Finance Discussion Continued

At Ethan’s request, rather than continue the discussion of finance in his post, I’ll post my response to commenter David TC’s response to me.  If people have an interest in continuing the conversation, they can do it here. I wanted to get a response up before day’s end so I apologize if the post is a bit sloppy.

Before I respond to DavidTC, I will say to Zic that I saw her comment about the $50 to $1 ratio.  That works for me although I thought it may have been higher.  In any event, that’s a staggering number and it goes to show why the damage to the financial system was to the magnitude it was.

Ok…

Ah, the US. Where we can’t solve problems _before_ they happen, because clearly everything is working and how dare anyone suggest otherwise, and we’re not allowed to solve them _after_, because we’re all emotional or something.

Wait…_as_? Are you asserting that we shouldn’t talk about how our _current_ ship is built _as that ship is sinking_?

I am all for having a conversation about the mortgage markets and mortgage securitization. It was going to be the topic of my next full-length post, but since there is an ongoing conversation, I thought I’d address the points in real time.  What I meant by my comment is that in my opinion, it is important to have some understanding  how the markets for mortgage-backed securities functioned prior to the crisis and where the markets have gone since.

We had a long period of time when the mortgage-backed securities markets hummed along just fine without any real problems (1980’s and 1990’s).  The markets were much smaller then.  The ratings agencies knew how to rate the bonds that the Wall Street conduit lending groups wanted to bring to the market.  Yes, with securitization there is an incentive for lenders to get aggressive as they are not the ones that ultimately take the risk.  However, the ratings agencies were there to make sure that didn’t happen, and believe me when I say that from my own experiences, the Wall Street lenders did not want to originate loans that they did not think would pass muster with the ratings agencies, as the loans would have been removed from the loan pools and put back on the originator’s balance sheet.  That threat was a strong enough incentive to keep Wall Street in check (at least I can say this with comfort with respect to commercial mortgage lending).

This dynamic completely fell apart during the subprime boom.  There was tremendous demand for mortgage-backed securities.  Wall Street was desperate for product and the loan brokers/originators had no problem giving anyone with a pulse a mortgage by any means necessary so long as people could make payments between the time the loan was originated and subsequently securitized.  The Wall Street firms were buying loan pools from non-bank originators.  The competition was fierce enough that the banks were willing to cut major corners on due diligence in order to buy loan pools.  There was far too much money in it for them to lose a deal.  By the time the ratings agencies got these steaming piles of crap and had to rate them, they had their own incentives.  They were rating securities like never before and making money hand over fist doing it.  Their clients were the banks, and when it came to a choice of simply letting the client winning the argument and doing what the ratings agencies should be doing, they didn’t want to piss off their clients.  There are lots of other players involved along the way (appraisers, brokers, etc.), but this is a good rough outline of what happened and we know how it ended up.

That ship sunk in 2008.  It’s dead.  It’s not coming back, at least at no time soon.  The crisis is too fresh in the collective minds of investors that few investors will even think about subprime-backed mortgage backed securities.

That I think it’s dead does not suggest that we should not do anything to prevent a recurrence.  Deregulation or a lack of necessary regulation as a chief culprit has been in my thinking since 2008.  To quote myself via my old blog:

We will have nothing to add to this debate if we continue to treat the actions of private individuals within the financial markets (behaving collectively or otherwise) as some sort of secondary concern or an unintended consequence of public policy. Part of this process, as painful as it could be for some, will be to acknowledge that in some areas (leverage and the mortgage industry in general), a lack of regulation made things worse

To me, the question isn’t whether or not we need to do something to address this, but rather how we address it.  If I read DavidTC correctly, he prefers a scorched earth approach to the secondary mortgage markets and would keep all lending on balance sheet.  I think this is both extreme and unnecessary.  As the markets for mortgage-backed securities seemed to function well when the underlying collateral was strong, I see no reason why the appropriate response to the issues that led us into a financial crisis is to craft appropriate regulations that will effectively require that mortgages follow certain guidelines, the same guidelines that are consistent with past practices.  I’m not sure if I am explaining this as clearly as I can.  However, this is already being addressed via Dodd Frank, as the Consumer Financial Protection Bureau drafts its rules governing Qualified Mortgages.  While the Qualified Mortgage rule will apply to lenders, it will also be the framework that is used to develop the rules that will govern securitizations (Qualified Residential Mortgages).

While this is still up in the air, the qualified mortgage rules seems to rule out most of the “exotic” loan types that ended up causing so many problems a few years back.  My hope is that the ratings agencies will only assign AAA or investment-grade ratings to securities where 100% of the loans are Qualified Residential Mortgages.  In my opinion, this would go a long way to solving a lot of problems that plagued these markets a few years ago.  Investors will have a lot more faith in the product and the ratings agencies will keep the toxic crap out of institutional-grade securities.  The new rules are set to go into effect in 2014 and they have not been finalized.

…and those reasons are?…Let me see if I can guess one of them: Because there is not enough capital in the market otherwise. You know what I say to that? Screw the market, then.

If I am an investor and I have an allocation to make towards commercial real estate loans, say $100 million, I have two choices.  I can either buy $100 million worth of whole loans (if I can piece that many together) or I can invest in, for example, a Super Senior AAA tranche of a CMBS issuance.  Whole loans are a bit tricky if only because if I wanted to aggregate a large number of them, I would have to purchase small loans and the underlying real estate on those loans may not be as good compared to the underlying collateral in a much larger CMBS pool where I am not only buying a slice of loans backed by very high-quality assets but I am also diversifying my risk (geographic and product type) in a much easier fashion than I ever could if I had to piece together my own portfolio of loans.

