More Subprime From Schumer

I just posted the opinion piece below that relates to how Senator Schumer continues to ignore Wall Street's role in the current mortgage crisis. Apparently, Wall Street and other banks were so hungry to originate mortgages, 23 year old kids were able to defraud them of millions of dollars. The FBI has geared up dramatically to uncover and prosecute those responsible. Here is a quote from this December 21 Wall Street Journal page 1 article:

Fraud goes a long way toward explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.

Here is the article I posted last night:
Charles Schumer is at it again. On December 19, 2007 he presented "A Call to Action on the Subprime Mortgage Crises: Putting Common Sense Ahead of Ideology" to The Brookings Institution. I have read those remarks and find that I must discuss them in order to keep the record, as I see it, clear. If you are new to my blog, you may not know that in October I reviewed a report sponsored by Senator Schumer that set up his current proposals. This presentation is the next logical step in the progression of deflecting attention away from the Wall Street participants and moving the burden to mortgage brokers, non-bank lenders, shareholders of Fannie Mae and Freddie Mac, and taxpayers. There is so much to be said about this that I will first provide a summary and then review the Senator’s remarks. If you are not familiar with Wall Street’s role in the subprime mortgage market, I suggest you read my October post first.

Senator Schumer’s presentation contains some things I agree with. For example, I can’t argue against a plan that says borrowers should be informed about the loans they are taking, or that borrowers should have an advocate if they are in default (two of Senator Schumer’s proposals). The problem, however, is that Senator Schumer continues to ignore the primary causes of the crisis and tailors remedies that shift the burden to other parties. According to the Senator, the crisis was caused by homeowners who were duped by unscrupulous mortgage brokers into taking out bad mortgages. To fix the problem requires regulation of those bad brokers and refinancing hundreds of thousands of loans even if it means putting taxpayers on the hook and even if these borrowers were not first-time homebuyers. I’m sure there are unscrupulous mortgage brokers and that some borrowers didn’t fully understand the terms of their mortgage. But is it the root of the problem? The Senator completely ignores the role of Wall Street and the subprime mortgage fee-fest that fed many of his campaign contributors over the past five years. He also ignores the role of the Federal Reserve and its failure to do anything to prevent this long developing crisis. Of course, his political motives for this are obvious and I believe he really does understand the origins of this problem. If not, I suggest he read some of the recent reporting to educate himself. This Businessweek article would be a good place to start learning about Wall Street’s role (the link only goes to page two – click back a page to start). He can also read this Fortune article that discusses how the Federal Reserve ignored this problem for too long.

I will give the Senator credit for at last acknowledging the issues relating to credit rating agencies and the conflicts of interest that pervade the securitization of subprime mortgages (as well as everything else). Of course, Congress was warned of these problems in connection with Enron as far back as 2002 and again in 2006 but chose to ignore these warnings. We are now paying the price for Congress’ failure to act.

Finally, Senator Schumer claims that Chairman Bernanke supports his plan to raise the caps for loans made by Fannie Mae and Freddie Mac (the GSEs) to include jumbo loans. I have two problems with this. First, Senator Schumer believes that the GSEs should use their lending capacity to refinance subprime loans on homes that cost, potentially, seven figures. He believes they should do this even though the GSEs have said refinancing these subprime loans is not profitable for them. Of course, these entities were chartered to help provide affordable housing and are owned by shareholders, but apparently that no longer matters. Let the funds be used for the well off and the shareholders pay the price.

Second, Senator Schumer states that this proposal has the support of FED Chairman Bernanke. I am not sure about that. In fact, I wrote about the exchange between the Senator and the Chairman regarding this issue. What the Senator does not state is that the Chairman did not give his support to this plan of simply raising the caps. Rather he was asked if the government could do something like this and he said yes. He said the GSEs could make loans up to $1 million and have the federal government guarantee them. That could be done. However, it would require a large political price because these would be taxpayer guaranteed loans in order to protect the GSEs. You can read about that exchange here – click on “stupidity”. The Senator does not mention anything about the taxpayer guarantee part of the exchange. If this is the “support” from the Chairman that he is referring to then this is a shameful act of political maneuvering and misinformation, and Senator Schumer should, in my opinion, clarify this point. It was obvious when he set the Chairman up for this. So obvious that I wrote about it.

At the end of the day, Senator Schumer apparently believes that taxpayers and shareholders of the GSEs should pick up the tab for this Wall Street mess, mortgage brokers and non-bank lenders should be regulated, but the Wall Street banks need not even be mentioned. It makes me wonder who is actually running Congress. It’s as good as money can buy.

