FHLB Seattle Sues Wall Street
FHLB Seattle, forced by regulators to write down millions in downgraded MBS last year , has effectively sued all of Wall Street for selling them $4 Billion in inappropriately underwritten MBS. This action accuses the Street of intentionally selling MBS that was underwritten with lax standards, didn’t have proper documentation or supported by documentation that was “untrue.”
This is a huge new front in the ongoing war between investors and the street for responsibility. Did the Street knowingly sell toxic securities? Did the ratings agencies turn a blind eye to the shortcomings of the new issues to generate fees, or were they “gamed” by Wall Street? Do investors bear all of the responsibility for their decisions? Is it cavet emptor all the time? What if you bought securities under false pretenses?
FHLB Seattle is a formidable and serious litigant. The risk of the responsibility for “bad” loans being put back to the underwriter just went higher.
[$$]Mortgage Suit Targets the Street – WSJ.com, February 16, 2010
Good News for Life Insurers
The insurance industry regulators have prevailed. The rule change is in effect and billions in capital has not been squandered. This common sense approach to capital measurements takes into account the economic value of a bond and its cost basis.
When determining the value of anything, isn’t what you paid for it important?
For example: If I paid $70 for a $100 face value bond, and I received $90 at maturity, is that good or bad? One correct answer is “it depends on what you were expecting….”
But the FACT that you received $20 more than you paid for it should count for something.
For Insurers, a $5 Billion Benefit – WSJ.com, January 15, 2010
Protection For Consumers Is Help For Us All
As much as we all hate bureaucracy and its associated expense, a “Consumer Financial Protection Agency” may be a good idea. Truth be told, there are many well-educated Americans who lack even a rudimentary understanding of finance. (A business executive was once overheard saying that he wasn’t going to refinance because he didn’t want to lose all that interest he had paid to his mortgage company). And there is a huge industry that is more than willing to exploit this lack of knowledge.
Unlike the FDA or the CPSC, however, the “CFPA” can do more than protect just consumers from dangerous products — or more often to protect consumers from themselves. By helping to assure upfront that debt instruments that eventually get packaged and sold as securities are solid, the CFPA will help us all.
Because the issuer rarely holds loans, we can no longer trust that the person writing the loan will thoroughly vet the applicant. These loan brokers have very little risk, so they have very little incentive to ensure the candidate is creditworthy. Instead they are more motivated to close as many loans as quickly as they can, regardless of quality.
Preventing the most dangerous loans from ever being made will help to ensure that the toxic loans that make regardless of quality us all sick never get into the system. Subsequently we can also have greater confidence in the rating agencies’ assessments. The consumer benefits directly, but we all benefit indirectly from a more reliable securities market.
Déjà Vu All Over Again
The $8,000 first time homebuyer tax break is set to expire. There are many who believe that it should be extended so it can continue to motivate new buyers and to help restore the hard-hit housing market.
The question is whether this incentive is good for the long term. As has been the case for decades, the loans being written for these first time buyers are usually bundled, rated and sold as a security. One should to hope that these homebuyers are being more carefully vetted than those who bought using “exotic” mortgages that they couldn’t afford. But human nature being what it is, there is an excellent chance that sellers, real estate agents and mortgage brokers are doing everything possible to close a deal. And well, if you’re overreaching a little? Not to worry. Everyone is reaching when they buy their first home.
A healthy skepticism pervades that we may be getting ourselves into the same default scenario 3-4 years from now that we have today. Poor underwriting is a big part of what put us into this mess.” Offering people a short-term incentive for a long-term purchase — whether it takes the form of a discounted mortgage rate that “resets” or tax incentives — has already proven itself to be a bad idea. There is no reason to believe the results are going to be any different this time around. Unqualified buyers lead to delinquincies, which then tend to default. Substandard collateral will always lead to a substandard security in total.
OK, Agencies, Your Turn…
Filed under: Bond Regulation, Multi-Obligor Bonds, The Rating Agencies
Here is the “skin–in-the-game” clause for originators and ratings agencies. This helps to prevent the next crisis.
We still need clarification and common sense review of the real value of existing multi-bligor securities. The existing bonds that have been downgraded will probably never be upgraded. These assets will be a drag on bank capital for years (until they mature). We need to address the existing problem. We can’t let static rules set bank capital levels. Accounting should reflect economic activity, not drive it.
Let’s ask the NAIC how to fix this problem. They have it figured out (see below).
