What to do about securitization? You know. the process by which banks slice up and pool loans into an investor-friendly treat, slathering each layer in a delectable coating of risk. The best part is the calories are totally off balance sheet, which means someone else puts on the pounds.
If you're the FDIC, you shrug. As everyone knows, securitization contributed to the financial crisis by making the risk of losing money somebody else's business. Instead of carrying whole loans on their books, banks are able to sell them off by the "tranche" to investors shrewd, reckless or clueless enough to buy them.
Government regulators know well that securitization played a starring role in the housing bust. And until recently they seemed ready to do something about it. But evidently they've had second thoughts. The FDIC on Tuesday shelved a plan to tighten standards on securitization. Under that proposal, banks would've had to reflect the value, and potential loss, of such loans on their books. Instead the agency will take the next 45 days or so and ask for feedback.
Specifically, regulators are looking at things such as if they should bar securitizers from hedging against the risk they entail in packaging loans, along with allowing tranches to be leveraged. Also under consideration is whether mortgages need to be at least 12 months old before they're diced up and sold off, among other restrictions.
The financial industry has lobbied hard against such barriers. And in fairness to banks, securitization plays an important role in the capital markets. Estimates show that securitized loans account for nearly 60 percent of the funding for home mortgages and fully a quarter of all consumer credit in the U.S. Depending on how it's done, securitization can be a good way to spread risk and often provides a cheaper form of financing than traditional debt or equity.
As FDIC chief Sheila Bair said in announcing the rule delay:
"We're trying to strike a middle ground here" between those who want to eliminate securitization completely and those who want little to change.Despite (or because of) its benefits, securitization has been widely abused. Lax underwriting, crummy loans, bogus credit rating, imaginary risk management -- all these problems relate directly to issues inherent in securitization. Those issues were allowed -- enouraged, even -- to fester by letting banks operate in a regulatory vacuum.
Yet the solution, despite the complexities of the FDIC's proposal, is straightforward, says Linus Wilson, a professor of finance at the University of Louisiana at Lafayette, by email.
"Banks should hold capital against assets for which their investors could lose money on," he says. "The rules allowing banks to move off balance sheet securitization 'sales' are confusing to investors and allow banks to skirt capital regulations."The FDIC itself is split over what do about securitization. Bair and other board members appear to favor more stringent regulations for banks. Others at the commission, including OCC head John Dugan, fear that could damage the securitization market and advantage non-bank financial firms.
Wilson doesn't buy it:
"Where are these non-bank institutions that Mr. Dugan is worried that banks must compete against? Most of the non-depository lenders blew up in the subprime crisis and the financial crisis of 2008. These assets and liabilities should be moved on balance sheet sooner rather than later. The securitization market should be driven by the desire to spread risk, not to book fake profits or skirt capital regulations."Hear, hear.