The "Great Recession," the moniker now attached to our most recent economic downturn, has put a bright spotlight on many financial areas of our economy that the average citizen has no ability to grasp. While Wall Street drew press attention for its seemingly unbridled greed, the "Average Joe" on Main Street had no idea what all the fuss was about, especially when it came to the near financial meltdown of our global capital generating industry. Mortgage-backed securities, CDOs, and securitization were to forever join our lexicon of notable terms, but clear definitions were lacking.
Congressional hearings followed that attempted to pillory Goldman Sachs, our foremost investment banker, in the public square. Other scenario participants were also grilled on the Hill, but the blame could not be securely fixed upon any individual party. The Enron scandal of less than a decade ago was blatant fraud, but the present catastrophe was more systemic in nature, propelled by every party's greed for transactional revenue and large bonuses down the line. It appeared that the possibility of debt recourse never entered anyone's mind, each party handing the "hot potato" onto the next in line.
Enron brought about the Sarbanes-Oxley Act, and in due course, President Barack Obama signed into law last July 21st the Dodd-Frank Act, a 2,000-page tome designed to address areas where federal regulation was obviously lacking. Consumer credit received much attention, as did the area of securitization, an industry that few know about, but is the mechanism that has generated necessary liquidity for such debt instruments as car loans, credit card receivables, and yes, mortgages.
With the Act now a law, everyone is waiting for the all-important issuance of detailed regulations to assess potential impacts on their respective businesses. The Commodities Futures Trading Commission has already issued final regulations for the currency trading industry. Many of the rules related to securitization are still being drafted and reviewed by various agencies, including the Securities and Exchange Commission. Reading the details involved is tantamount to reading the IRS Tax Code, an activity that only a few CPA/attorneys in the nation actually relish. However, the devil is in the details, and the thickness of the Dodd-Frank Act can easily disguise the intent of its small print.
The major concern areas addressed by the Act are summarized below:
* "Skin in the Game" Provisions: Both "originators" and "securitizers" that participate in securitizing financial backed securities must now retain a portion of credit risk in the instruments that they create and sell. The level of risk retention has an upper limit of 5% and may not be hedged or transferred by a securitizer. Risk retention will apply to collateralized debt obligations, collateralized loan obligations and any other related asset-backed securities. Regulators will also determine allocation rules. Risk retention rules must be issued within 270 days of the enactment date of the Act, July 21, 2010;
* Exemptions: The Act specifically allows for an exemption of the above risk retention rules for "qualified residential mortgages" and to assets issued by government agencies. Rules to follow from regulators;
* Regulators: Rules will be forthcoming from a host of federal agencies. The Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, and the SEC are the designated regulators. The Secretary of Housing and Urban Development and the Director of the Federal Housing Finance Agency will issue rules related to residential mortgages;
* Disclosure Requirements: These are voluminous and address timing issues;
* Conflict of Interest Clauses: These rules are designed to eliminate incentives that would encourage any participant in the transaction to "bet" against the success of the pool of securities. A one-year limit is proposed, but exemptions will be defined in the rule-making process. Issuers must also perform due-diligence and release their findings.
These are but a few of the general areas that the Act has focused upon, but many lawmakers believe the Act did not go far enough. Many suggest that incentives in the industry must be overhauled. There are far too may parties chasing the same fee revenue and related bonuses. Greed drove the selling side of the industry to over-perform, thereby demanding more product from the origination side of the business. This pressure led to "no-doc" loans and gaming of the rating process. Investment and commercial banks are fighting over the same slice of the pie. Some say a return of Glass-Steagall Act's separation rules would have been a more appropriate solution.
Whatever the outcome, a healthy and thriving securitization industry is a necessary component of our entire capital generation process. New rules may encumber the industry, but, hopefully, will not put a chokehold on liquidity. The housing industry already has eight years worth of inventory to clear off its books. Mortgage-backed securities are here to stay, and a thriving market must be present if our real estate industry is ever to recover.
This Learning Curve was written by Tom Cleveland, founder, Cleveland Consulting Services.