With that introduction and summary, here is my review of Senator Schumer’s remarks.

Senator Schumer’s remarks begin by bashing the Bush Administration’s economic policies as too ideological and irresponsible. I agree with him, especially when it comes to tax policy and saving for baby boomer health care. His next focus is on what he calls the “Four Myths Surrounding The Subprime Crises.”

His first myth is that subprime lending led to millions of brand-new, first-time homeowners. He states that according to the Office of Comptroller of the Currency, only 11 percent of subprime loans went to first-time buyers last year, so the majority of subprime loans were for refinance or buyers who had already owned a home. He then goes on to conclude: “Too many of these borrowers were talked into refinancing their homes to gain additional cash for things like medical bills.” He provides no support for this claim and implicates mortgage brokers as evildoers out to rip off poor desperate homeowners. He then goes on to say that “too large a percentage [whatever that means] went to investors and speculators.” This point is also without support, but is worth remembering because when Senator Schumer speaks about why we need to help out these poor subprime borrowers he is clearly not speaking to this “too large a percent” of subprime borrowers. What is really amazing is that Mr. Schumer goes on to spend an entire page of his presentation talking about how the Paulson rate freeze plan will not help enough borrowers. Which ones? He also ignores steps that have been taken already to help some 300,000 borrowers through FHA programs such as FHASecure and the pending FHA Modernization Act. The spin is so bad it hurts.

His second myth he calls “The Myth of the Unqualified Borrower”. I love this one. He claims that a study of credit scores clearly indicates that many subprime borrowers could have qualified for prime loans. He fails to consider, however, any debt-to-income or loan-to-value criteria (or any other criteria for that matter). So in fact we really don’t know whether these people could have qualified for a prime loan or not. All we know is that their credit scores were in a range that could possibly have qualified them for some mortgage amount. The other thing about this “myth” is how it is in direct contrast to all of the hype we have been hearing from HUD and the FHA. The FHA Modernization Act, supported by the Senate, lowers the underwriting criteria for FHA guaranteed loans. If all of these borrowers could qualify for prime loans, then why do we need to lower the underwriting standards to refinance all of them into FHA loans? Sounds like BS to me. You can get more details on the FHA Modernization Act from my post on it, but it is enough to understand that the thrust is to reduce the amount down from 3% to 1.5% and raise the size of the loan that can be financed. (The FHA role in refinancing hundreds of thousands of subprime loans is also a potential problem that could lead to a taxpayer bailout.) The Senator concludes this “myth” by stating “it’s clear that many subprime borrowers have the financial foundation for sustainable homeownership, but may have been tricked into unaffordable loans by unscrupulous brokers.” There we go again – it’s all the fault of those brokers. Did the Senator ever consider that maybe these borrowers wanted more home with less down and pressured the brokers to come up with a financing arrangement to satisfy their demands?

Myth three is “The Myth that Borrowers Can Easily Obtain Perfect Knowledge of The Terms of Their Mortgage Loans.” Well, if he is referring to the fact that the rate varies and the payments are likely to go up, borrowers can easily obtain and understand that information. The other thing borrowers generally understand is that if they cannot make their payment they will lose the home. According to Senator Schumer, however, most people are too stupid to understand this and so we must step in to protect them. Now, I wonder which people these are. Are these the ones who had to refinance to pay medical bills or the “too large a percentage” of investors and speculators? No, these must be the ones who were duped by the unscrupulous brokers. Yah, that’s it. How many of those are there again?

Myth four is that the free market will fix everything. I agree with his supposition that free markets do not fix everything, but stupid policy doesn’t fix everything either. If the Senate had listened to all of the warning signals it got about the housing bubble and leaned on the FED a little more, or about rating agencies and acted on that, then much of this mess probably could have been avoided. Instead, the politicians (pretty much all of them) stuck their heads in the sand because they didn’t want to throw cold water on a very popular housing boom (especially when their contributors were making a fortune from it). Glass houses and all of that.

The four myths are followed by warnings of impending doom. In fact, according to Senator Schumer “we are facing an economic downturn that we haven’t seen in this country since the Great Depression.” Yikes! If this is true I’m really glad I took most of my money out of long positions in equities! He goes on to point out that “a 10 percent decline in housing prices could lead to an overall $2.3 trillion economic loss…” That would be bad, but less than half of the approximately $5 trillion in losses from the dotcom bubble bursting. I agree this is not good for the economy, but the Great Depression? I hope not.

