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.
David,
FYI, while Going Private is mostly inactive, Equity Private is posting all the time at dealbreaker.com if you’re interested.
Chris, thanks. I know Equity Private writes over at DealBreaker, but I don’t read DealBreaker because of the tone there, and the low signal/noise ratio. Maybe that has changed with Carney leaving and EP contributing, but sites that make it their permanent goal to rake muck get an attitude that makes them less reliable.
Correct me if I’m wrong, but aren’t most auto loan ABS deals already structured in a very similar way to your suggestion? I thought the main culprit of this was actually the RMBS deals with step-down mechanisms?
No, Frank, you are largely right, though few equity pieces accept zero coupons. The idea is that the equity gets paid last — no interest, no principal, until everyone else gets paid off.
While the general quality of the CDOs is imperiled by perverse incentives, isn’t the current state of affairs (IE no one being able to value the CDO, thus the formation of TARP) a direct result of the way these securitizations are structured?
That is, aren’t these so complicated that no one can easily examine the actual quality after the SHTF to accurately determine their worth? Is the housing bubble made worse by securitization as it is currently constructed?
J Lo, If the amount of equity in the deals is sized properly, then the risk to the more senior tranches becomes minor. My proposal implicitly wipes out the tranches that are less than single-A in terms of risk. It also would force originators to focus on quality lending, or else, they would lose money on every deal.
If lending quality is high and leverage is low, there’s no problem. It would be akin to a well managed bank making corporate loans. That said, my proposal reduces the profitability of securitization… many originators did not put up much if any money, so any payments from the equity tranche were gravy.
In my opinion, CDOs aren’t complex, unless they include other structured finance products inside them. Will this totally solve the illiquidity problems? No, but the new CDOs will be higher quality, and their debts more liquid.
David,
Your proposal makes sense. Regarding this,
“In my opinion, CDOs aren’t complex, unless they include other structured finance products inside them.”
What then explains the lack of a market for CDOs (the ones that aren’t comprised of other structured finance products)? Is it the heterogeneous credit quality of the underlying mortgages?
Marketability is limited by heterogeneity of credit instruments underlying the deals, lack of transparency (sometimes hard to get deal data if you don’t already own the deal), and thin tranche sizes, aside from the most senior tranches. But if you have the data on the corporate credits, they are simple to model.