Saving Securitization: The Industry Needs To Embrace Best Practices

Jul 16 2010 | 8:42am ET

By John Joshi, CapitalFusion Partners -- The media has portrayed Wall Street and financial firms as blood sucking vampire squids out to destroy the world. Politico.com recently ran a cartoon that portrayed the financial marketplace as a meat market grinding up consumers in its quest to generate profits, which generally sums up public opinion.  More specifically, the securitization industry has come under fire.

The average John and Jane Q. Public does not understand what securitization is nor do they see the benefits that result from it, and industry groups have done little to educate them. The popular perception is that a lot of spoiled brats are crying to get their marbles back so they can continue playing. In fact, securitization brings many benefits to both issuers and investors, and it is time for the industry to stand up and educate both regulators and the general populace about these benefits.

New Regulatory Landscape

Yesterday, the Senate finally garnered enough votes to pass the regulatory reform bill, and Wall Street is bracing for change. The securitization markets are a miniscule part of the financial sector and it could be years before those markets return to any sense of normalcy, if ever. Below is a brief outline of some of the proposed rules being discussed by regulators that could affect the securitization industry.

• Income Verification Clarity: New securitization deals must disclose how borrowers' incomes were confirmed for the loans being sold
• Standardized Loan-Level Data Provided: Computerized loan-level data must be provided initially and on an on-going basis
• Additional Time for Analysis: Investors must have more time to ponder the information about the loans in the securitization pool before purchase
• Issuer CEO Certification
• 5% Skin in the Game: Bank creating these assets must have some skin in the game
• SEC Computer Model for Analyzing Securities

Benefits of Securitization Markets

Securitization has played an important and constructive role in the evolution of our financial system. It has brought new sources of finance to the consumer market, not only for mortgages, but also for auto loans and credit card purchases.

The benefits to issuers include alternative sources of funding, reduce funding costs, off-balance sheet treatment and risk reduction. At the same time, investors benefit by having more liquidity, better asset/liability matching, a positive return in “normal” markets, and capital relief.

Change is Coming, Embrace It

The financial sector and specifically the securitization sector will change forever.  The freewheeling days of securitization have come to a close. As an industry we can embrace the change and be a proponent for developing a new robust securitization market and work with regulators in drafting the best policies. A market that is viewed by the regulators and the public for the benefit it brings to society and not simply for the greed and egregious behavior of the past should be the goal of industry participants.  Below is a list of best practices that, if adopted, will go a long way toward reaching this goal.

Best Practices for The Securitization Market

  • Improved Transparency  - Alignment of economic interests between originators and investors, we think a mandatory minimum retention of risk in respect of securitized assets must address a number of important issues in order to be practical and beneficial.
  • Standardized Disclosure - Certain high-risk practices, such as “no doc” loans, should be prohibited outright. Moreover, we believe the current disclosure regime and underwriting practices can be improved. Specifically, we would increase loan-level disclosures, and encourage regulators to study ways of improving the standardized public disclosure package. 
  • Rating Agency Reform - Reforms relating to credit rating agencies (CRAs) are vital to reinvigorating the securitized debt markets
  • Reps & Warranty - Originators, whether banks or brokers, need stronger incentives to originate loans that are in conformity with what they have promised
  • Effective Regulation  - The financial reform bill is a good first step in introducing regulation in some previously unregulated areas. Now the task for regulators is to enforce it
  • Stakeholder Alignment - Compensation structure for all stake-holders needs better alignment
  • Transparency on Leverage - Stronger capital requirements and better reporting of leverage.  Improve Netting Capabilities across markets and exchanges

Conclusion

The industry as whole has to set up a self policing mechanism, i.e. a “Best Practices for the Financial Securitization Industry.”  Industry groups need to work together to foster greater transparency and cooperation; develop standards and hold themselves accountable for their actions.  Ironically, as the regulatory landscape becomes clear there will be teams of lawyers and analyst pouring over each new regulation and dissecting every sentence to find the next arbitrage opportunity.  I hope we have all learned the lessons from the past and will not repeat our mistakes as we develop the new securitization markets that serve a crucial function in our society.

John Joshi is a managing principal at CapitalFusion Partners and FinCap Financial Services. At CapitalFusion he has responsibilities in business development, portfolio management and oversight of all strategic business initiatives. Previously, he was an executive vice president at Countrywide Alternative Investments. He has also served as a group head and portfolio manager for Structured Finance Asset Management and Trading at the Clinton Group.
 


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