Who Does the SEC Want to Bless Mortgage-Backed Securities?

Over the past decade, the Securities and Exchange Commission has been bumbling at best and grossly negligent at worst. But when Floyd Norris' Friday column suggested that a new SEC regulation (.pdf) would force investment bank CEOs to bless the mortgage-backed securities their firm underwrites, that seemed a little far fetched -- even for the SEC. Luckily, his description isn't quite right.

Here's the key excerpt from Floyd Norris' New York Times column:

The investment banks that put together mortgage securities told regulators that they should not be required to evaluate the credit quality of the mortgages they package and sell. And then they argued that they had no ability to do that.

The Securities and Exchange Commission has proposed a new set of rules for such mortgage-backed securities. For some of them -- the ones that are sold publicly and in an expedited way that does not require the commission to carefully review the offering -- the proposal included a requirement that the chief executive of the firm that put the deal together provide a certification of the deal's quality.

That certification would include a statement that the C.E.O. had reviewed the deal and believed the mortgage assets had "characteristics that provide a reasonable basis to believe" the securities would pay off. The commission said it believed the attention the executive would have to give each deal "should lead to enhanced quality of the securitization."

First, this is all very complicated, so let me try to simplify. Imagine there was a mortgage company called Nationwide. It originates a billion dollars worth of mortgages and wants to securitize them. So it hires an investment bank called Silverman to slice up the pool into bonds and sell the new securities to investors. Silverman "puts the deal together." Whose CEO would be responsible to vouch for the loans?

Norris' article certainly implies it would be Silverman's CEO -- but it wouldn't be in this case. It would be Nationwide's CEO. To the extent that anyone should stand behind loan quality, it should be Nationwide, who is the lender. The lender understands the assets better than anyone. It has an underwriting strategy through which the loans were originated. It has all of the performance data and probably services the loans.

Silverman, on the other hand, is just the middle man. It gets the loan characteristics from Nationwide, structures the bonds, and sells them to investors. Forcing Silverman to vouch for the quality of the mortgages would be nonsensical. Thankfully, that's not what the SEC has in mind.

The sort-of-exception to this rule, however, would be if there was another "full-service" bank called M.P. Jorgan. Jorgan's consumer side may have originated those mortgages, and called up its securities (investment banking) division to structure and sell bonds based on those loans. But ultimately, the CEO signing-off would still be that of the consumer bank -- not the CEO of the investment banking division.

So in a technical sense, investment banks would not be required to bless the credit quality of the mortgages they package and sell under the SEC proposal. That appears, however, to be what Norris suggests. If so, then his description is incorrect, according to both the SEC and Securities Industry and Financial Markets Association, who both confirmed my interpretation of the proposed rule.

The accurate conception of the proposal is a little less controversial, but still very controversial. Now the question is just whether whoever owns the assets prior to securitization should be forced to specify that the loans have "characteristics that provide a reasonable basis to believe" the securities would pay off. Since no one can predict the future -- including CEOs -- this burden should probably ultimately lie with the investors, provided they are able to obtain all relevant information to analyze the assets combined with their own assumptions about the market. As Norris notes, however, naturally investors are happy to impose this requirement on these consumer banking CEOs. That way, they can continue to pass the buck if the securities they buy go bad.