Aleablog is worth visiting. Several times a day. Today they point out a study (The Future of Securitization by Günter Franke and Jan Pieter Krahnen) linking incentives, particularly bonuses, to the collapse in securitized products. There’s a danger here of linking this sort of study to initiatives to reduce senior manager pay, or rattle sabers on income inequality. As if the mere quantity of compensation, rather than its structure was the guilty feature here. Of course, we have no doubt that the casual reader with the proper political bent will depart with that take-away. That is, however, naive, and those dangers aside, we think this one of the smartest works on the issue in a long while. (If somewhat belated. Not to boast, but I’ll just boast that some of us were onto this issue over a year ago- forgive the shameless self-citations). But, then, we love anything with Goethe’s name attached. Key passage from the abstract to note:
Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements.
(Much) More after the jump.
Securitization: Not Guilty [Alea]
Kierkegaard, Scientologists, Private Equity [Going Private]
Liquid Reflections [Going Private]
Continue reading »
With all the finger pointing going on, and consistent with our concern that incentives contributed to the clusterfuck that is the mortgage industry today, we decided to take a quick look at fees to see what kind of cash was flowing around in the business. A small, back of the napkin guess has become quite a large (if somewhat simplistic) model so I thought we’d share it with you and see what you had to say.
In summary, our incomplete and work-in-progress calculations figure for something like $2 trillion in fees flowing to various parties in the real-estate, mortgage, securitization and securitization^2 businesses between 2003 and mid-2008. That’s some serious swag, and you don’t have to look very far to see why no one was in much of a hurray to shut any of it down or to rock the boat.
Of course, we’ve made some pretty thick assumptions, particularly where management and underwriting fees come in with respect to the securitization layers of the industry. As usual, we are enlisting the help of the savviest readers on the street (Main or Wall). Browse on through the model, particularly the assumptions sheet, and if you see something you know is off, and if you can pitch us a decent source for better figures, we’ll tweak it right up. Find something spectacular and we will buy you lunch from our newly minted Dealbreaker Swag Lunch Fund.
Or, if you are a Google Docs user yourself, take a copy for yourself and play with it. We’d love to see what you come up with. If you’d like to jump into a copy and do some collaborating, send me a request for an invitation at ep at dealbreaker dot com and I’ll add you as a collaborator.
Edits:
3:47 pm: MBS underwriting fee adjusted to 1.25% (need a better source here but this might be close).
Dealbreaker MBS Fees Model
VantageScore has managed to sell Fitch Ratings on the idea that they should use their FICO score replacement as a means to rate mortgage securities. In general I like the idea. Instead of vague “prime” or “Alt-A” terms, or using FICO scores that vary depending on the agency delivering them, there is a consistent measure that can flow up to the aggregating securities for ratings, to define tranches, etc.
Like it or not, securitizing mortgages continues to be essential to mortgage financing, a rather significant component of the economy. Pariahs though the ratings companies and terms like “CDO” look today, and as much as I hate introducing simple “scores” to complex credit and risk analysis, something practical has to be done. And, like I always say, better a credit score derivative blended by two ratings agencies, than just one.
Fitch Becomes First Rating Agency to Accept Mortgage Loans Based on VantageScore [BusinessWire]
Back “in the day” you didn’t really care what default rights investors in senior tranches of your CDO negotiated for. Hell, the whole damn thing is insured. And, on top of that, there is a ton of junior stuff under them to absorb it all. Why not just given them what they want and pump the price up a little bit? Most commonly, senior tranches get the reins on payments out of the trusts if certain covenants are violated.
Usually that sort of thing activates if certain of the underlying instruments are downgraded, if payments are missed, or if total assets fall below a certain level. (Good luck substantiating this last one in a mark-to-market environment).
Lately, downgrades have been hitting many CDO structures and giving the senior note holders control over the entire CDO structure’s revenue. As you might imagine, junior note holders grow quickly irritated. A lot depends on who the senior note holders are.
If its a bank holding the top tier, as you might guess, they will often just liquidate. Other senior investors, however, are more likely to freeze out the junior investors and keep the income for themselves without liquidating. Not a bad setup if you are getting something like 100% coverage on the interest you expected when you bought the damn things. You have no balance sheet issues and the market is so out of whack you are likely to take a loss if you sell. So… why liquidate?
Much different the plight of the junior note holder who now can kiss any income goodbye and has little, if any, recourse if the seniors take over the show.
If you guessed that this particular scene is getting a lot of play right now, you’ve been paying close attention.
