Are the new securitization regulations workable?

By Felix Salmon
June 16, 2009

Binyamin Appelbaum has details of the new regulations surrounding securitization, and it all looks incredibly unworkable to me, especially the central plank:

Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security…

The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment.

What on earth is a bank’s chief risk officer supposed to do with an edict that she cannot hedge a certain chunk of the bank’s balance sheet? I can see that she might not be able to explicitly create a synthetic CDO to bring that idiosyncratic risk down to zero. But if a bank has exposure from securitizing credit-card receivables, say, or commercial real estate leases, or student loans, or residential mortgages, then similar risk will reside elsewhere on the balance sheet, and the bank will — and should — just reduce the amount of that risk instead. It has the same result, from an all-over risk perspective, and the new regulation is rendered utterly toothless.

As for the idea that the ratings agencies should make it clear that ABS aren’t corporate bonds, well, as Agnes points out, that’s pretty silly: I think everybody knows that by now. The problem is that if there’s a separate second scale for ABS (and maybe even a third scale for munis), no one will have a clue what the new ratings are supposed to mean. It would be a bit like being given two apples, and told that one costs 15 foos while the other costs 17 bars.

I would rather encourage the ratings agencies to try and make credit ratings as laterally comparable as possible, and to try to set ratings so that you don’t have the enormous default-rate discrepancies that exist right now between different asset classes. Investors could then judge for themselves the degree to which the ratings agencies had succeeded.

My fear is that ratings agencies might start issuing separate credit ratings for munis, which will be considered much safer than the equivalent credit ratings on corporate bonds, just as a wave of muni defaults is about to hit. In general, the key here is to decrease the importance of the ratings agencies, rather than trying to regulate them on the grounds of how important they are.

But a couple of the proposals make sense: paying originators of securitized loans gradually, over time, for instance, rather than up-front when the loans are securitized; or standardizing contract language in the ABS market to make such securities easier to compare to each other. They just won’t make an enormous amount of difference.


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Is that 5% a first loss/equity exposure, or a pro-rata share of total losses/exposure? The distinction’s important, and I can imagine a CRO having more problems with being unable to hedge the first than the second.

To be honest, I’m not clear on what the old ratings were supposed to mean. Is that a one year probability of default, a five year probability of default, an expected loss over a particular timeframe? I seem to recall that the one-year probability of default for corporate bonds is pretty well exponential with credit rating, with a bump of one minor level (i.e. A to A+, or A+ to AA-) reducing the odds of default by about 44%, but it was never clear to me whether that was what they were targetting; for debt-backed tranche securities, recovery rates would make a big deal.

Well, hedging positions is very important for the bank but the main point is understanding what you buy into.
At the end of the day a loan is part of an investment and therefore you should first understand the asset, then understand the loan. If you are sure of your investment, you can then risk and diversify in the loans sector you originates.

CDO and these type of complex products which were used to hedge between investments (not simple interests swap or currency hedging which are very usefull and easier to understand) were wrongly assesed and therefore not covering the bank anyway…
so if we could come back to basics (understanding of the sector you invest in wether in equity or loan) that will be a hughe improvement!

Concerning rating agencies, they are too costly, too inefficient for our financial system and will always have a conflict of interest wether they works for banks or investors. Funds should only trust their analysis of a business… not delegate and then blame!

Posted by Elodie | Report as abusive

perhaps more directly: the bank should (or could) hedge risk, but from a capital requirement point of view that hedge should not count. the bank should need to reserve for the unhedged position.

Posted by q | Report as abusive

I can appreciate that maintaining “skin in the game” with regards to securitizing loans should lead to more careful loan underwriting, but that retention will also expose the banks to greater risk. I believe that the originators of asset-backed securities grossly misjudged the risks of the instruments that they were creating because they were counting on diversification and a rising real estate market to mitigate those risks. If they have learned their lessons from this crisis, which I believe they have, then they should be better able to manage this risk, and the proposal could help rebuild confidence in the ABS market.

“To be honest, I’m not clear on what the old ratings were supposed to mean. Is that a one year probability of default, a five year probability of default, an expected loss over a particular timeframe?”

Well, it varies from rating agency to rating agency, and has changed during the credit crisis, but the basic idea is timely payment of interest and ultimate repayment of principal. This is complicated by several factors – Moody’s rates on an expected loss basis, for example, whereas the others are based on probability of default. Meanwhile S&P has incorporated a new “cliff risk” factor designed to ensure that AAA ratings are not just very unlikely to default, but also likely to be stable – so a low PD isn’t enough – the shape of the loss curve is important.

Posted by Ginger Yellow | Report as abusive

There is another argument for using a separate rating scale for securitized products – which is to prevent them from passing through the “loophole” in investment guidelines for pension funds, insurance companies, etc., that allows them to hold anything with a certain rating. If the senior piece of a sub-prime RMBS is no longer “AAA” but is now “SP-1″ or whatever, then the investment guidelines of these institutional investors would have to be rewritten specifically to allow them to hold these assets, whereas before the issue never came up, even though they should have known that these were not the same as corporate AAAs.

Posted by Nate | Report as abusive