A few years ago, the securities markets financed hundreds of billions of dollars in mortgages without any government guarantee. Now, those markets are virtually closed to such financing.
Whether or not they will ever come back is open to question, but Wall Street made clear this week just how intransigent it would be in resisting the kind of changes that might convince investors the waters were safe.
The investment banks that put together mortgage securities told regulators that they should not be required to evaluate the credit quality of the mortgages they package and sell. And then they argued that they had no ability to do that.
The Securities and Exchange Commission has proposed a new set of rules for such mortgage-backed securities. For some of them — the ones that are sold publicly and in an expedited way that does not require the commission to carefully review the offering — the proposal included a requirement that the chief executive of the firm that put the deal together provide a certification of the deal’s quality.
That certification would include a statement that the C.E.O. had reviewed the deal and believed the mortgage assets had “characteristics that provide a reasonable basis to believe” the securities would pay off. The commission said it believed the attention the executive would have to give each deal “should lead to enhanced quality of the securitization.”
The public comment period on the S.E.C. proposal closed this week, and on the final day the principal Wall Street trade group, the Securities Industry and Financial Markets Association, known as Sifma, weighed in with a split opinion.
Its members who invest in such securities thought the certification idea was a fine one.
But Sifma’s members who would be required to issue the certifications did not like the idea at all.
“In the view of our dealer and sponsor members, it is not the role of the depositors and its officers to undertake any sort of credit analysis,” Sifma told the commission, adding, “They are not trained to do so.”
In industry jargon, those who create mortgage securities are called “depositors” because they deposit the individual mortgages into the securitization trust. They may have made the loans themselves, or they may have purchased them from the original lenders.
There is much more to the S.E.C.’s proposed rules. There would be detailed “asset level disclosure,” so investors could have a better chance of assessing the quality of the mortgages, and there would be required updates to that information. There would also be what some people call a “road bump,” barring the sale of new securitizations until investors had five days to review details of the offering. In the old days, investors learned what they had bought after they had bought it.
Or, to be more accurate, they learned what the sponsor told them about the mortgages. There was usually a promise by the sponsor to buy back mortgages that did not meet the requirements. In practice, sponsors have often denied the mortgage was not proper, leaving investors with the choice of accepting that conclusion or mounting an expensive lawsuit. The S.E.C. proposes to bring in a third party to assess disputed mortgages, but to give that party no real power to force repurchase. Some investor groups want more power for such an inspector.
The S.E.C. traditionally has focused on disclosure rather than the merits of investments, and Mary L. Schapiro, the commission’s chairwoman, has said that current securities laws are not ideal for regulating asset-backed securities. She suggested last fall that Congress might consider passing a separate law for such securities, much as it did for mutual funds in 1940.
Without such a law, the commission is trying to set rules to ensure quality in deals that are allowed “shelf” registrations, which can move much faster than other deals. It is those deals that would need C.E.O. certifications. Other offerings could proceed on a different basis, but the commission still wants to assure that disclosures are the same, even if the securities are sold in nonpublic offerings.
Under the old rules, shelf registrations are available if the securities have a high rating from a bond rating firm, like Moody’s, Fitch or Standard & Poor’s. The value of such ratings proved to be very low, and the new rules seek to find other ways to differentiate high-quality deals from lower-quality ones.
The issue of C.E.O. certifications stems from 2002, when the Sarbanes-Oxley Act required chief executives and chief financial officers to certify that their filings were accurate, to the best of their knowledge. Some observers thought that added nothing to the law, and they were right in some ways. False filings were already illegal, and executives were subject to legal penalties if it could be proved they knew the filings were false.
But it appears that the act of signing made many executives pay more attention to what it was the company was saying, and to force more checking. The S.E.C. hopes that will happen with securitizations as well.
The Sifma filing argues the certifications being contemplated now would go much further, because company chief executives are not required to forecast whether the company will be able to meet its obligations, and there is no way they can forecast whether a large number of mortgages will default in some future recession.
If the S.E.C. insists on a certification, Sifma offered its own version. It is one that closely tracks existing fraud law, and so probably would add no new legal risk. But it also would be unlikely to reassure many investors.
“Based on my knowledge,” states the Sifma-proposed certification, “the prospectus does not contain any untrue statement of material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading.”
It is worth asking why all this is necessary. Prospectuses for the old deals did not provide the detailed disclosures the S.E.C. now seeks, but the details that were there, like the credit standing of subprime borrowers, made it clear there was real risk. But institutional investors were in a search for higher-yielding securities, and took the AAA ratings as a reason not to study the securities carefully.
If there is to be a revived private mortgage securitization market, it will need investors who are willing to do their own work analyzing the investments. And it will require that those in a position to control the underwriting standards when the loans are made have incentives to make loans that will be repaid.
In a filing with the Treasury Department and the Department of Housing and Urban Development, which sought suggestions for improving the mortgage market, Jay Diamond of Annaly Capital Management, a firm that invests in mortgages, recalled a comment attributed to the head of a subprime mortgage lender who had been asked why his firm kept lowering its standards as risks grew.
“The market is paying me more to do a no-income-verification loan than it is paying me to do the full documentation loans,” said William Dallas of Ownit Mortgage Solutions. “What would you do?”
The Dodd-Frank Law just enacted and the S.E.C. proposal seek to change incentives by requiring sponsors of securitizations to hold on to pieces of them, and to not hedge away that risk. Monitoring the hedging activities of a big firm like Goldman Sachs will not be easy for the regulators.
With the private mortgage securitization market moribund — there was one recent issue, but it contained only superhigh-quality mortgages — the United States home mortgage market has split in two.
A vast majority of mortgages come, in effect, from the government. They are guaranteed either by a government agency or by the government-sponsored enterprises Fannie Mae and Freddie Mac. The rest, usually mortgages too large to be insured by Fannie and Freddie, are written by banks and stay on their balance sheets. Those loans charge higher interest rates than are available on the loans sold with government guarantees.
Fannie and Freddie are in business only because the government bailed them out, and some in Washington say they would like to get rid of them. But there seem to be remarkably few well-thought-out ideas about how to replace them. Some ideas kicking around call for having the government issue what would amount to catastrophe insurance for private securitizations, charging fees for that. In some variations, the government would be expected to closely monitor underwriting standards, charging higher fees or not offering insurance at all on securities backed by lower-quality loans.
The Obama administration has called a conference for Aug. 17 to hear ideas on the subject, and promises a comprehensive proposal on Fannie, Freddie and a new mortgage regime early next year. It is hard to see how it can reduce the government’s role in a major way without causing new problems for the already weak housing market.
But such an outcome will be even harder if Wall Street insists that the firms responsible for putting private financings together have no responsibility, as Sifma put it, “to undertake any sort of credit analysis.”
Floyd Norris comments on finance and economics in his blog at nytimes.com/norris.
