After reading jck’s piece Securitization: Not Guilty, I said to myself, “well said.” He cited a study that showed that misaligned incentives were more to blame than secutritization itself. (Academic paper here.) And he cited this clever piece from the seemingly erstwhile blog Going Private.
Here’s my view. I have lived through the first era of securitization, and I always thought that the equity/originator got off too easily. They got their money out of the transaction too quickly, allowing themselves to profit if the deal survived for a while, and then died. The equity of the deal should take the largest risks, rather than the subordinate certificates (most junior aside from equity).
Here’s my solution. Require that the deal sponsor and originators retain the full equity piece, and that the size be regulated to make it significant. Further require that the equity is a zero interest tranche, where the excess interest builds up to protect the subordinate securities. They get paid last out of any residual cash flows of the deal. The size of the equity piece might vary from 1% of principal on credit card, auto and stranded cost ABS, to 10% on CDOs. Note that the equity pieces cannot be traded here, they must be owned by the sponsors or originators.
Now, if the equity only gets paid at the end, several things occur:
- Sponsors/Originators have to be well capitalized.
- They will be a lot more careful about credit selection, and not accept high-interest risky borrowers.
- The subordinate certificates will get paid less interest, but with more certainty.
Does this change the nature of securitization? Yes, and in a good way. Securitization is useful, but in its initial phases, it suffered from the equity not having enough at risk. My proposal solves that. Put the equity at the back of the cash flow bus, such that the originator never makes a gain on sale, and that part of the financial system will be sound once again.