The Big Squeeze on Securitization

As the dust continues to settle on interpreting the blended effect of  Todd-Frank, new FASB standards and Basel III, the news doesn’t look very good for securitization, particularly for the banks that have historically utilized securitization as a relatively less expensive tool for raising capital and fueling their consumer finance business lines, including residential mortgages, credit cards and auto loans.

The combined impact of the new capital adequacy rules under Basel III, skin-in-the-game standards under Todd-Frank (assuming a conservative application of the rule by the FDIC and others) and FASB’s fair value accounting standards will simply make securitization a much more expensive capital formation tool.  This bad brew doesn’t even include the costs associated with new investor disclosure standards for securitization.

While it’s hard to predict just how much more costly securitization will be, relative to other financing alternatives,  not a single expert we have spoken with expects these incremental costs to be minor.  The net result will be that many firms that utilized securitization to fund their mortgage banking or credit card operations, will likely now look to a combination of other funding alternatives AND reduce their activities in these business lines.  It just won’t make much sense to do otherwise.

For those who suggest that demand will always rule the day, we would respond that consumer demand for more product may very well create more lending, it just won’t come from the highly regulated sector of the economy (i.e. the banks), it will come from independent enterprises.  In our view, this is exactly the sector of the financial services markets that got us into trouble in the first place.  From the go-go mortgage brokers and bankers to the “no credit history necessary” credit card issuers, one can’t deny that the seeds for disaster in the 2007 crash were planted in the unrestrained growth of these specialty finance companies.  Many of these firms were and continue to be run very well, with robust credit standards and policies.  Unfortunately, too often that wasn’t always the case and it simply put too much pressure on the heavily regulated companies and the local and federal regulators charged with oversight.

While the dust has not settled completely and there is always time for common sense to come back into vogue, we foresee that the net result of this combination of remedies will squeeze traditional issuers of securitized debt, pushing them to the sidelines and opening the field to a group of market participants which will be much more difficult for the regulators to get their collective arms around.  Clearly,  this isn’t what the authors had in mind.

Fair Value Accounting Losing Favor

Bravo to the FDIC, who last week came out with a strong critique of FASB’s proposed Fair Accounting Rules.  This time, Sheila Bair has it right.

As applied to banks and other lending institutions, the FDIC is quite right to point out that forcing banks to take ongoing market-driven snapshots of the value of their holdings is contrary to the business model for these organizations and gives investors in these companies an irrelevant set of data points for relative value of the institution itself.

We agree completely with those that believe the proper approach to measure and value these organizations is the continued utilization of an amortized cost accounting regimen.

Hopefully, the weight of the argument against Fair Value Accounting continues to build.

Now if we can only get the FDIC to look inward at policies for Safe Harbor and Skin-in-the-Game, we’ll really be making progress towards reviving broad-based interest and trust in securitization.

More consolidation among the securitization trustees

The news out this week that US Bancorp’s Corporate Trust Unit has acquired Bank of America’s Securitization Trust Services business on the back of M&T’s recent whole-bank acquisition of Wilmington Trust brings more turnover and disruption to the structured finance markets.

The BoA structured finance trust business came to Bank of America as a throw-in to its acquisition of La Salle Bank in 2007.  Prior to the crisis, La Salle was one of 5 or 6 leading providers of bond trustee services to the securitization industry and had a sizeable stable of clients in both the US and European markets.  At that time, the business likely generated more than $150mm in annual revenue and was very profitable.  No doubt BoA kept the business because of its strong financial footings and its abilities to generate cash balances for the company.

However, with the continuing slide of the securitization industry in both the US and Europe and the recent heat being placed on the trustee community by asset-backed investors, it stands to reason that the time to sell was right.  US Bank already has one of the leading securitization businesses and, with their existing scale and infrastructure, stands to be able to assimilate this business relatively easily and buy themselves some valuable time while the markets for new issues recovers.  The deal also provides access to a much deeper bench of euro-market clients.

At the end of the day, probably a good move by both organizations.

However, when coupled with the consolidation of the much smaller Wilmington and M&T Bank securitization trust businesses, this leaves issuers and arrangers with an ever dwindling choice of providers of bond trustee and administrative processing and reporting services for these complex financings.  That can’t be good for pricing and it might prove to be a challenge for issuers and investors to find the right levels of service quality that the new market standards will demand.

We’ll be watching.

