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Geithner's Plan Just Doesn't Get It: Securitisation Is The Solution - Not The Problem

Interest-Rates / Credit Crisis Bailouts Jun 21, 2009 - 03:42 PM GMT

By: Andrew_Butter


Best Financial Markets Analysis ArticleSecuritisation has a bad name these days, and that's Official; President Obama says it was a big part of the problem. And he's absolutely right; it was THE problem.

What happened was a bunch of shysters on Wall Street cooked up a load of dud securities and sold them all over the world, and then a bunch of morons wrote naked insurance on them and now they can't pay out on the claims.

Now no one wants to buy that stuff, good or bad, and it's impossible to tell the difference without opening up every tin (; even then you have to be an expert, (they got names on them like SAMIII05AR7, like viruses).

With all the finger pointing going on it's easy to forget that for the past fifteen years, 70% of credit in USA was linked to securitisation.

Until that engine re-starts the government can helicopter as many more trillions as it wants at the economy, and that won't make a blind bit of difference.

Certainly not to unemployment which is now central to the negative feedback loop (, as that goes up foreclosures go up and then defaults of legacy assets go up, then credit gets tighter, then corporations cut back, and so unemployment goes up and round you go again.

In an interview yesterday President Obama said that he fully expects unemployment to top 10%. At this rate 15% is in sight - have a look at ( 

For that dismal statistic to change America has to wean itself off what Bill Cohan calls its "morphine drip" of easy money, which is backed not by hard assets (like gold or real estate (if that's hard)), but by the promise that the children and the grandchildren of every American will pay it back in goods and services some time in the (distant) future.

But however much morphine goes in; it is simply not possible for the Government to replace the primary engine of credit that has sustained America for so long ( there just aren't enough trillions.

They have been talking about fixing the engine for almost a year.

First there was TARP, which was structured like a huge blind buyback of Edsel Sedans that were clogging up the inventories, but that failed to even get off the ground insofar as the securitisation market was concerned.

Then there was PPIP and although we hear that Secretary Geithner has Bill Gross on his speed dial (, that new-fangled scheme to gouge the US Taxpayer is starting to look as dead as a rotting mule (, and unless house prices go down another 20%, which they won't, that's never going to happen because the sellers, won't sell at stupid prices. They don't have to.

The Stress Tests and the FASB rule changes allowed the suckers who got stuck with the bad-stuff to hold them to maturity by which time it will be possible to tell the good ones from the bad...Que Sera Sera!

But it's one thing to clear out the inventory of un-saleable junk, or to build a bigger warehouse, it's another thing to get anyone with half a brain to buy a new one, and that's what America needs, new ones.

The Geithner Plan to the Rescue?
The Plan had about seven pages on securitisation (pages 40 to 47), most of that (perhaps all of it) was good sensible stuff, investors need to know what they are buying, they need to have sufficient information to do their own valuations, trades should be properly recorded and data on that should be available for investors. Obvious stuff, it's hard to understand why this took so long coming.

There are three problems.

The PLAN is not going to get through into legislation without some serious mauling, even if the Fed gets to hold the big ball (a big if), they won't be reporting back on how they propose to handle that until October, and that's Fast-Track! So how about the legislation on securitisation, when will that get into law, and when will it take effect?

Guys in case you didn't notice, the economy is bleeding, and it's bleeding right now!

Sticking it to the bankers
Senator Dodd conveyed the mood perfectly when he opened the proceedings of the Senate Banking Committee, brandishing a copy of The Washington Post that contained an article about how Wall Street were "up-in-arms". Their "gripe" was about the 5% "skin-in-the-game", that the new proposals are recommending (and they can't hedge that either). He was livid! If there had been someone close-by remotely connected to Wall Street he would surely have hit them with his newspaper!

One thing is for sure, this time the lobbyists will certainly have to earn their seats on their executive jets. What with an election coming up, and plenty of people in every constituency in America who were seriously harmed by the fiasco; they will need every brown-paper-bag they can lay their hands on.

Well tying up the bankers in bureaucratic red tape might make everyone feel better, but that misses the point. The point is that the industry produced a load of lousy quality product, that's a quality issue, and anyone who knows about quality knows that the way to excellence is not via the blame game.

But the government, any government has no place getting into the kitchen and trying to tell people how to make a quality product, and it certainly has no place dictating how much money people can get paid for producing the product.

That's what it's trying to do, and if it makes that mistake, it can spend a year trying to micro-manage, but in the end whether anyone is going to want to "make" the product, and indeed whether anyone is going to want to buy some, is a lot less than certain.

Quality 101
Three things need to happen for the securitisation engine to re-start, and none of these are properly detailed or addressed in the plan. Until these three things happen, securitisation will not re-start and America can expect at least one dark winter, and maybe two

1. Liability

If a manufacturer produces a car, then sells it, and in the next five years 26% of the cars catastrophically have a wheel fall off when they are driving at seventy miles an hour down the freeway, the manufacturer is liable. Not just to pay to repair the car, but also to pay for damages.

Well that's what happened, AAA bonds that were "rated" for a 0.0026% chance of "wheel fall off car driving down freeway" suddenly had 26% of their wheels fall off. In any other industry there are laws that hold originators (manufacturers) liable if a specified failure rate is exceeded, and the manufacturers need to take out product liability insurance against the risk of that, and sometimes all failures.

So why not the originators of asset-backed-securities? And no sorry, a CDS just doesn't hack it, the liability if the insurance fails has to rest with the originator.

One way to get some of that done quickly would be to put up legislation for Covered Bonds which are a tried and tested formula that have been used in Germany for 200 Years, in this formula the buyer has recourse not just to the collateral, but also to the originators. And that's not just 5%, that's the whole caboodle, and guess what, their credit history is impeccable. OK there is nothing to stop a US investment bank issuing covered bonds, and there is no reason why that should be the only formula, plus there is a balance sheet issue, (although these bonds are as liquid as water). But in the current environment, something is better than nothing.

And if Wall Street thinks 5% is "harsh", try unlimited liability; that would sober things up. Some people can work with that, some can't, the ones that can't need to find another profession - try driving a taxi

2. