Viewpoint: Skin in the Game, or Baby and Bathwater?

(Update 1; adds clarifications) In what’s affectionately being called “Obama Wednesday” in some quarters, details of what’s being billed by a breathless press as “the most sweeping financial reform proposal since the 1930s” are not surprisingly already beginning to leak out. But what’s being leaked thus far isn’t really breathtaking, or even new-ish. The latest details, leaked via the U.S. Treasury early this week, show that part of the financial reform package will include a so-called ‘skin-in-the-game’ requirement for issuers in the structured assets space, including particularly mortgages. The idea here is that issuers would be required to hold onto 5% of the risk of any asset-backed deal (mortgages, or otherwise); further, issuers would not be allowed to hedge their exposure on that particular piece of risk. Never mind the odd business of suggesting some weird sort of approach to hedging here — effectively hedging against some risks, where regulators allow it, while leaving other risks exposed to the wilderness, to fend for themselves. (How that’s supposed to be possible, I won’t claim to know.) And never mind, too, the even odder business of suggesting that banks and other regulated financial institutions actually increase their exposure to risk by not hedging their positions. (Aren’t banks already under duress for a lack of regulatory capital?) None of that matters, because this is hardly a new idea; and the previous objections to the idea have already been put on the record. House Financial Services Committee chairman Barney Frank (D-MA) originally included the idea in recently-proposed legislation this past April that is among a spate of efforts from inside the Beltway designed to put the regulatory screws to a badly-misbehaving mortgage market — that legislation, HR 1728, or the Mortgage Reform and Anti-Predatory Lending Act, was itself a revamp of an earlier proposal put forth by Frank, Rep. Mel Watt (D-NC) and Rep. Brad Miller (D-NC) that had cleared the House in 2007 but stalled in the Senate. So, let’s at least step back, take a deep breath, and actually think about what’s being proposed, based on the trial balloons out there in the press at the moment. The first thing that should be coming to any market participant’s head when they hear about this so-called ‘skin-in-the-game’ rule is this: isn’t skin in the game what has literally crippled once-proud institutions like Citigroup Inc. [stock C][/stock]? Isn’t skin in the game what put Lehman and Bear Stearns into history books as former Wall Street firms, too? Show me some skin Let’s take a trip down Securitization 101 lane, both for a quick refresher and to drive home a point. Most structured securities — at least of the non-agency variety, for discussion’s sake — make use of subordinated cash flows, or “tranching,” as a means of internal credit enhancement. The idea is that the pooled cash flow from a bunch of mortgages, for example, can be split up any number of different ways such that junior bond positions absorb credit losses first, helping protect the cash flow allocated to senior bondholders, and allowing those senior and super senior bonds to attain that all-important AAA-rating from a rating authority. As a result, the capital structure of most private-party RMBS deals — think subprime and Alt-A here — include a so-called equity tranche (sometimes referred to as a residual, or junior subordinated note, depending on exactly what’s being done). Residuals are/were typically held by the issuing entity, designed as a sort of ‘skin in the game’ piece — and these so-called subordinate tranches typically commanded higher yield premiums, too, given their first-loss position in the capital structure (which in turn fueled the CDO craze, but we’ll stay away from discussing the real roots of the credit crisis in too much depth here). Regardless, the above overly simplistic discussion should make it amply clear that — if anything — the problems at Citibank and elsewhere aren’t because the banks had too little skin in the game. It’s because they had too much. Which brings us fill circle back to the leaked proposal at the Treasury, the one that would require issuing entities to hold 5 pct of a given deal (in the form of a residual, perhaps?): it doesn’t really matter, and it certainly does little to change the outlook for securitization as an industry. Baby, meet bathwater Perhaps much more damning is the stance among some in the regulatory community that seem content to throw out the baby with the bathwater, damning securitization as a process for causing this mess. Remarks such as this, from a June 15 Washington Post op-ed penned by Timothy Geithner and Lawrence Summers, should scare anyone involved in the securitization industry:

In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The fact that this dreck is coming from the head of Treasury (and from Lawrence Summers, too) scares the living snot out of me, because it demonstrates a fundamental misunderstanding of securitization. A lack of some much-needed oversight into structured finance by federal officials is now being used as an excuse by those same officials to toss cold water on the entire concept? Now, to be fair, I’ve seen nothing yet in the Geithner/Summers op-ed, or in the financial press, that suggests a plan to suck the atmosphere out of the securitized products market; the 5-percent rule is hardly Earth-shattering, for example, as we’ve already covered. But the idea that any of the proposals put forth from this point on will emanate from such a misguided ethic? Scary as hell, for one thing, and also unlikely to either a) promote a market recovery or b) prevent such a mess from taking place again. If the goal is to help credit markets recover, a blanket damnation for securitization seems more to me like a nail in the coffin than a jumper cable. And to be sure, there are more complex and fruitful debates that should be had over regulation and its place in and around securitized products: credit default swaps come immediately to mind here, as colleague Christopher Whalen over at Institutional Risk Analytics has long railed about. Such a debate is at least centered around the realization that the real problem facing many Wall Street firms isn’t a lack of skin in the game — it’s too much of it. Paul Jackson is the editor-in-chief of and HousingWire Magazine.

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