Maybe Some Good News for “skin in the game”

Perhaps some sanity will prevail after all in the conversation about “skin in the game” for issuers of asset-back securities in the US markets.  There seems to be some growing momentum to broaden the definition of mortgage collateral that will be defined as “prime” and therefore remain exempt from the new skin in the game requirements legislated by the Todd-Frank law.

Those that have been following legislative changes and resulting policies at the Federal Government level are very familiar with  pronouncements by Sheila Bair and others touting the Todd-Frank measure for issuers of securitized debt (primarily mortgage-backed issuers) mandating that, going forward, they retain 5% of their new debt issues on their books.

The theory is that by requiring issuers (lenders) to keep some “skin in the game”, they will do a better job underwriting the underlying assets which are pledged to the program.  We are already on the record stating that we don’t really understand the benefits of this measure as it is only  a small, incremental, increase to the current level of skin in the game that an issuer already has.  We do, however, agree that  the words do make for a good sound bite or campaign slogan.

Requiring issuers to take the 5% position in their programs only adds cost to their programs, making them a less efficient method for raising capital.  What has been ignored in the crafting of the cure to “the problem” is that issuers of mortgage-backed debt, whether they be issuers placing their own paper through their proprietary programs or they be investment bankers aggregating assets through a conduit and then issuing  to their clients,  are today and have always been only as good as their last issuance.  The reputation risk that an issuer faces, risk that may preclude them from ever being able to tap into the market again, far outweighs any burden an additional 5% of the deal could hope to “achieve”. 

We would simply ask a theoretical question to test the validity of this 5% rule.  If, all things being equal, the 5% rule would have existed prior to August 2007, does anyone think that this would have prevented the crash in the securitization market?  We think the answer is an obvious no.  Someone might retort that it’s simply not fair to pose the question in that way (i.e. the 5% fix, by itself, is not supposed to be a panacea) and they might be correct.

However, if we can agree that it would not have prevented the mess, then what is the purpose of the 5% rule?  The purpose can only be to put some sense of integrity into the securitization market. 

But let’s look deeper.  What really caused the collapse in the securitization markets?  Most would agree that the initial wave was driven by the rapid disappearance of confidence and we would agree with that.  Confidence in the rating agencies, confidence in the investment bankers, confidence in the issuers and finally confidence in the US Government about whether they would stand behind these deals.  This all adds up to a panic.

However, let’s reverse engineer this some.  How is that so much confidence (i.e. 25 years of market experience) can be lost so fast.  The answer is quite frankly that everyone in the daisy chain finally had to acknowledge that they were relying on somebody else to vouch for the deal.  All the partygoers were focused on was the yield, their profits or their next loan.  We simply don’t see how the issuers or bankers holding an extra 5% of this bad product would have mattered much.  An extra 5% of garbage held by the garbage man doesn’t make the other 95% smell any better today than it did yesterday!  But if no one was sniffing around, who would have known?

Another way to look at this is to simply assume for a minute that only one big issuer was underwriting all these no money down, no doc, walk away mortgages.  Maybe not a stretch to think that there was in fact such a scenario in place in, let’s say, 2003.  We mean SOMEONE had to start the downward spiral!  Do you mean to tell us that this issuer would have cared about a 5% rule.  The answer is of course NO, so long as they could issue their paper at something close to the market for other more reputable issuers. 

However, those reputable issuers, with much better underwriting discipline and, as a result, less profitable operating margins, would simply view the 5% rule as another added cost to their program.  Each $1 of collateral they generate starts with a discounted value of 95 cents.  It doesn’t take a genius to realize that those nickels add up.   It’s also not hard to figure out that under certain market conditions, this Todd-Frank “tariff” makes securitization a less efficient method of raising capital for  issuers.

You might wonder why that matters.  To understand the potential impact of this rule, we think you have to look back on a little history and go back perhaps 25 years when the securitization market was in its infancy.  In the 1980’s, many financial services companies utilized asset-based financing (e.g. factoring) and many corporations were issuing high yield bonds to finance their activities.

What securitization brought to the debt markets was a structure which was both more flexible and more efficient (less costly) for the issuer.  The very important by-product was that as this structure became more widely accepted by institutional investors, it opened the door to a whole new group of investors which provided the impetus for the expansion of the “Global Balance Sheet”

The historical parallel is that we have now entered a global economic phase where that Global Balance Sheet has been shrunk dramatically and issuers no longer have as efficient a securitization market to help rebuild this balance sheet.  Instead, we have returned to the 1980’s as more issuers are turning to asset-based finance and junk bonds.

