Just say no to CDOs

June 17, 2009

Enough of tinkering around the edges, it’s time for tough reform. The Obama Administration’s plan to overhaul the regulation of the financial system doesn’t go far enough when it comes to the securitization market — a source of credit that both it and Wall Street see as vital to the future of consumer and commercial lending.

If the administration wants to ensure that the excesses seen during the credit boom don’t happen again, it should ban the repackaging of these securities into even more complicated debt structures like collateralized debt obligations.

Securitization itself isn’t the problem. Its advent in the 1970s helped democratize credit, which is a good thing. Without it even homeowners with stellar credit and fat down payments may not be able to get a mortgage.

But Wall Street’s slicing and dicing of already complicated and opaque asset-backed securities into yet another highly engineered financial product created an environment in which risk-taking by banks and mortgage originators flourished. That was the real driver behind the breakdown in the “traditional relationship between borrowers and lenders” that government policy makers hope to reinstate.

The repackaging of securities gave all participants a false sense of security since many bought into the idea that such slicing and dicing diluted and spread out risk – even if the collateral backing the deals was questionable loans. It also created unsustainable demand for everything from subprime bonds to leveraged loans to corporate bonds, narrowing risk premiums to such a point that many investors felt compelled to leverage up on more debt securities just to juice returns. That created even more demand for credit, making things like due diligence quaint relics from another era.

And Wall Street banks, rating agencies and homeowners — all beneficiaries from the credit machine — certainly weren’t complaining, that is until the whole thing went pear shaped.

Dictating that lenders hold on to 5 percent of the risk associated with asset-backed securities and tweaking the way ratings agencies label these complex securities to differentiate them from corporate bonds doesn’t do enough.

For one, banks selling bundles of home loans in securities had plenty of exposure to the risk, and the toxic assets, or what polite company is now calling “legacy loans,’ continue to dog bank balance sheets. For another, the draft of Obama’s proposal includes loopholes in that proposal. It gives federal banking agencies leeway to raise or lower that 5 percent threshold and provide exemptions from the “no hedging” rule — or, in other words, allowing banks to mitigate that slice of risk.

By banning re-securitization, the administration can do more to prevent a repeat of the credit debacle than anything else it’s proposed to date. It would draw a clear line in the sand rather than layering on more compliance that creative bankers could eventually learn to work around. And it would reestablish that stronger link between consumers and lenders that had served both so well.

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