When did I earn it? Part 3: what’s the fix?
[Continued from Part 1 and Part 2.]
Yesterday’s post deconstructing a Wall Street Journal article had reached the point of observing that securitization has made agency risk worse, because it has separated the value chain into separate discrete steps, each performed at different times by different people. That increases certain types of risk. As Mycroft Holmes put it:
“That is a principle of securitization; each time the banker slices offer a lower tranche — as a concession to the Bourse, we have adopted their term — the remaining junior security is on the one hand higher yield, and on the other, a distilled or more concentrated residue of risk. Distillation of risk — issuance of securities and holding the residual and most junior piece — requires special handling. That in turn takes special knowledge, special expertise, and constant vigilance.”
Not only are there information-loss risks along the way, the potential for agency risk is vastly increased. Just take a look at the Journal’s nifty diagram again:
The folks holding the bag, at the far end of time and most removed from the originator’s knowledge, are the holders of these complex securities. They’re more vulnerable than back in the good old
when everybody knew who owned Bailey Savings and Loan:
“Just a minute - just a minute. Now, hold on, Mr. Potter. You’re right when you say my father was no businessman. I know that. Why he ever started this cheap,
Do you know how long it takes a working man to save five thousand dollars? Just remember this, Mr. Potter, that this rabble you’re talking about — they do most of the working and paying and living and dying in this community. Well, is it too much to have them work and pay and live and die in a couple of decent rooms and a bath?”
In the world of Bailey Savings and Loans, banks held loans, and funded them with community deposits:
Until the past couple of decades, most mortgage lenders had a strong motivation to avoid having loans go bad: They carried the loans on their own books. Sometimes they still do. When lenders sell loans to packagers of securities, the lenders often keep the riskiest slices of those securities. However, even that slice was “increasingly traded away” in recent years, according to the Geneva Report.
Markets always clear, and commodities can always be traded.
The market for trading credit risk expanded during the housing boom, through the use of instruments such as collateralized debt obligations. These are securities that can be backed by a mix of assets ranging from mortgages to credit-card receivables.
This is intrinsically a good thing. Slicing risk into different pieces allows them to be bought by people best able to evaluate them and manage them, which means risk gets priced more cheaply, which means loans get cheaper, which means more people can afford more homes. That’s all good.
The problem arises that this new technology, like any new technology, can be abused. And the consumers are uneducated about the risks. Now we’re collectively paying a multi-multi-billion-dollar tutorial in managing the risk of mispriced and misallocated credit risks.
Even when lenders sell all of their loans, poor lending decisions can come back to haunt them. If loans default soon after they are sold or otherwise fail to meet promises made by a lender, that company can be forced to buy back the loan, often resulting in a huge loss.
The idea of a post-closing (repurchase obligation) is incredibly useful; it telescopes the buyer’s due diligence, which means it costs less to trade the assets. But it relies on the seller being solvent enough to make the repurchase, and when the seller is caught by a perfect storm, the boat sinks.
Captain, about that loan loss reserve …
Such losses have forced some subprime lenders out of business over the past year.
Subprime loans, those given to people with low credit scores, grew from $160 billion in 2001 (or 7.2% of new mortgages) to $600 billion in 2006 (or 20.6% of new mortgages), according to Inside Mortgage Finance, an industry newsletter.
“In the past, banks making loans would have a strong incentive to work with borrowers to prevent them from defaulting,” the report said. “Today, a lender can hedge its credit-risk exposure … reducing or eliminating this incentive to stave off defaults.”
Today the lender should still be pro-workout, but as I’ve previously posted, securitization creates obstacles to loan restructuring, because in slicing the debt into pieces, control rights were also sliced up. Now it takes a committee to authorize anything, and the committee will usually be hard to form.
The other casualty of slicing and repackaging is information, especially at the level of individual loans:
Investors who buy mortgage-backed bonds need some way to measure the risk of these investments. Many turn for guidance to Wall Street rating services, which assess bonds and other investments.
Many of the new securities — even some backed by mortgage loans to borrowers with low credit scores — were able to earn top “triple-A” ratings, due to the complex ways in which they attempted to divide the risk.
Don’t lose it
As I pointed out in Resell or Farm, when you buy a product based on the labels, what do you do when you find the label is wrong and the store is closed?
In recent months, many of those ratings have fallen sharply, making the bonds far less valuable. That’s sparking a debate over the role played by rating services in developing the market for securities like these. An issue: the way in which rating companies are paid for their opinion of a bond’s risk.
Of course, a rating service’s reputation is on the line each time it issues its opinion on a security, and a damaged reputation can be costly. And representatives of the firms say their aim is to keep ratings and fees independent of one another.
It’s called ‘internal control’s or ‘Chinese walls,’ and some are more porous than others.
Ratings on one side, fees on another, and nobody patrolling the wall itself
Otherwise, for instance, a rating service could have an incentive not to downgrade a security, even if that seemed necessary, says Anthony Mirenda, a spokesman for Moody’s.
Mr. Mirenda is imprecise. The incentive is there even if the transaction-specific knowledge is sequestered elsewhere. Moody’s employees can read their own financial statements as well as they can read other companies’. Mr. Miranda is trying to say that by separating ratings and stated fees, Moody’s reduces its temptation. As a matter of logic, it’s unpersuasive.
S&P said, in a statement, that ratings are adjusted when “unforeseen and often unforeseeable events lead us to change those opinions” and added that a change doesn’t mean “an earlier opinion was necessarily ‘wrong.’”
We just hate that word ‘mistake’, suggesting as it does that other word, ‘culpability,’ and its corollary, ‘litigation.’
At risk of downgrade
We began this essay with Howard Baker’s epistemological question, and converted it into its financial equivalent: what did I earn, and when did I earn it? But when we return to the rating agencies, we revert to Senator Baker’s original form: what did you think, and when did you think it?
A rating agency has a categorical imperative to upgrade or downgrade securities when it has relevant new information. It also has a duty to seek out that information.
“When the facts change, sir, I change my mind; what do you do?”
For structured products such as mortgage-backed securities, downgrades traditionally are rare. From 1981 to 2006, just over 2% of top-rated triple-A bonds fell to double-A or below, on average, over the next five years.
Past performance is no guarantee of future results, is it?
Last year, rating services downgraded thousands of mortgage-backed securities and collateralized debt obligations. Some of those downgraded securities had received top-ranking triple-A ratings when they were issued in early 2007, but ended the year downgraded to “junk” status, a fall of at least 10 notches.
That’s not a fall, that’s a collapse!
Basically, falling off the ladder
One striking thing about the current situation is that some of the investors getting burned worst by the recent market turmoil are among the biggest names on Wall Street and the most sophisticated industry veterans.
Yes, I’ve said this repeatedly, cold comfort though it is. The housing market’s crumple zone has worked, distributing the pain among people and entities and stretching it out over time.
Yes, cold comfort
Consider, for instance, the market for collateralized debt obligations, or CDOs. Merrill Lynch and Citigroup were the two largest underwriters of CDOs in much of the past three years, according to Thomson Financial. The firms also played the role of investors, and held onto significant slices of the CDOs they underwrote.
Those holdings have proved disastrous for the firms and their shareholders. The stock prices of Merrill and Citigroup lost more than 40% of their value last year.
The big boys have taken their lumps, discovering that what they thought they earned, they in fact hadn’t earned. They dug the ditch, and tendered the bill, only to find themselves in the ditch with their customers.
Risk is back in a big way, and the price of knowledge, as it always has been, is high.
You want my bonus back? Just you try to come and get it.
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