We can only hope that the rule will be ammended and add as much flexibility to the definition of  exempt collateral to the skin-in-the-game rule as possible.  As we have said in the past, if you want to fix something, go back to the underwriting (origination) process and enforce the laws that were already on the books prior to 2007.

What will happen to the role of the trustee in securitization?

Over the past few weeks, the bond trustees have been officially dragged into the slugfest over who will ultimately pay for  investor losses in the US mortgage-backed and CDO markets.

For the most part, the trustees have been able to stay out of the flames over the past 2-3 years as issuers, servicers, rating agencies, bond insurers and underwriters have alternately felt the wrath of investors looking for some scalp.  However, the recent and seemingly unrelated hub-bub over the processing of foreclosures wound up creating a number of “ah-ha” moments in the media, as several ongoing legal tangles involving informational requests related to mortgage files held by the trustees in connection with their role as “document custodian” for mortgage-backed trust appointments also kicked up some dust.   Several theories were connected to the performance of these trustees which might suggest some liability issues for these organizations.

At first blush these concerns seem logical as most think of a trustee as a person or entity entrusted with looking out for the best interests of the trust that they oversee.  In this case, one might think that the trustee for a mortgage-backed bond or CDO program might have the responsiblity for doing everything or at least many things on behalf of bondholders to ensure that their investment is protected.  Isn’t that what a trustee does?  Certainly that would fit under a generic definition of what most folks think a trustee does.

The connection between the foreclosure mess and the trustee role has been tied by some into the trustee’s responsibility to conduct a review of the mortgage files delivered to it by the issuer at the time of issuance (or shortly thereafter).  Just as it can be easy to assume that everyone knows what a trustee does, so too can it be easy to assume what constitutes the trustee’s “mortgage review” process.  Wouldn’t it mean that the trustee is providing a learned-eye to the collateral pool which has been set aside to protect the interests of the bondholders?

The answer is no.  The trustees document review process is almost always limited to an acknowledgement that a list of several documents (mortgage note, insurance, etc.) is included in each file that is delivered to it as part of the trust.  It is almost always the responsibility of the issuer or the issuer/servicer to “properly convey” each asset (mortgage file) to the trust.  The trustee does not perform any validation process except to confirm that each file has been delivered and that each file is complete.  Even to the extent that it has these limited responsibilities, the trustee is usually afforded significant indemnities from the trust for all but its own negligence (a very high standard).  So, you see, we do not believe that the trustees will wind up with the tab in this bar fight.

Having said that, we do find it interesting to read the recent white paper released by the American Bankers Association’s Corporate Trust Committee which sounds more like a “run for the bushes” strategy than it does a defense of an important role played by the trustee in a securitization.

The analysis uses arguments such as relatively low compensation and trustees are usually appointed very late in the formation of the transaction.  We took the major thrust of the argument to be “We don’t have any control over how the deal is put together, we don’t do very much and we don’t get paid much anyway, so don’t blame us!”

While we agree with the final conclusion that the trustee (unless they signed off on documents that are outside of what we would consider to be industry norms) has no material role in the conveyance of the mortgages (assets) to the trust, we do take issue with the trustees trying to shield themselves as they have.

Trustee Role – Agent or Fiduciary:  

We would begin with the definitional role of the trustee.  As we stated above, we agree that the role of a trustee in a typical securitization is unlike what most people assume it to be.  The trustee in a securitization is usually viewed as a “stakeholder trustee” in that its fiduciary role is to protect the cash flows attributable to the bondholders under the trust.  It is responsible for monitoring that the proper amounts are received each month and that those payments are properly distributed.  Further, when insufficient funds are provided, it is tasked with tapping into certain reserves and other resources (e.g. servicer advances) to keep payments on track.  Essentially, the role of the trustee for a performing securitization is more administrative in nature then it is fiduciary.  What the trustees fail to mention is that for the past 20 years, not unlike the rating agencies, the trustees have been very happy to let investors and other assume that their role was much more fiduciary in nature then they had negotiated in their agreements.  How else to hold the line on their compensation levels (something they have not actually done a very good job of)?

