Too Big To Fail, Part VI: Securitization Is Dead

Today, I resume my analysis of the Financial Stability Improvement legislation draft (.pdf) released on Tuesday. I wrapped up the "Financial Stability Improvement Act of 2009" portion of this yesterday, after considering the new oversight council, how systemically risky firms will be chosen, what heightened regulation will look like, capital requirements and a future emergency provision. Today, I'll probably just tackle two more sections -- securitization and the resolution authority. Then I'll summarize.

The securitization provision is incredible. If enacted as is it may be the beginning of the end of securitization.

Congress calls this portion the "Credit Risk Retention Act of 2009." It essentially answers the call for lenders and investment banks to have some "skin in the game" when it comes to securitization.


First, let's say you're a lender who originates mortgages. If you want to hire an investment bank to turn a pool of mortgages into bonds to sell as mortgage-backed securities, then you must now retain some portion of the risk exposure to that pool. This will have a few outcomes.

The logistics to this are somewhat problematic, because they could inhibit innovation in bond structure. I know financial innovation has become a derogatory term these days, but if securitization is done properly, then such creativity can have huge benefits. One of the great things about securitization is that you can create bonds with different risk and return characteristics for different kinds of investors who have varying risk appetites. You may still be able to still do that, but it could get logistically messy to have the bank retain some precise percentage of the risk from each of the kinds of bonds sold.

This provision also necessarily limits a lender's origination volume and makes securitization more expensive. For example, let's say you're a mortgage company with $1 billion of funding. You can use that to create mortgages, so you do. Before, you could sell that billion in loans to investors through securitization. Now you must hold 10% of the risk, which presumably means you will need capital to cushion for that potential loss. Let's say that takes $3 million -- which implies a presumed loss rate of 3%.

First, this makes securitization more expensive, as you must hold additional capital. Your return will be lower. Second, since you have hold more capital, it limits the amount you can lend each time subsequent to a securitization. Next time you will have to subtract that capital from the amount of money you have to lend. Limiting credit might not be all bad, but it is something to note.


But this can also applies to "securitizers," which I take to mean investment banks that perform the securitization. It applies to them if there is no lender to take on the risk. I suspect that Congress had more esoteric asset-backed securities like collateralized debt obligations in mind when it decided to include securitizers. In this case, the investment bank originating the bonds themselves must be exposed to some portion of the risk. This will debilitate the markets for these kinds of bonds, because investment banks hardly want to have to hold additional capital for the deals they structure. That would wipe out the some or all of the fees they get for the transaction.

5% to 10%, Or More

So how much risk will these guys have to retain? It depends on how well their underwriting methods conform to what the regulators put forth as guidelines. They must retain at least 5%, but maybe as much as 10%. Maybe even more if regulators really don't like their underwriting.

No Hedging!

Now here's the really, really interesting part: lenders and securitizers aren't allowed to hedge that risk. The document says that these new requirements:

prohibit a creditor or securitizer from directly or indirectly hedging or otherwise transferring the credit risk such creditor or securitizer is required to retain under the regulations

The clear intent here is that Congress wants lenders and securitizers to take the risk seriously. But part of being a bank is trying to hedge as much of your risk as possible. This appears to imply that banks can't buy credit default swaps or other hedges that would limit their risk. I don't see how they would not be very bothered by this provision.

The Potential Outcome

Finally, it should be noted that lenders often hold some portion of securitizations already. The really ugly, nasty part of an asset-backed deal is called the residual interest. It takes the first loss. That means losses on the underlying loans deplete that bond first, before hitting any of the more "senior" bonds. Lenders and securitizers will sometimes choose to hold onto that piece because it's hard to sell to, well, anyone. This regulation might just seek to force them to hold -- and not hedge -- it.

All in all, this provision looks like a fatal blow to securitization. If it doesn't completely destroy the market, it will almost certainly leave it in ruins. Many would applaud either result, but I think that's a short-sighted view. I've defended securitization in the past, because when done properly, it really does make for a more efficient financial market. It provides investors with better diversification and allows them to more easily meet their portfolio objectives. It provides banks and finance companies with more money to lend. While it played a part in what all went wrong, I've long maintained that securitization was more a vessel for the poison than the poison itself.