FDIC May Tie Underwriter, Rater Pay to Asset-Backed Performance – Bloomberg.com, November 19, 2009
Hooray for the NAIC!
The Insurance Industry regulators made their choice yesterday. To give insurance companies accurate values on the downgraded mortgage bonds they own, the regulators made the common sense decision to abandon a ratings-based system and use an expert third party to measure the true economic value of holdings. By using Pimco, the industry will prevent an unnecessary drain from insurance companies’ balance sheets.
This is a logical, and effective solution that proves that regulation can work.
Hooray for the Insurance Commissioners. They saw an unintended consequence, and repaired it using a market based solution.
Pimco Chosen by Regulators to Review Insurer Home-Loan Holdings – Bloomberg.com, November 18, 2009
Sometimes The Old Ways Are Better
The underlying problem with many of the multi-obligor bonds – those that include home mortgages – is that the housing market collapsed. It’s easy to see all the warning signs of the implosion in retrospect, and it is just as easy to point fingers at those who were instrumental in helping to blow up the bubble—mortgage brokers, home ownership advocates, developers, real estate agents – the list is long.
So is there value in ensuring that these “junk loans,” those that put people into homes they could never afford, are removed from the market? Expunged so that bad loans never make it into multi obligor securities? Absolutely.
There are two ways to accomplish this.
The first is wildly inefficient and compels homebuyers to exercise self-restraint, to forgo the home of their dreams and to get the home they can afford instead. It also expects homebuyers to understand what it is that they can afford given the complex mortgages that they have available. Moreover it also obliges that all the homebuyer-facing players (real estate agents, mortgage brokers, etc.) forgo their natural inclination to maximize their income and to push the buyer into the most expensive piece of property they can.
The other way is simpler. It was the way loans were written not long ago. The mortgage issuer makes certain the homeowner has a down payment he or she doesn’t want to lose and they have the resources to pay back the loan. To ensure this happens, the issuer needs to suffer a loss for loans that go bad. Until this responsibility is re-established, bad loans will be forever finding their way into the markets.
Check and Double Check
The SEC recently decided that the rating agencies must reveal more information on past ratings so that investors could compare relative performance. This will be helpful to see whether there is a pattern of preference given one issuer over another. But this will only lead to supposition. Is the issuer just very good at assembling low risk collateralized debt obligations, or are they receiving preferential treatment? We’ll never know.
What is probably more valuable to ensure ratings are justifiable is that the SEC has also ruled that raters must share the underlying data used to determine ratings.
This will establish three important checkpoints: First, competing agencies can offer unsolicited ratings for structured finance products, in essence creating competition to achieve the most precise assessment. Second, investors will be able to examine the underlying data to verify the ratings so rating agencies will be critical of their own work. And third, if a bond does go south, investors will only have themselves to blame for failing to do their due diligence on their own behalf or their clients’. With full disclosure, raters could be relieved of liability. Caveat emptor!
Congressional Debate Over Rating Agency Bill
Congress can’t help themselves.
They discovered that municipal bonds are rated differently than corporate bonds.
It’s true. The ratings scales are not equal. Muni ratings are much tougher than corporate bond ratings.
Politicians yell that the ratings agencies are unfair to municipalities, raising their cost of borrowing due to the unduly harsh ratings.
First of all, Congress can’t tell the NRSROs how to rate (what with all that pesky First Amendment language).
Secondly, should we be upgrading all muni bonds, right in the beginning of a recession?
The state of California has been the most vocal about this issue. Maybe they should work on improving their financial condition, instead of rigging the ratings.
House Democrats, Republicans Differ Starkly on Rating Agency Bill – The Bond Buyer, October 28, 2009
Greater Competition Is A Solution
The Obama administration appears to be proposing changes that are focused on disengaging investors from their reliance on the big three, Fitch, Moody’s and Standard & Poors. Instead the administration seems to be urging investors to do more of their own research.
The idea is right, to keep the ratings independent from the issuers. But the hope that investors are able or willing to do any credible research is a stretch. Instead, regulation should be loosened to allow room for dozens of smaller players, with various specialties, to compete with the big three on quality and price. Until recently regulation was actually a barrier to this type of competition.
When coupled with a standard ratings scale that has the fine gradations needed to measure structured credit products, either alpha or numeric, we can quickly achieve a viable, market-based solution with a minimum of government regulation.
