The Obama plan will need considerable refinement to prevent a complete shut-down of securitization that forces the federal government ever deeper into the banking system. Critical aspects of the Obama plan attempt to end incentives in the originate-to-distribute model that greatly contributed to the financial crisis. The problem arises because assets sold into the secondary market can eliminate risk for brokers, lenders and issuers – risk the credit ratings agencies wholly failed to catch when liberally bestowing their AAAs. But, as the trillion or so dollars now backing the TALF make clear, securitization has become critical to retail finance.
There’s a lot to the Obama securitization plan, much of it aimed at improving transparency and accountability in the asset-backed securities (ABS) market. Key to the contradiction in its policy goals is the plan to force originators and sponsors in ABS to hold five percent capital against credit risk that could not be hedged. Unless implemented with finesse, the capital-at-risk requirement will blow securitization apart and return retail finance to the old days in which banks made loans and kept them on their books. The only exception would be new use of covered bonds – still in their infancy in the U.S. – and even greater reliance on GSEs.
An early sign of the government’s predilection for federal support for ABS is in the economic-stimulus law, which creates a new backstop for SBA securitizations. The GSEs are of course now wards of the state, and the TALF puts as much as $1 trillion of Fed and TARP money on the line. These programs are temporary and the Administration plans big changes for the GSEs, but all of them will have to stay and grow if the Administration and bank regulators press on with the planned securitization reforms.
To be sure, the plan is open to structuring the ABS capital requirement and permitting it to be hedged under certain conditions. Let’s hope this is carefully considered and the final rules refined or a good idea will go bad and a whole lot of prudent consumer loans won’t get made.
FedFin finds a fundamental contradiction in the Administration plan for asset securitization – it ends the originate-to-distribute model in favor of traditional financial intermediation even as Treasury is pushing trillions into securitization support programs like the TALF. What’s left of securitization in the Obama plan would require capitalized credit risk transfer – assuming the regulators use proposed discretion – and flow principally through collateralized secondary market channels like covered bonds or what’s to come of the GSEs and other securitization guarantors. The Administration plan to some degree simply reflects market trends (e.g., recent FASB rules), but its broad securitization reforms go well beyond them in ways that would substantially reduce the leverage and capital benefits associated with securitization. Given the critical role securitization plays in retail finance, the Administration might find itself forced to prolong government securitization structures such as the TALF or rely to a still greater extent on GSEs and similar entities because private-label markets in a wide range of asset classes would be small or non-existent at least until broad market recovery and recapitalization.
Despite the Administration’s soft touch on the credit ratings agencies, FedFin believes the combined force of proposed reform – many of which will advance regardless of what Congress chooses to do – and market trends will end structured securitization for the foreseeable future. This report analyzes the Administration’s securitization plan, focusing in particular on the implications of up-front capital requirements. Combined with the overall recapitalization of the financial sector included in the Obama plan (see Client Report REFORM13) and already underway by bank regulators (see Client Reports in the CAPITAL series), these changes will have dramatic impact on secondary-market structures.
The full text of this report is available to subscription clients.