The presentation ends with seven policy options proposed by Senator Schumer to address the subprime mortgage crisis. Here they are, in a nutshell:

1) Provide more mortgage counselors to serve as borrowers’ advocates. OK, not bad.
2) Raise the portfolio limits for Fannie Mae and Freddie Mac so they can refinance subprime loans, even though these entities have said this would not be profitable for them. Also raise the cap on the loans they can make to include jumbo mortgages (no mention of the government guarantee part). I don’t like these, especially when the GSEs are saying they want no part of it.
3) Allow states to issue tax-exempt bonds to refinance subprime loans. As long as it’s not my state tax dollars guarantying the loans, fine.
4) Modify the bankruptcy code to change the protection mortgage lenders currently enjoy – mortgage loans are exempt from restructuring in bankruptcy without the consent of the lender. OK, but this could make mortgage loans more expensive in the future. Senator Schumer understands this, and acknowledges that this could be limited to only existing loans. This one gets a maybe and a ho-hum from me. If the lenders will be better off cutting a new deal they will.
5) Enact new regulations covering practices by mortgage brokers and non-bank lenders, including limitations on the types of loans they can make. Remember these brokers and non-bank lenders? They are the bad guys in all of this, according to Senator Schumer. Notice how these are mortgage brokers and non-bank lenders, and not banks or investment banks. If you didn’t click on that link to Senator Schumer’s top contributors you may not get this point as clearly. Here it is again. The Senator simply ignores the role of Wall Street and the investment banks in this crisis and makes no mention of any remedy targeted to them.
6) Create an easy to read summary of mortgage terms for borrowers so the big bad mortgage brokers can no longer dupe them into bad loans. OK.
7) Finally, Senator Schumer proposes to closely examine the role of rating agencies in all of this. Hooray! He is finally getting warm.

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Dirty Little Secrets of Subprime

I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:

1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?

2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.

3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.

“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”

At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:

“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.

4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.

5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”

Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html

6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.

I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.

Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.

All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.

Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html

Looks like all the lose ends are getting tied up nicely.

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Public and Private Bank Regulators

Revised - see excerpts added at end.
Revised 10/23 - see joint press release regarding capital adequacy rules for conduits at end.

I am not an expert on banks and banking, although I have been a banker and I have read a few books on the subject. Because of that, consider this an opinion piece based on some observations that I would like to share regarding the current credit crises. If you plan to use any of this information for anything important please remember to verify.

My conclusion is that too much of our financial system is currently regulated by rating agencies. This is accomplished by (get ready for this one) - using the market distortion of bank regulation to avoid bank regulation. Now this is not a rant against rating agencies. In fact I like rating agencies and they play a very important role in our economy. But I believe they have been making too many decisions that impact us all in what has effectively become a dual system of public and private regulation. Here is my reasoning:

On one hand, the banking industry is structured to take excessive risk because of all the safeguards built in by regulators. We don’t want banks to fail. The results are bad – people lose money, fewer loans are available and that slows the economy, etc. So, to protect us from that, banks get certain privileges. First, they have a lender of last resort – the FED. Banks, assuming they are not insolvent, can pledge collateral to the FED and borrow from it if they run into a liquidity problem. If they have no assets the FED is willing to take and not enough liquidity to meet withdrawal demands, then they are most likely insolvent. But even then, there is the “Too Big To Fail” doctrine that, we all know from history, is true. The impact of a large bank failure on the economy would be big and bad, so we don’t believe the government would let that happen. Finally, the FDIC insures deposit accounts (within limits) so even if a bank does fail, the depositors get their money back. Look at all the bail out built into the system. This limits the downside risk of lending because in the worst case, who gets hurt really? So, banks have a built-in incentive to go for the gold (make risky high interest loans).

In order to ensure that banks don’t just swing for the fences, there is the flip side called bank regulation. Banks are prohibited from owning certain types of risky assets like stocks and junk bonds. They are also required to hold a certain level of equity capital that is based, in part, on the risk level of the assets they own (the securities, loans, etc.) to provide a cushion against insolvency. If the value of their assets declines, there must be enough equity to absorb it. They also must keep a certain percentage of the deposits they owe to depositors in reserves to help ensure liquidity. These regulations are enforced by regulators and are in place to counter balance the protections we offer banks and prevent them from focusing on volume instead of quality of loans. These checks and balances result in a profitable banking system that is less likely to fail, and that results in better credit ratings for banks. So, all of the regulation helps banks maintain good credit ratings.

