In our latest issue of The Institutional Risk Analyst, we tell the story of Westamerica Bancorp (NASDAQ:WABC) and how it acquired an insolvent bank last Friday. This is an example of how to solve the larger problems facing the US economy, IOHO. Great bank, BTW. That is a 39% efficiency ratio dear friends. I love these people. If you want to read the whole thing with links and our usual sales pitch, etc. click here.
And one of these dayz, Barry is going to join our affiliate program so I can start paying him money. You financial portal owners in the audience please note.
Below is an excerpt where we discuss our conversations with several observers of the secondary mortgage market about how to solve the toxic asset problem once and for all and get on with the national economic rebuild. Especially please to hear from the veteran banker from the Valley of South Texas, where subprime lives every day.
As this issue of The IRA goes out, in Washington the Obama Administration is wrestling with three basic issues: dealing with troubled banks, restoring illiquid securities markets and restarting economic growth – though not necessarily in that order of priority. The political issue of “helping homeowners” is significant as well. But perhaps it is time to consider whether the Wall Street-centric priority of restoring function to the existing securities markets for “toxic assets” is not independent of these other very real priorities. Reports that Treasury Secretary Geithner is focusing additional spending on spurring new market activity and not remediation of existing securities is, to us, good news.
This does not mean that private label securitization is dead or that the toxic cannot be cleansed. Indeed, we’ve heard from a number of practitioners in the channel on the state of the securitization markets in recent weeks, partly as we have been working to organize an all-day event in Washington on May 4, 2009 sponsored by PRMIA, “Market & Liquidity Risk Management In Post-Bubble Markets.”
One confirmed participant in that event, Sylvain Raynes of RR Consulting, told The IRA last week:
“The securitization market will come back because the next generation will not remember what happened here, in the same way this one forgot the depression, the 1929 Crash, and even the S&L crisis. Is that ancient history? As far as how this “come back” will emerge, that’s easy. What we will see is an accelerated version of the first cycle, i.e. the one that took 25 years to unfold first time around. First, prime RMBS will start-up again with simpler and more meaningful underwriting criteria (that’s already happening) then the prime credit card and auto sectors will be brought back to life. Maybe US medical receivables will be the next big, ‘exotic’ asset class to take off.”
So the good news seems to be that the private securitization markets are beginning to fix themselves, albeit without a vital federal leadership role in terms of setting standards for the future. Raynes lists three areas where such leadership and perhaps legislation is needed:
* First, define a meaningful template for data disclosure regarding all securitizations and OTC contracts, and enforce it. This is already largely done in the form of Regulation AB for securitizations. Enforce it.
* Second, mandate monthly valuation-feedback via a monitoring system that uses remittance reports and publicly published models from the rating agencies. That’s much harder to do, but will soon happen.
* Third, mandate educational standards in the area of structuring and primary market valuation for securitizations and OTC contracts.
With those positive thoughts on the private securitization market in mind, we come back to the central task facing the Obama Administration, namely to help the banks, help homeowners and also the broad economy. One interesting idea we heard from a veteran banker in South Texas might provide food for thought in terms of how to deal with the existing body of toxic assets on the balance sheets on banks, the key issue that must be resolved if banks are to start lending again.
As part of the Obama Administration’s efforts to support the primary market for new mortgage securitizations and also provide new capital to banks, below we describe an approach that harkens back to the market maker model The IRA described last year when we first started talking about the need for more bank capital (“More Bank, Less Bucks: A Four Point Plan for the Rescue,” October 6, 2008).
Here’s the basic approach:
* The US Treasury would tender for all of the private label CDO/MBS extending between a range of dates, say 2004 forward to year-end 2007, representing trillions of dollars in assets held by investors and banks globally. The pricing on this paper will reflect current market prices, but say the average price was 50% of face value. Only issues that actually have an enforcable legal claim to collateral will be eligible. Derivative structures without collateral will not be eligible.
* Treasury then transfers all of the purchased toxic paper to the FDIC Deposit Insurance Fund, which acting as receiver under 12 USC restructures the trusts that are the legal issuers of the bonds and recovers legal ownership of the underlying collateral. The FDIC arguably has the power to call in all bonds and related investment contracts, and extinguish the claims of those parties which do not respond to the Treasury tender. The legal finality of an FDIC-managed receivership under 12 USC is what is required to end the toxic asset issue once and for all. The bankruptcy courts could be used in a similar fashion, but the unique legal authority of the FDIC suggests to us that this agency should run the process as part of its larger asset sale operations.
* This now “clean” whole loan collateral will then be re-sold to solvent banks in the localities where the property is located, using zip codes and other means to identify eligible buyers, priced at say 90 cents on the dollar, with a full recourse guarantee from the FDIC and financing from the Federal Reserve Bank in the relevant district. The banks will initially be guaranteed a minimum net interest margin and servicing income, and immediately begin to service the loan and manage the credit locally. Indeed, the participating bank must agree to retain and service the loan so long as government financing is used. The bank has the option to repay the financing from Treasury and take full, non-recourse possession of the loan.
We don’t pretend that this simple outline is sufficient treatment of this proposal, but we have heard several permutations of this approach from veteran bankers in the loan origination channel all over the US. We see several advantages to this “community bank” approach to the crisis, which might be combined with modest additional capital infusions to solvent community and regional banks like WABC, if they even need it.
* First, it puts the trillions of dollars in now illiquid mortgage loan collateral trapped inside thousands of securitization deals back into strong local hands, who are responsible and incentivized to both manage and service the loan.
* Second, it re-liquefies the balance sheets of the US banking industry and it will vastly improve the prospects for home owners and housing markets around the country. If we are going to further lever the balance sheets of the Treasury and Fed, let’s do it for a real reason and with a clear purpose.
* Third, the approach outlined above provides the Obama Administration and the US Treasury with maximum bang for the buck in terms of both addressing the solvency problems facing the banks and also helping the economy and the housing industry.
One downside: This new market paradigm suggests that loan servicing as a standalone business may be at risk. Once community banks begin to accumulate significant local servicing portfolios, they may rediscover the benefits of keeping the credits that they originate. Sorry Wilbur!
And what about valuation? Well, as our friend Kyle Bass of Hayman Capital likes to remind us, all of these assets are valued and traded every day. It’s just a matter of organizing the purchase process in a transparent and competent fashion. Starting with our friends at shops like Hayman, Black Rock and RW Pressprich, we know people who know how to trade illiquid assets.
Of interest, securitization experts like Raynes believe that servicing will remain a viable business model, but only time will tell. We notice that nobody seems to want the Lehman Brothers servicing portfolio that is still sitting in the NY bankruptcy of the parent. We’ll be exploring these and related issues regarding securitization at the May 4 PRMIA event in DC.