An important point that is missing from the discussion is the possibility that the role of the trustee may be different in a post-default scenario then it is pre-default.  Once again, we believe the ABA white paper may have taken a wrong turn as it included a section detailing the “history of the trustee” including the Trust Indenture Act of 1939 (“TIA”) and the 1990 Reform Act.  We think it a mistake to even bring a discussion of a qualified indenture (qualified under the Act) into a discussion about the trustee’s role in a securitization.  To do so, immediately brings in a proverbial smoking gun in the form of the prudent man standard.  Without going into too much detail, the prudent man standard establishes a standard of care for trustees of debt financings qualified under the TIA.  The standard essentially required a trustee in a post-default scenario to serve their bondholders with the same level of care and interest as if it were managing its own affairs.  Clearly, this standard was/is meant to provide bondholders with a high degree of comfort that the trustee has their back.  The paper goes on to argue that even if you apply a prudent man standard to a trustee for a securitization, the trustee must have “actual knowledge” of a condition before it is required to act.  Here’s the problem though…… The ABA goes on to argue that the trustee in a securitization has much more difficult duties to perform than would be found in a regular corporate bond offering and we think this only seems to work against their “the trustee needs actual knowledge” argument.  OF COURSE, an asset-backed trustee knows more about the relative stability of that bond issue then they would for the typical unsecured bond.  So, armed with this information what would a “prudent man” do?

The slippery slope here is….. If the assets conveyed to the trust were not properly conveyed and if the trustee has any information to the effect that there may be a problem with the mortgage collateral it is holding then hasn’t an even of default occurred?  If the answer is yes, then the prudent man standard may already be in play for the many of the issues that continue to make principal and interest payments. 

We would not have even gone in the direction that the ABA has chosen in defending the role of the trustee in a securitization.  It could come back to bite them.  While we believe that the trustee typically only needs to ensure that payments are being made, pre-default, it may come down to an argument over whether the ONLY default that the trustee needs to concern themselves about is a payment default.

The Trustee Comes In Late:

The ABA goes on the record stating that in many or most transactions the trustee is brought into the transaction very late in the process and infers that this negates any influence the trustee may have on forming the structure.  We buy this argument but only to a degree.  Once again, we would probably have not chosen this argument to support our case for the trustee.

Let’s be honest, when looking at the asset-backed trustee market in the US over the past 15 years, this market has been dominated by just a handful of providers.  If you go back to the league tables for 2005, ’06 or ’07 you will find that The Bank of New York Mellon, US Bank, Wells Fargo and Deutsche Bank controlled nearly the entire market, with a handful of other providers holding very small shares of the market.

The facts are that these large providers (and most of the smaller providers giving chase) were all very well versed in the nuances of their roles, the standards that various issuers of asset-backed securities wanted in their agreements and were all very happy to continue to provide these profitable services under conditions which put continuous pressure on both their roles/duties and their compensation levels.  We would also note that each of these trustees would pay good money for expert legal advice in connection with these appointments.

Perhaps the ABA was not trying to suggest that the trustees did not understand what they were getting into with these programs but with most big issuers utilizing standardized documentation time and time again, we find this argument to be weak at best.

Why Not Stand on Your Principles?

For so many years, the trustee community has wrung its collective hands suggesting that it is not paid anywhere near what it should be for its “critical” role in these complex financings.  Given their response in moment of crisis, is it any wonder they get little respect?

We would suggest that the trustees stop hiding and get involved in the solution to these bad bond programs, instead of continuing to perpetuate the problem.

We would start with a staunch definition and defense of their role.  No, they do not have the responsibility to put themselves at financial risk on behalf of their bondholders.  Their role IS mostly administrative in nature but, if bondholders want them to take action on their behalf then those holders (a majority thereof) must provide direction and proper indemnities and the trustees should be willing to take up the charge.

Secondly, we would get more proactively involved with determining if the programs for which they serve contain assets that may not be eligible (conveyance issues or other reasons).  Once again, this should be done only where the trustee will be paid for its work and will be properly indemnified.

Third, we would suggest that trustees become much more engaged in providing investors, issuers and other related parties with a “transparent” description of the roles and duties that they will assume for these transactions.

We suspect that unless trustees, collectively or individually, begin to change how they do business and how they conduct themselves in crisis, their role in securitization will only continue to become less and less relevent over time.  We suppose that might culminate with changing the name from “trustee” to “paying agent” to eliminate any illusion of a meaningful fiduciary role for these providers.

Is it time to separate the truth from the fiction about securitization?

The recent news cycle has produced another spate of news articles once again laying the blame for the global financial crisis at the feet of securitization.

