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.