup of him. His writing has been all over the blogosphere, including The Big Picture. And he’s been at the forefront of issues related to securitization and the financial markets.

I’m going to post some of it and go over it, but you should read it all:

To ensure adequate transparency, enhanced disclosure rules should be required both for deals with and without static pool data (such as asset backed commercial paper). Data on the specific underlying collateral in each pool should be made available for a reasonable period (not less than two-weeks) before a deal is sold and brought to market. This should be done to enhance investor due diligence, to foster the development of independent analytical data providers, and to reduce reliance on rating agencies, The loan-level data should be available in an electronically manageable and standardized format…Regardless of the nature of the deal (private placement or registered) the data should be publicly disclosed to the loan level and all servicer advances to the pool shall be disclosed as such on a timely basis. Any subsequent repayments of servicer advances should also be reported in a clear manner…

Rather than recognize this lack of timely loan-level performance disclosure standards, regulators and legislators have been pushing to require issuers to hold a slice of every deal they issue. On the surface, this appears to make sense. But on closer examination, that requirement would not have prevented the past crisis and it probably won’t prevent the next one. Many of the firms that have been harmed by holding these securities were the same firms that issued them. The retention argument comes from the belief that issuers may have knowingly sold toxic securities. But more often, these firms didn’t have the available information or resulting ability to fully model their exposures. To force them to increase concentrations of these held securities will only increase their risks…

Contracts that Work

We also need to address the lack of uniformity in the contractual obligations between various parties to a securitization. “Pooling and Servicing Agreements” (PSAs) and “Representations and Warranty” terms can be several hundred pages long. They define features like the rights to put back loans that had underwriting flaws, the responsibilities of servicers, and the relationship between the different tranches…

The lack of standardization and the length of the documentation effectively created opacity, which contributed to the problems in the securitization market. When panic set in and investors began to question the value of their securities, they knew that they did not have the time to read all of the different several-hundred page deal agreements. This reinforced the rush to liquidate positions. What investor wants to be the last one holding a security whose terms he doesn’t fully understand?…

Amazingly, three years after a crisis, there is still no single standard accounting or legal definition of either delinquency or default. The entire purpose of accounting standards and securities law is to provide a framework for comparability. Yet we still do not have a single and accepted definition for so many of the key credit measures…

Simply, we need standards that transfer credit and liquidity to investors, but place underwriting risk with the issuer for specific period of time tied to the final closing of the collateral pool (after any revolving period) and linked to resets and amortization of loan specific types of collateral…

Because of the lack of a fiduciary obligation to the first lien holder, the servicers are often motivated to protect their firm’s second lien positions, rather than the first lien holders’. And because of the way the servicing agreements are written, servicers are often able to justify their inaction by hiding behind the disparate obligations they owe to investors in different tranches…New rules in securitization should clearly define the servicer as a owing a fiduciary duty to the investor in securitized pools. Or perhaps more effectively, it should specifically prohibit financial entities from owning servicing where the servicing results in a conflict.

I was actually surprised that he didn’t recommend the issuer hold a slice of the risk of what they originate. When we talked about it, my head spun around going “adverse selection game theory” over and over again, and he responded that this assumption assumes that what is in the securitized item must be junk. But it doesn’t have to be, it just needs to be properly disclosed, with those records publicly accessible to all while being maintained for new information. There needs to be a standard, both on the legal side, and on the disclosure side. We don’t want the originators holding credit risk, we want them to hold underwriting and legal risk.

“The entire purpose of accounting standards and securities law is to provide a framework for comparability.” This framework isn’t coming, and so it’s up for the government to require it. Once the data is disclosed, market participants, rationally seeking profits, will find the tools, models and mechanism to understand it. But if that data isn’t trustworthy, or isn’t required to be updated, or, and this is where the big problem comes in, there is legal and definitional uncertainty as well as a lack of comparability added to the equation, then we lose the whole point of having market information here, and securitization can’t function.

The Rosner piece is a bit technical, but I hope you give it a read (and watch the talk). At the very least, it emphasizes how broken the system remains, and gives a way out that emphasizes the idea that the government needs to jumpstart the market portion of it.

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