As a borrower, yes, while CMBS lenders will compete in the same markets where most other institutional lenders operates (life co’s, commercial banks, finance companies, etc.), there are many situations where traditional lenders will shy away from opportunities.  Typically, lenders like the life companies and more conservative commercial banks have a “check the box” approach to their loan underwriting criteria.  If a property is located outside a primary or secondary “target” market, they’ll pass on the deal.  If the property has a specialty use component, they’ll pass on the deal.  If the property has certain fundamentals such as short-term lease expiration, they may pass.

CMBS lenders will aggressively pursue these opportunities.  Their underwriting will be far from shoddy (those days are definitely over).  They will underwrite to the appropriate cash flow and require holdbacks, reserves, etc. appropriate for the level of risk.  They will size the loan accordingly.  If they can, they will get comfortable with the underlying real estate.  The tertiary market risk will get diversified away as the loans are sliced and diced and placed in pools.

Also, unlike the 2007 environment where CMBS lenders were taking as many shortcuts as they can, for the most part, the ratings agencies have been holding the line.  This is an important point.  A common theme in discussions about securitization is the incentives issue.  Loan underwriters that securitize and sell loans may not be motivated to exercise as much care as they should because they do not bear the ultimate risk.  The ratings agencies are back doing what they should be doing, and that’s making sure these things don’t happen.  I can understand for  people not in the business to have a hard time believing that, but my recent experience with CMBS lenders is that compared to previous years, CMBS lenders are more stringent with their requirements.  When we press them on this as we negotiate with them, the reasons we get back are usually ratings agency-related.

That is the world I see it and as I have lived it.

If there is not money in a market, we don’t need to run around inventing weird submarkets so that we can get random pension funds investing in the market and losing all their money when it collapses. It’s complete nonsense.

Nobody is “inventing weird submarkets”.  These markets have been in existence for a while.  What I expect to see is the markets functions the way they did before things hit the fan.

There is no threat of the CMBS market collapsing.  Once the market for residential mortgage backed securities rebounds further, there will be no threat of collapsing.  Why?  I will give you three reasons.  1) The market has no interest in the kind of garbage that was making its way into loan pools back in the old days; 2) to further reinforce (1), it is my hope that the rules governing qualified residential mortgages provide a strong enough disincentive that both securitized lenders and investors avoid the product entirely; 3) the ratings agencies will work in the interest of investors more than Wall Street.

There’s one other thing that you need to know about the profit motive: the CMBS lenders are in this business for the long haul, and it is VERY bad for business to sell bad paper to investors.   Is it any wonder that Goldman Sachs scoured the four corners of the Earth to find investors in far flung locations to sell off its subprime holdings after the markets imploded?  No one wanted to touch their stuff.  As much as I hate the term “long-term greedy”, historically, mortgage-backed securities originators have behaved more this way than they did during the subprime boom.

If businesses need money, how about all those superrich who keep calling themselves ‘investors’ and ‘job creators’ and ‘risk takers’…actually take a fucking risk and create some jobs by _investing_ in a company. Instead of having banks issue loans so they can buy sliced and diced securitized randomness and never actually risk anything.

Please explain why one has anything to do with the other.  Are you suggesting that companies not take out loans and only raise capital through the more expensive equity markets?  This is starting to sound too much like folk economics to me.

A lot of people here seem to be content with _explaining_ the nonsensical system set up, like I don’t understand it. I actually think I understand it fairly well. Perhaps not perfectly, but fairly well.

I am not convinced that you understand it.  All I have learned from you is that you don’t like the markets.  Nothing more.

In fact, I’m starting to suspect I understand it much better than other people, who have drank the kool-aid that it is somehow _useful_ and not this crazy money-shuffling gibberish dance that the rich have created to siphon money out.

This is hyperbole masquerading as an argument.  The markets are very useful.  I’ve laid out reasons why I think they are.  I work in these markets.  I deal with mortgage lenders.  I deal with clients looking for loans.  I know why they are more inclined to seek out a loan from a CMBS lender vs. a life company or commercial bank.  I know what my clients are getting themselves into when dealing with the CMBS lenders.  This is my real world experience.

Are they understood by the people buying them? Are they understood by the people rating them?

On the commercial side, I’d say both.  The ratings agencies know what they are dealing with and understand how the underlying real estate has to be underwritten in order to achieve the correct ratings per the criteria.  While the institutional investors buying the AAA paper will give credence to what the ratings agencies say, they will look at the underlying collateral and make their judgments accordingly.  Also, the highest-risk pieces of the loans originated by the CMBS lenders, the B piece, are typically sold to B piece buyers (hedge funds, private equity, etc.).  As these buyers hold the riskiest piece, they are very savvy to the underlying real estate.

I’ don’t think that the dynamic works quite as well on the residential side because the number of mortgages in a pool is substantially larger.  The last few years notwithstanding, I expect buyers and the ratings agencies to pay closer attention to what’s going on.

Either way, I see the markets becoming increasingly transparent and the forthcoming regulations in the residential mortgage markets can only make that better.  I hope this helps.