Reserve Bank of India Taps the Brakes on Short-term Loan Structures

Once again demonstrating a firm but steady grasp on managing the future of its structured finance market, the Reserve Bank of India (“RBI“) announced some tweaks to its earlier announced guidelines for securitization in the local market.  The specific aim of this week’s announcement is the market for securitization by banks and other finance companies that securitize short-term or “micro loans” in the domestic market. 

The announcement this week adds clarity to two important considerations for both issuers and investors:

1)  Issuers will be required to hold assets to be included in securitized structures for a minimum period of time, thereby eliminating the temptation for issuers to engage in what has become commonly known as the “originate to distribute” model.  In less civilized conversations this has also been called the “pump and dump” model.  For most of its history in the US, issuers of securitized debt would typically “season” their portfolios in order to build track records and confidence in the performance of the collateral prior to placing these assets into a securitized structures.  Rating Agencies, investors and other counterparties would routinely require this activity for private market securitizations.  This practice, which was largely and successfully self-regulated by the securitization industry for more than two decades, became  “unfashionable” in the middle of the last decade.  In their guidelines, the RBI will require issuers in most cases to have held or “seasoned” micro loans for nine months before placing these assets into a securitization.  Since many or most of these types of  loans have a maturity of one year, this will either force a change in the underlying structure of these loans (e.g. extending the term) or it will eliminate many of these micro-loan structures from the market.  For loans with a maturity of two years, the guidelines call for the originator holding those loans on their books for a full year.

2)  The second major issue tackled by the India central bank in this announcement is the requirement for issuers to retain a percentage of these types of loans on its balance sheet.  The objective is to eliminate undue risk being passed to investors and to add integrity to the underwriting process.  For loans with a maturity of less than two years the requirement is 10%.  For longer term loans, this requirement drops to 5%.  Obviously, the objective is to acknowledge the greater risk associated with the shorter term collateral.

At the height of activity in the India market a large number of specialty finance firms known as NBFC’s (Non-Bank Financial Company) and MFI’s (Micro-Finance Institution) became very active in the short-term loan market and, clearly, many of these firms utilized the liquidity of the securitization markets to fund their operations.  We find a comparison of the hundreds of specialty residential mortgage finance companies that sprung up in the US market in the early part of the last decade to these MFI’s in India to be compelling, as the temptation to cut corners in both markets seems to have been irresistible. 

However, unlike the new regulations proposed in the US market which have chosen not to single out specifically egregious structures or classes of issuers, the RBI has done just that by essentially splitting the legitimate parts of the securitization markets away from the decidedly less legitimate parts of the market.  In other words the RBI has chosen to address the obvious problem and taken steps to cut it out.

How can you not like the straightforwardness and “transparency” of their objectives.  To the RBI it seems more than logical to acknowledge that a “one size fits all”  set of remedies is not the answer.  They have chosen to acknowledge the obvious.

Something that US regulators still have time to learn from.

Securitization IS the Answer

At several points along the way during the life of this publication and certainly throughout the past few years as the securitization industry has been whipsawed and accused of everything short of global warming, we have offered the opinion that the single most important step to revive the global economy is to revive the credit markets.  We have gone on to say that the best way to revive the credit markets is to support the revival of securitization as a legitimate mechanism for originators of financial assets to attract non-financial investors to the market.

Last week, there was a particular good essay published in and written by Burnham Banks.  Mr. Banks’ arguments are short and sweet and really hit the nail on the head.

Here’s a link to his article: 

Definitely worth a read.

Securitization Conflict of Interest Rule Would Restore Confidence

Last week’s decision by the SEC to put forth proposed Rule 127B could be a huge step in restoring confidence and integrity in the securitization markets.

Deserved or not, many investors, regulators and other government officials still blame the investment banks for the collapse of the credit markets in 2007.  What remains a particularly “hard to explain away” fact is that at least several of the banks that were underwriting mortgage-backed and CDO programs in 2006 and 2007 were simultaneously shorting those securities for other clients and worse, in some cases, for their own account.

One has to fully understand the complexities and separation of information, client and  risk strategies to even begin to understand how the investment banking side of a company could have been hawking a new CDO, while at the same time, that company’s asset management group or proprietary trading desk was shorting the same security.  Even if you buy into the argument that these groups did not and should not have been communicating with each other, the sheer fact that the bank was on all sides of the market for this security seems to most rationale thinkers like a clear conflict of interest.

