In reviewing the House's financial regulation plan a few weeks ago, I was very critical of its ideas for reforming securitization. In fact, I said that the proposed changes could mark "the beginning of the end of securitization." The Senate's plan (.pdf) released this week also seeks some asset-backed market changes. Its plans are potentially even more debilitating to the industry. But it also, separately, proposes a few good ideas.
Concerns All Asset-Backed Securities
First, I should point out that I was initially incorrect in my summary a few days ago when I noted that the Senate's proposal only appeared to address mortgage-backed securities (MBS), rather than the broader asset-backed securities (ABS) market. In fact, the Senate's summary, for whatever reason, only mentioned MBS, while the plan itself calls for the changes across all ABS.
Skin In The Game
The major change that the Senate calls for is similar to the one that the House wants -- that "securitizers" have some skin in the game. In other words, they want those who create these bonds to retain some risk. The idea is that the products won't be as risky if they are forced to hold onto some. In the past, I've asserted that this theory is fundamentally flawed: banks and originators all voluntarily retained plenty of exposure already. So I won't rehash that argument here.
In writing about the House version, I noted that it calls for at least 5% of risk to be retained by the originator or securitizer. I thought that was pretty drastic. The Senate wants at least 10% retained. That's bordering on crazy. In a $1 billion MBS deal, that means banks must be exposed to as much as $100 million worth of risk. This seriously damages the attractiveness of securitization, as it makes it much more expensive.
There's another odd difference between the House and Senate versions. The House's plan appeared to require originators -- like mortgage companies -- to retain the risk. In cases where there wasn't a clear originator, however, the securitizers -- who are generally investment banks -- would retain the risk instead.
But the Senate version ignores originators and calls for the securitizers alone to bear the risk. This is bad for a few reasons. First, it doesn't directly encourage those actually originating the loans to do so more responsibly. The mortgage companies, for example, could still create bad loans and just sell off all the risk. In theory, of course, the investment banks just won't do those deals, since they won't want to have 10% of that excessive risk. So in a sense, the result might be the same, but this change is a weird roundabout way to get there.
Second, even if the assets are relatively safe, there's no way investment banks are generally going to want to have to keep 10% of the risk on the all bonds they create through securitization. Realize that the investment banks don't own these assets. It's their job to shift ownership from the originator to investors. But now you're forcing the banks to bear 10% of the risk. The fees they collect for the service they provide are significant, but I'm not sure this business will continue to be profitable with such a strict requirement. The banks' consideration of whether or not the fees outweigh taking on this risk adds an entirely new dimension to the process. They're going to have to hold capital against that risk, which will take a bite out of their fees.
It should also be added that, like in the House version, the Senate will not allow securitizers to hedge the risk they would be forced to retain.
Loan Level Data Disclosure
As bad an idea as the risk retention might be, the Senate did manage to stumble over a few quite good ideas. The first is that it would:
require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data necessary for investors to independently perform due diligence
This makes the black box transparent. Even though it also makes securitization a little more expensive, I think that cost is worth it, because investors would now be able to fully evaluate the bonds they purchase. They also wouldn't need to be as reliant on the rating agencies for analysis, because they could perform it themselves.
Finally, the Senate wants better and more transparent due diligence. The details of what that would look like remain sketchy, however, since the Securities and Exchange Commission would ultimately draw up those requirements. Of course, due diligence is already performed, but investors are not always privy to those full results. Now they would be, and the SEC may require that the due diligence be even more thorough.
The Future Of Securitization
Unfortunately, since the House and Senate both appear to agree that originators and/or securitizers having skin in the game is a good idea, I think whatever final version of this bill is passed will likely include that concept. But it will probably look more like the House's version than the Senate's, since the House's makes more sense. I still think it could debilitate the securitization market, however.
And that's a shame, because some of the Senate's other ideas on the matter, like loan level disclosure and due diligence transparency, are quite good. I think they would ultimately strengthen the market, since investors could become more comfortable with MBS/ABS. As a result, the Senate's plan serves as a great example of bad regulation, which seeks to create arbitrary rules that could destroy a market, and good regulation, which seeks to enhance information and transparency.
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