Once you take away these regulations, or more precisely, figure out how to avoid them, you take away the check on the imbalance toward too much risk. I believe this is one of the major issues with off-balance sheet vehicles such as SIVs and ABCP Conduits. As noted above, banks are required to have risk-based capital that is calculated based on the risk of the assets they hold. This is the implementation of one of the checks against all of the protections banks are afforded. When it comes to ABCP Conduits, however (including the now infamous SIVs), banks calculate the amount of risk-based capital required by multiplying the line of credit used to enhance the conduit by 10% (the regulations allow them to do this). So, they escape 90% of the risk-based capital requirement. Shouldn’t this lower their credit rating? (Now, I believe these numbers are generally correct, but as I said I am not an expert on this and I do not have access to a law library at this time. I did find some support for these numbers here: http://www.chapman.com/media/news/media.485.pdf.)

Now we see why banks love this structure. They take the interest rate differential between the assets funded by the conduit and the liabilities funding the conduit and earn a fee from it while only using up 10% of the risk based capital they would be required to maintain if they did this on their balance sheet. This jacks up return on equity by, in effect, getting around the capital requirements.

Let’s look at an example, a make believe bank named PLUS 90 Bank. It has lines backing conduits of approximately $77 billion. Lets be very generous and assume that the assets would be risk-weighted at 20% if they were on the balance sheet, so the bank would be required to keep $1.232 billion dollars in capital to support these assets ($77 x .2 x .08). But, because they are not on the balance sheet, the bank needs only $123.2 million in capital ($77 x .2 x .08 x .1). This $1.1 billion dollar difference is why the banks love this structure. They can avoid the capital requirement and enhance the return on equity. Lets do a simplified example:

Suppose a bank acquired assets with $77 billion and funded that purchase with time deposits. They would earn an interest spread on the investment. Since we are using a risk-weight of 20%, these would be pretty good assets and the interest spread would be on the low side. Assume it is 1.5%. What is the return on equity before expenses?

($77,000,000,000 x .015) / 1,232,000,000 = 0.9375, or 93.75%. Leverage!

What happens if the bank takes this whole thing and moves it off-balance sheet?

($77,000,000,000 x .015) / 123,200,000 = 9.375, or 937.5%! Even if the bank makes a 1% fee from the off-balance sheet entity, that’s still ($77,000,000,000 x .01) / 123,200,000 = 6.26, or 626.00%.

Looked at another way, with a 10% capital requirement, the bank can provide 10 times as much credit off-balance sheet as it could on-balance sheet (in fact, they can probably leverage it even more if they can avoid the 10% bank line; is this why there are troubles afoot with the SIV structure?). See what I mean about the regulations? This structure makes a mockery of the basic idea of limiting bank exposure through the regulatory framework. So what, then, does limit bank exposure? Well, the limit is really the market for commercial paper. This market is driven, in large part, by the perceived quality of commercial paper and that is where the rating agencies come in.

Rating agencies examine the structure of conduits and the quality of the assets they hold. They also look at the credit lines from the banks that provide liquidity to the conduit should there be a problem, so in part the rating assigned a conduit depends on the rating of the bank. See, the rating of the bank that is in part determined through the regulatory structure is then used to backstop a conduit, which is used to avoid those very same regulations. Eureka! (For more learning on how rating agencies rate conduits you can go here http://americansecuritization.com/uploadedFiles/Moodys_ABCP.pdf where you will find Moody's Update on Bank-Sponsored ABCP Programs: A Review of Credit and Liquidity Issues from September 2007.) (See below for some excerpts.)

As long as rating agencies opine on a particular conduit, the money flows. If there were a problem and the bank had to actually fund the credit lines that could impact the rating of the bank and in turn the rating of the conduit. Sounds like circular reasoning to me, sort of like making a loan to the CEO of a company and using her stock as collateral. We know how those work out when there’s trouble afoot. In any event, this structure leverages up the amount that can be loaned given any level of total bank capital as long as the rating agencies opine, hence they are regulating the banking system. This would not be a concern if there were no bank lines behind these structures because then bank solvency would not be an issue. Unfortunately, when they are backed by bank lines bank insolvency can become an issue, and how big of an issue is regulated not by the bank regulators but by the rating agencies.

Here are some details from the Moody’s report referenced above. Note the asset classes that are financed through conduit structures. Sounds like traditional bank lending assets to me. (I do not know if these include SIVs.)

