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Bair: Securitization Rating Alchemy Fueled Toxic Mortgages

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The "alchemy of rating-agency assisted securitization" of subprime and Alt-A mortgage products fueled the growth of easy credit access that greatly contributed to the current crisis, said Federal Deposit Insurance Corp. (FDIC) chairman Sheila Bair. A more transparent securitization process is the solution for the pain still felt in the financial markets, according to her comments, made Thursday before the Financial Crisis Inquiry Commission. Credit-rating agencies (CRAs) are often assigned blame for giving structured finance vehicles high ratings despite significant risk in underlying mortgage products. Bair's use of the term "alchemy" in describing the role of the CRAs invokes an image of an archaic scientist transforming junk metal into precious gold. Although CRAs sometimes assigned triple-A ratings to residential mortgage-backed securities (RMBS) that would eventually be slashed in the midst of massive subprime-related defaults, CRAs are not the only party Bair held responsible in her comments. She recommended both originators and securitizers retain some form of recourse to ensure sound underwriting for future structured finance transaction. And consumers should understand financial products offered to them as well as demonstrate an ability to repay. "Investors and creditors should face some amount of loss, in the event of default; this should cause them to perform due diligence and not simply rely on third-party assessments of the quality of the investment," Bair said. "And finally, we must impose market discipline by ending too big to fail. This is best accomplished by establishing a credible resolution regime for large interconnected firms." According to Bair's comments, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which were established in response to the last major financial crisis - the thrift and banking crisis of the '80s - allowed the shadow banking system to grow outside of the regulated sector. The interconnectedness of large financial institutions and regulated banking entities led to a financial system-wide sentiment that many banks are too big to fail. Another industry growing up within the financial system, mortgage securitization, at first facilitated the flow of credit among banks and thrifts but soon led to the rapid growth of government-sponsored enterprises (GSEs) responsible for buying and securitizing mortgages. As the practice of securitization grew, the share of whole mortgage loans held by banks and thrifts fell off in recent decades, from 39.6% in late 1990, to 25.4% in Q309. At the same time, the share held by the GSEs swelled from 42.6% to 51.4% in Q309. The GSEs, Bair said, created a market for investors to buy securities backed by loans originated by banks and thrifts, thereby providing more liquidity for the banks and thrifts to make more loans. "Many argue that the shift of mortgage holdings from banks and thrifts to the GSE-retained portfolios was a consequence of capital arbitrage," Bair said. "GSE capital requirements for holding residential mortgage risk were lower than the regulatory capital requirements that applied to banks and thrifts." The private-label securitization market grew alongside the agency MBS market, fueling the credit for subprime, Alt-A pay-option adjustable-rate mortgages (ARMs). These private investment firms took on significant risk, including employee compensation structures. For example, employees that specialized in long-term investments were often rewarded in bonuses based on near-term results, which Bair said magnified risk-taking. Her comments echo a growing sentiment that executive bonuses at publicly-traded firms ought to be reigned in. House Financial Services Committee chairman Barney Frank (D-MA) announced this week the committee will hold a hearing January 22 over compensation at both financial and non-financial firms. "Very large percentages of the revenue of some of these companies are going to compensation, and it does seem to me that the issue about whether or not the shareholder should be able to comment on that overall amount is relevant." The Committee's hearing follows a move by President Barack Obama to tax banks that received bailout funds. Congress is also looking to crack down on executive pay. Rep Peter Welch (D-VT) to introduce legislation to levy new taxes on yearly employee bonuses at financial institutions that receive financial assistance from TARP. Under the bill, bonuses above $50,000 in either cash or stock would be taxed at a rate of 50%. Write to Diana Golobay.

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