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.

About markferraris
Managing Principal Orchard Street Partners LLC

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