• 09 Jul 2008 at 10:15 AM

Will Paulson’s Proposal Revitalize Subprime Lending?

It’s often said that regulators are always solving the last problem while the next one creeps up on the markets unaware. That notion was certainly tempting yesterday as everyone who’s anyone in market regulation gathered at that conference near Washington, DC. But we couldn’t help thinking that despite speeches from the Fed’s Ben Bernanke, Treasury’s Hank Paulson and JP Morgan’s Jamie Dimon, the folks there didn’t even get as far as addressing what led us to the current financial crisis.
Let’s take Paulson’s proposal that covered bonds could restart the mortgage market. Ensuring that mortgage originators and those securitizing the problems have ongoing skin in the game may in fact improve the quality of those bonds. But Paulson made his proposal in the context of talking about reviving loans for subprime market. Will covered bonds restart interest there?
Not very likely.


Over in Europe, they’ve had a lot more experience with covered bonds. As it turns out, they aren’t a very effective way of securitizing subprime. Why not? Because subprime loans are inherently risky. You know a certain amount of them are going to default. In fact, the securitized subprime was designed to accommodate the fact that there would be relatively high default levels. (They went wrong by underestimating the defaults levels.)
Here’s how Sam Jones at FT Alphaville describes the disconnect between trying to use covered bonds to revitalize subprime home lending:

Subprime securitisation works because you overcollateralise to accommodate statistically modelled losses: in a subprime RMBS or CDO, you expect losses to occur, and the tranching – the structuring – is what compensates for this and allows for ratings all the way to triple A.
The tranches are ‘attached’ to the collateral in such away so as to reflect the statistical unlikelihood of – say – 50% collateral default with only 50% recovery. In that very bearish scenario, 25% of the collateral’s value is lost. If the AAA attachment point was 70% – it would still not see those losses. Thus it’s AAA.
In a covered bond though the security – the AAA rating – is achieved differently and not through tranching. The triple A (at least going by form) comes from the quality of the collateral on offer and the fact that it is secured in an on-balance sheet pool, immediate recourse to which is protected by specific statute.
Further, the market value of that pool is set and the issuing bank has to make substitutions in the event of collateral deterioration. And Further in many cases the bondholder has full recourse to the issuers balance sheet in the event of a shortfall.
Thus the backing for covered bonds in Europe is unexciting: prime mortgages, public sector debt and ship loans.

5 comments (hidden to protect delicate sensibilities)
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Comments (5)

  1. Posted by guest | July 9, 2008 at 11:01 AM

    You can hit the re-set button on your Nintendo 64 all you want, but it doesn’t fix the fact that it’s broken.

  2. Posted by guest | July 9, 2008 at 11:39 AM

    “Subprime securitisation works”
    If by works he means creates millions in commissions while costing billions for the bagholders, I agree.
    “In a covered bond though the security – the AAA rating – is achieved differently and not through tranching”
    The triple A is achieved by paying S&P or Moody’s a large fee to rubber stamp dog shit.

  3. Posted by guest | July 9, 2008 at 12:16 PM

    I guess if the market is right about Fannie and Freddie, then covered bonds will need to happen in order to provide liquidity for boring prime mortgages.

  4. Posted by StMarc | July 9, 2008 at 12:29 PM

    The thing to remember about these kind of people is that they have AMAZING short-term memory, no long-term memory to speak of, and no mental process for separating the two.
    This is why:
    1) Nobody in finance ever recognizes a bubble. “Gee, prices are exploding for no reason tied to any fundamental property of the asset itself? Never seen that before, let’s hop on the ride quick!”
    2) After one pops, anything even remotely near it is anathema to them for the duration of their short-term memory. “Mortgages? There were mortgages in that subprime thing! We ain’t backing no mortgages without cover, period. Who’s this Warren Buffet guy that I can be sure his $5K home equity loan won’t go down the toilet tomorrow? Huh?”
    M

  5. Posted by Anal_yst | July 9, 2008 at 1:32 PM

    11:39′s second point unfortunately seems to have been the case, at least in a number of circumstances, evidenced by the SEC’s recent report. Verbatim guys telling each other they knew the shit was going to hit the fan, hoping they could collect enough fees to retire early enough before the house of cards came crashing down. Maybe law school is a better idea than biz, seeing as these suits will likely draw out a solid 5+ years