As my time at the American Securitization Forum conference had nearly concluded on Tuesday, I attended a session specifically addressing the question of how the industry could better align incentives. In other words, how should things change so that issuers don't make money by originating bad loans? Like so many sessions during the conference, this one boiled down mostly to discussing whether or not it's a good idea for securitizers to keep some "skin in the game," retaining some of the risk in the pools of loans they sell. While bankers and issuers are very wary of the idea, one panelist made it clear that some investors support it.
A quick refresher in case you haven't read any of the other posts I've written about the "skin in the game" proposal. The idea is that, by holding back some of the risk for themselves, securitizers would naturally have more prudent underwriting standards than the originate-and-distribute model provides. The problem is that it's a little bit unconvincing that it will help: most banks had plenty of mortgage- and asset-backed bonds in their portfolios when the mortgage market collapsed -- they had lots of skin in the game. And yet, they still originated plenty of bad loans. Moreover, it would curb securitization volume significantly if banks had to retain a portion of the risk. It would also make securitization more expensive, undermining one of its best features: the low cost.
So instead, most banks and issuers prefer other alternatives. They include better disclosure, enhanced reporting, providing more information on the underlying loans to investors and better due diligence on data integrity. Yesterday, I noted an additional proposal by Comptroller of the Currency John Dugan. He suggests universal minimum underwriting requirements, to ensure that issuers aren't just giving out loans to anyone with a pulse. The bankers and issuers also stress that any "skin in the game" proposal should be carefully crafted to have different risk retention requirements for different types of structures and loans, as not all asset-backed bonds are created equal.
Of the panelists in this session, however, one stood out: an investor. And this wasn't just any investor. This was Kishore Yalamanchili, a managing director at the investing titan BlackRock. He supports the "skin in the game" proposal. He said:
If you look at the issue on a more dispassionate basis, which is hard for me, you look at what happened. The originators typically get all the cash flows from the transaction and they securitize them They were originating loans at 101 and selling loans at 103, and making good money, so they could care less what happens . . . Same thing with bankers: they're getting their transaction fees. Same thing with rating agencies: they're getting their rating fees . . . So who's the guy left behind? The investor is the guy left behind holding the bag on the performance of the loans for the next 30 years or 40 years.
Although he prefaces this statement claiming to be looking at this issue from a dispassionate basis, I'm not convinced he really is. It sounds pretty obvious to me that he's talking from the investor's point-of-view. If he wasn't, then he'd take a little responsibility and concede that some blame also should fall on the shoulders of investors, who voluntarily bought this stuff without understanding what they were getting. They were left "holding the bag" because they wanted it.
Indeed, there's something rich about BlackRock, of all people, complaining they got taken advantage of by tricky bankers and issuers. BlackRock is arguably the most sophisticated investor out there. If anyone should have known better than to purchase bonds that they didn't understand, it's BlackRock. And if anyone had the infrastructure and expertise to actually do enough analysis to better evaluate the bonds, it's BlackRock.
Again, no one crammed these securities down investors' throats: they all purchased them willingly, even happily. While issuers certainly should have originated safer loans, investment banks could have pushed them to provide more information for disclosures and rating agencies could have used more accurate models and assumptions, none of that matters if investors refused to purchase what they didn't fully understand. The reason that mortgage-backed securities flourished wasn't because issuers wanted to write millions of bad loans, investment banks were willing to sell anything or rating agencies were too easy with their grades -- it was because investors strongly demanded these bonds. If they hadn't, there would have been no market for bad MBS.
And maybe that's part of the answer to aligning incentives. Investors need to be more prudent going forward. If investors will only buy what they understand, then that's the banks and issuers' incentive: they'll be forced to originate better loans if they want to securitize them. In fact, this is what we're seeing now in the market, and why securitization has been essentially lifeless other than the Federal Reserve's support for the past two years. Investors have realized their mistake. Let's just hope they don't forget the need for to understand what they're buying now that the rest of Wall Street is feeling better.
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