It now seems that the SEC agrees with that point of view and we don’t really see how they could have come to any other conclusion.

We believe that the industry should warmly embrace the proposed rule 127B and move on. 

We note that the American Securitization Forum has given a somewhat reserved endorsement of the proposed rule.  Their concerns are that activities including legitimate hedging and market making are not impinged by an overly conservative implementation of 127B.

We would suggest that these concerns, while academically legitimate, are way “over baked”.  Cleary, banks that are active in the underwriting of securitized debt will not underwrite every transaction, even for the same issuer.  As this is clearly the most predictable outcome, the abilities of any single bank to conduct active investment businesses (both for third-party clients and for their own account) can’t really be expected to be a hindered by this rule. 

In fact, we would argue that by forcing firms to choose which roles or sides they take for individual transactions, we would do much to encourage competition and market efficiency.

If the ASF meant in their commentary to include concerns about an investment bank being restricted from hedging against a deteriorating portfolio position during the first 12 months (the proposed rule suggests a 12 month prohibition for underwriters), we would acknowledge that the rule will put more pressure on the investment banker to construct a transaction with better fundamentals. But isn’t that really the point after all? 

If the banker doesn’t think the security has at least a year’s worth of legs, why were they underwriting it to begin with?  If they still hold a substantial percentage of the issue on their books 12 months out, perhaps they should question why they did the deal in the first place.

We see proposed rule 127B as perhaps the most legitimate fix to the securitization industry since the financial crisis.  We believe the entire industry should embrace the rule and take a major step towards reviving market confidence across the board.

Fannie/Freddie Suit Brings More Gloom to Mortgage Industry

Last week’s announcement by the Federal Home Finance Agency (“FHFA“) that they would sue 17 major banks on behalf of FNMA and FHLMC throws more cold water on the stalled recovery of the US residential mortgage market.  Not that the filing was a complete surprise, given the trail of developments over the last few years regarding shoddy underwriting standards by some of the most aggressive mortgage originators but there is a legitimate school of thought that suggests that such action probably doesn’t solve anything and the only pockets that will wind up being lined here will be those of the lawyers working on behalf of both sides in this dispute.

The evidence seems mighty clear at this point that the 17 organizations named in the suit (see list below)  may have been among the many lenders that were much less than “on the ball” in underwriting thousands of mortgages that eventually found their way into the Government programs.  The rub is that the banks are very likely to make the case that “if anyone should have understood what they were getting with these mortgages, it was the GSE’s”, including FNMA and FHLMC

The banks will undoubtedly argue that the GSE’s, perhaps more so than any other “sophisticated investor” in the market, knew exactly what they were buying from these banks.  Keep in mind that this was not some type of shotgun wedding.  These “trades” took place over several years so, even if one wants to argue that the banks snuck some bad mortgages into the Government programs, how can one seriously believe that the mortgage agencies should not have been conducting their own due diligence on the underlying quality of the product? 

If you ask us, we think this argument has some legs and is probably why several in the industry are suggesting that neither side likely has much motivation to settle this case early.  On that basis, probably too bad for the mortgage industry, as this will undoubtedly put another wet blanket on the industry’s recovery.

Another related development this past week was Bank of America’s decision to exit its correspondent mortgage business and the rumors that an exit of their wholesale business is not far behind.  Clearly the notion of having to take responsibility for the actions of a large network of correspondent mortgage originators sounds less and less appealing to BoA, particularly when banks, which have acted as very useful “clearing houses” for the US mortgage market, begin to feel like they have been left “holding the bag”.

Here are the 17 banks named in the FHFA suit:

Ally Financial (ex-GMAC), $6 billion
Bank of America Corp., $6 billion
Barclays Bank, $4.9 billion
Citigroup, $3.5 billion
Countrywide, $26.6 billion
Credit Suisse Holdings USA, $14.1 billion
Deutsche Bank, $14.2 billion
First Horizon National, $883 million
General Electric, $549 million
Goldman Sachs, $11.1 billion
HSBC North America, $6.2 billion
J.P. Morgan Chase, $33 billion
Merrill Lynch/First Franklin Financial, $24.853 billion
Morgan Stanley, $10.58 billion
Nomura Holding America Inc., $2 billion
Royal Bank of Scotland Group, $30.4 billion
Societe Generale, $1.3 billion