“In the United States, Moody’s rates 113 bank-sponsored programs, with total ABCP outstanding of US$522 billion as of June 30, 2007. Of these, 62 are multiseller programs, with US$461 billion outstanding, 22 are securities arbitrage, with US$67 billion outstanding, and 10 are hybrids with US$32 billion outstanding. Looking at the multisellers, we note that these are highly diversified programs. On average, these programs fund 62 different transactions among 10 different asset types. The largest asset types by outstanding amounts are credit cards at 15%, trade receivables at 13%, commercial loans at 11%, auto loans at 10% and securities at 9%. Mortgages also make up 9% of the total, mostly in the form of warehousing lines that fund newly originated mortgages for short periods of time. Highly rated CDOs comprise about 3% of the assets. Note that US multiseller programs typically have 8% to 10% program credit enhancement, nearly covering any single one of these asset classes.” And,

“Securities arbitrage programs are similarly diversified, averaging 126 different individual securities among 7 different asset types. The concentrations by dollar par amount reflect more the term securities market, with CDOs comprising 35%, commercial mortgage loans 17%, residential mortgage loans 13%, home equity loans 12% and student loans 5%. Of these securities, 89% have Aaa ratings from Moody’s, and another 6% have Aa ratings. An additional 5% are rated Aaa by rating agencies other than Moody’s. This leaves less than 1% rated below Aa.”

Regarding the link between ABCP Conduits and their sponsoring banks:

“As we have noted, all three types of bank-sponsored programs – multisellers, securities arbitrage and hybrids – rely on liquidity and credit enhancement provided by Prime-1 rated entities. For most of these programs, most of this support is provided by the sponsoring bank. Therefore the credit rating of these programs is also linked to the rating of the sponsoring bank. Should a liquidity or credit support provider be downgraded below Prime-1, Moody’s would review the ABCP conduit rating and might downgrade the conduit’s rating.” And,

“Moody’s includes a review of the sponsor and the support providers when assigning a rating to an ABCP program. As a result, we believe that those parties are able and willing to perform according to the terms of the agreements supporting ABCP programs in general, and bank-sponsored conduits in particular.”

I welcome all comments and additional learning on this topic. Please feel free to leave your thoughts and point out any faults in my fact base or logic.

For posts I have done on the SIV issue you can scroll down or click on the link to your right. There are two additional posts from the past week.

Update: Here is the announcement of the rule for bank capital in connection with conduits, which can be found here: http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040720/default.htm

"For Immediate Release
July 20, 2004
Agencies Issue Final Rule on Capital Requirements for Asset-Backed Commercial Paper Programs

The federal banking and thrift regulatory agencies today issued a final rule (393 KB PDF) amending their risk-based capital standards. The rule permits sponsoring banks, bank holding companies, and thrifts (banking organizations) to continue to exclude from their risk-weighted asset base for purposes of calculating the risk-based capital ratios asset-backed commercial paper (ABCP) program assets that are consolidated onto sponsoring banking organizations' balance sheets as a result of Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, as revised (FIN 46-R). This provision of the final rule will make permanent an existing interim final rule.

The final rule also requires banking organizations to hold risk-based capital against eligible ABCP liquidity facilities with an original maturity of one year or less that provide liquidity support to ABCP by imposing a 10 percent credit conversion factor on such facilities. Eligible ABCP liquidity facilities with an original maturity exceeding one year remain subject to the current 50 percent credit conversion factor. Ineligible liquidity facilities are treated as direct credit substitutes or recourse obligations and are subject to a 100 percent credit conversion factor. The resulting credit equivalent amount is then risk weighted according to the underlying assets, after consideration of any collateral, guarantees, or external ratings, if applicable. All liquidity facilities that provide liquidity support to ABCP will be treated as eligible liquidity facilities for a one-year transition period.

The rule, which will be published shortly in the Federal Register, will become effective on September 30, 2004. "

For the rule and a good description of ABCP Conduits here is the link to the FED's publication: http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040720/attachment.pdf

Check out this piece from the FED from the link referenced above:

"The resulting credit equivalent amount would then be risk-weighted according to the underlying assets or the obligor, after considering any collateral or guarantees, or external credit ratings, if applicable. For example, if an eligible short-term liquidity facility providing liquidity support to ABCP covered an asset-backed security (ABS) externally rated AAA, then the notional amount of the liquidity facility would be converted at 10 percent to an on-balance sheet credit equivalent amount and assigned to the 20 percent risk weight category appropriate for AAA-rated ABS."

So, the rating agencies determination of the risk in the conduit is used to determine the amount of capital the bank must keep which in part determines the rating on the Bank which in part determines the rating on the conduit. I' dizzy!

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