We are especially fond of the academic pundits who have conducted a thorough study of the structured finance markets and reached the conclusion that securitization was always doomed to fail and would, inevitably, bring the markets down with it.  With no disrespect to the many hours of analysis that these folks have conducted to reach their conclusions, we really do think it’s time to back the conversation all the way up to the opening credits to understand if this “urban legend” is accurate.  We think we know where folks got off the tracks in their analysis. 

It seems that back in 2007, when the markets were tanking and regulators, lawmakers, academics and the financial media were getting a crash course in the capital markets, it became very easy to try to follow the easy path and simply boil down all the buzz words, like credit markets, off-balance sheet financing, CDO’s, credit default swaps, etc. into a few interchangeable terms and securitization seemed to fit the bill.

Further, it became valuable to many actors in this play to place blame for the whole mess on the bankers and other Wall Street types for the crisis.  When they looked around for words to describe exactly what the bad guys did and why they were to blame, the term that seemed to stick the best and the term that was seemingly tied only to this group of “villans” was securitization.  You certainly couldn’t refer to such things as “lending laws'”, “regulatory oversight” or “main street bankers” and hope to deliver the same sizzle in your story.  You also couldn’t tie the other buzz terms ONLY to the Wall Street Bankers, so your story or theory just wouldn’t be as clean as following the securitization theme and hanging the blame on the Buttonwood Tree.

The problem with this “blame securitization” angle is that it completely ignores the successful 25 + year run that this financing tool had in the global markets.  So, if we are right, that securitization is not to blame, then where would we suggest folks look?

The answer is less complex than you might think.  It is currently in vogue within academic circles to conclude that the US residential mortgage market had become an “originate to sell” market and that because lenders could easily sell new loans into securitization structures (either to GSE’s or in the private market) the market entered into an inevitable downward spiral.  In other words, because these loans could be dumped so easily, bankers could not help themselves. 

We sort of see this logic as blaming the car for a speeding ticket.  Securitization is simply a set of tested structuring tools and methodologies which provide originators of financial assets with a mechanism for attracting non-financial investors into the market.  It is not these structuring tools which led to crisis; it was the quality (or lack thereof) of the assets which were placed into these structures.  If the underlying assets had performed as expected (or even close), these programs would not have collapsed. 

We would take note of the hundreds of securitizations completed during the period of time leading up to August 2007 , even many CDO’s, that continued to perform throughout the crisis, despite a series of downgrades and pressure on the underlying assets.  The same can be said for thousands of transactions that were completed 5 and 10 years ago that continued to pay their investors throughout the past 3 years.

Our conclusion is fairly simple.  It wasn’t the structures (i.e. securitization) that tanked the markets, it was the collateral.  If this view is correct, then it seems to us that the way to correcting the problem will not be found in restricting securitization through revised Safe Harbor standards, FAS 166/7, Skin-in-the-Game and onerous reporting standards.  The real answer lies in doing  a much better job ensuring that lenders do not create financial assets of such poor quality.  In other words, we much prefer a strategy which puts us in front of the ball.

Of course, to suggest such a theory begins to open the door to a less than clear-cut explanation and begins to bring in a number of different actors that may not sound as appealing to an audience as blaming the Wall Street crooks.  These other actors would have to include local and regional banks and mortgage companies that were creating exotic loans, federal and state regulators who had all the power and plenty of regulations already at their disposal to oversee the activities of these lenders.  It would also include Congress who had the responsiblity for overseeing the  activities of the largest participants in these markets; namely the GSE’s.

We do not believe that it would be productive at this point in time to simply make this an exercise of attempting to shift blame for the crisis.  However, what we do believe would be helpful to the dialogue going forward is to point out that fixing securitization, at least in the manner that has been proposed, is far from the answer.  In fact, unless the powers that be begin to understand that we need to separate the discussion between reforms to “asset origination” and those for “asset securitization”, we do not see how the securitization markets can recover.  The current “fixes” make securitization too costly for issuers, too uncertain for investors and too much trouble for both sides to get involved with this security type.

No wonder, so many traditional issuers of structured debt are now looking to other funding alternatives including high yield debt and asset-based financing.  This all sounds like a return to the 1980’s to us.

So let’s split the discussion, focus on the real culprit, “asset origination” and let’s restore most of the very good components of a highly functioning securitization market, including “real” Safe Harbor, true sale and off-balance sheet standards that both issuers and investors can rely upon.