Regulating Securitized Products: A Post Crisis Guide PDF
Preview Regulating Securitized Products: A Post Crisis Guide
Regulating Securitized Products A Post Crisis Guide Rasheed Saleuddin West Face Capital Inc. © Rasheed Saleuddin 2015 Softcover reprint of the hardcover 1st edition 2015 978-1-137-49794-9 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-69814-1 ISBN 978-1-137-49795-6 (eBook) DOI 10.1057/9781137497956 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Saleuddin, Rasheed, 1966– Regulating securitized products : a post crisis guide / Rasheed Saleuddin, Partner, West Face Capital Inc. pages cm 1. Asset-backed financing. I. Title. HG4028.A84S255 2015 332.6392—dc23 2015002669 To Ammon This page intentionally left blank Contents List of Figures viii Preface ix Acknowledgments xvii About the Author xviii List of Abbreviations xix 1 Introduction: Securitization as Villain and Savior 1 2 Securitization Markets and Mechanisms 2 0 3 Securitization, the Global Financial Crisis, and the New Regulatory World 6 1 4 What Is Regulation, and What It Can and Can’t Do – In Theory and Practice 1 03 5 Issues Involved in Regulating Securitization in the Public Interest 128 6 Toward a Better Regulatory System and Risk Transfer to Real Money Investors 1 50 Notes 175 Bibliography 196 Author Index 209 Subject Index 210 vii List of Figures 1.1 Total securitization volumes 2004–2014: US and Europe 2 1.2 CDO issuance 2013–2014: US and Europe 2 2.1 Highly stylized securitization structure 2 2 2.2 Highly stylized securitization structure: loss allocation 2 3 2.3 European outstandings by asset class and country 2014 2 6 2.4 Stylized waterfall with O/C tests 3 7 2.5 Leveraged super senior 4 3 2.6 Balance sheet CDO 4 4 2.7 Basel I regulatory arbitrage structure 5 1 2.8 Multisector CDO and CDO squared 5 7 2.9 Basel II RBA risk weighted and leverage: five years 5 8 2.10 Basel II arbitrage structure 5 9 3.1 The landscape in 2007 6 9 3.2 ABX pricing through the crisis 7 3 3.3 A llowable leverage under Basel III ERBA for securitizations 9 9 6.1 Stylized capital recycling structure 1 51 viii Preface On 17 July 2007, US investment dealer Bear Stearns’ asset management arm announced that two funds that were invested primarily in bonds backed by low-quality residential mortgage loans to US borrowers, most of it purchased with borrowed cash, had lost almost all of their investors’ money, totaling $1.6 billion. A few weeks later, both funds were placed under Chapter 11 bankruptcy protection. The confusing aspect for many commentators at the time was that the two funds held nothing but bonds rated, by the accepted experts, higher than many countries (AAA/Aaa 1 ), and certainly higher than almost any bank or corporation. As creditors seized the funds’ collateral and tried to sell the bonds on the market, they – and the rest of the market – realized quickly that holding AAA-rated securities was far from a risk-free proposition. 2 Investors in such esoteric securities, as well as investors in those institutions that held and/or underwrote them, began to worry. 3 By the autumn of 2007, it was clear that not only were these securities riskier than their top-rated AAA status implied and extremely illiquid, such returns as had been made before the funds collapsed had been earned using an almost unheard of amount of leverage. Investigators into the Bear Stearns debacle were able to identify over $14 billion in borrowed money, with some individual positions levered more than 60 to 1. 4 That same summer, simply because it was unknown how much ‘subprime’ (mortgages that did not meet the usual standards of the government-sponsored securitization market) exposure was held, investors refused to roll over C$32 billion in Canadian short-term indebtedness (non-bank asset-backed commercial paper (ABCP)). These revelations of a toxic combination of hidden credit risks and hidden leverage heavily stressed a market that had begun to focus on the general prevalence of short-term borrowing funding long-term assets. The Global Financial Crisis (hereafter, the GFC) had begun. The inner workings of the market for bonds backed by mortgages and other assets such as corporate loans was hitherto known and understood by only a few investors, bankers and other stakeholders (such as rating agencies), even as issuance grew at a faster pace than traditional debt instruments such as cor- porate bonds. Once it was understood that many leveraged institutions were holding exposure to subprime assets that were suffering accelerating funda- mental impairment through delinquencies and defaults but also to investments that were highly sensitive to ‘marked to market’ 5 volatility as well as short- term financing risk (and the associated maturity mismatches), worry turned to panic, and the crisis gained momentum. While the panic caused more damage ix x Preface than might have been expected from the poor performance of one asset class, the truth is that much of the devastation was directly caused by securitized products and, especially, the extreme leverage, often hidden, the technology and regulators allowed. The forced sale of investment bank Bear Stearns, and the guarantee of its assets, to JP Morgan, the bailout of insurance giant AIG, and the conservatorship (effective bankruptcy) of the US government-spon- sored entities (GSEs), Fannie Mae and Freddie Mac, 6 were all a direct result of market price or fundamental impairments due to subprime securitization. As such, many point to the Bear Stearns news as the starting point for the GFC, the largest financial crisis since the Great Depression, which continues to leave its mark on the global real and financial economies, as well as on the psyches of many investors and economic actors. The economic costs of the GFC to the US economy alone was recently estimated by researchers at the Federal Reserve Bank of Dallas as being between $6 and $14 trillion in lost output. 7 US unemployment more than doubled, from 4.5% in 2006 to over 10% in 2010. In some European countries, youth unemployment soared above 40%, and remains above 20%. I would expect that most rational citizens of the globe would not want such events to be repeated. However, ensuring the safety of the global financial system is far from easy or simple. As the worst of the crisis receded, attempts at redesigning the various national regulatory regimes have struggled due to acrimonious and often ideological battles between politicians and industry, with academics, the press, public interest groups and even the odd member of an irritated and frustrated public weighing in. The major trouble with rewriting the global rulebook for financial market regulation to mold the financial system into one more in keeping with the ‘public interest’ is that both the causes of, and the solutions for, the recent crises are often bitterly contested. It is no surprise that the financial industry is resisting increased regulation as memories fade. After all, economist and ex-member of the Bank of England’s Monetary Policy Committee Charles Goodhart observes that ‘[i]f regulation is to be effective, it must have the effect of preventing the regulated from doing what they want to do’. 8 As lawmakers and regulators work through each aspect of a new regime, there is pressure to water down tough new limits, and this gets worse as public attention wanes and new issues arise. The regulatory regime for banks, insurers and other investors and manufacturers of securitized prod- ucts such as subprime residential mortgage-backed securities (RMBS) is still evolving, but the further we drift from the depths of crisis, the less urgent reforms now seem. The frustrations of some of the excess’s worst critics such as Martin Wolf, Barney Frank, Joe Stiglitz, Anat Admati and Martin Hellwig are evident, resulting in highly accessible and compelling books intended to prod stakeholders to continue to focus on the need for financial market reform.
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