Insecuritization

BRUSSELS – There is no shortage of analyses of what went wrong in the world’s capital markets over the past 18 months. What is clear is that a complex set of relationships, interactions, events, and omissions on the part of many different actors, rather than any single factor, was to blame. I am convinced, for example, that over the years there has been too much “regulatory capture” by the supply side of the financial services market, with its well-organized and powerful lobbies. By contrast, there has been too little engagement on the demand side. That is an imbalance of which legislators must be much more conscious. A second problem for regulators, supervisors, and, indeed, credit rating agencies was scarce resources. When investment banking markets were booming – and the private sector easily recruited up top talent – regulators and supervisors found it difficult to get the budgets to keep up with innovation and police the markets. In the future, governments will have to commit the necessary resources to ensure more robust oversight of risk management in financial institutions. Capital markets must be subject to much more detailed and frequent hands-on supervisory inspections. In Europe, crisis management mechanisms must be put in place to manage their deeply integrated nature, as 80% of Europe’s banking assets held in cross-border banking groups. A third problem – particular relevant to banks, risk managers, and traders – has been misaligned incentives. Incentive structures have been overwhelmingly aligned to short-term performance. In firms where this was most pronounced, there has been almost total destruction of shareholder value. As a consequence, a wholly unacceptable long-term burden has been imposed on taxpayers. Privatizing banks’ profits and socializing their losses is not acceptable in democratic societies. The structure and timing of performance pay in banks must be more closely aligned to long-term shareholder interests and financial stability. Incentives for brokers and credit rating agencies have been even more perverse. In the United States, brokers were selling mortgages without checking whether the borrower had the means to repay. They had no stake beyond the immediate “sale.” Financed via Special Purpose Entities, mortgages were parceled up in debt packages and securitized entities in which neither originators nor sponsors retained any material long-term stake but paid credit rating agencies to award a nice little ribbon marked AAA. When the packages were unwrapped, most of their contents turned out to consist of pools of toxic assets for which there was no proper due diligence, no evidence of capacity to repay, and little cushion to cope with a market downturn. That’s why I have proposed much tougher measures in the revised Capital Requirements Directive amendments now being considered by the European Parliament. This will require thorough independent due diligence on securitizations, proper cash-flow sensitivity analysis, and less reliance on credit rating agencies paid by issuers. Originators or managers of these securitizations will be required to retain a meaningful stake in each tranche of the issue. I was pilloried for this proposal when I initially put it forward. I am therefore glad to see that a G-30 advisory group has now supported this principle, and that it is gaining increased traction in the US. But some banking industry lobbyists have sought amendments in the European Parliament that would totally neuter the proposal’s effectiveness. Even more irresponsible are attempts to undermine a requirement for adequate due diligence on securitization positions prior to investing – with some amendments containing wording that would make it virtually impossible for supervisors to monitor compliance. Mortgage assets and leveraged loans created in huckster shops, carved up and buried in “CDO squareds” (securitizations wrapped in other securitizations), and characterized by progressively more obscure, more contingent, and more complex orders of priority for allocating cash flows have no place in capital markets. The opaqueness, wholly unnecessary complexity, and near impossibility of undertaking independent due diligence on these structures’ underlying risk have undermined trust in the securitization market. Financial institutions – and their trade bodies – are doing themselves no favors by vigorously opposing meaningful reform. Is it any wonder that the valuation of securitized investments has become so challenging, that mark-to-market valuation on securitized assets has become meaningless, depressed, or both, and that the securitization market itself has seized up? Rather than restoring the trust and confidence in capital markets needed for recovery, those European Union members and banking federations that submitted “wrecking amendments” to the due diligence and securitization proposals are reinforcing the suspicion that is now embedded within them. If successful, they will impair the revival of a transparent, responsible, and vibrant securitization market – a market that, if properly managed, can contribute meaningfully to sustainable, long-term economic growth. Charlie McCreevy is EU Commissioner for the Internal Market and Services. Copyright: Project Syndicate, 2009.www.project-syndicate.org

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Insecuritization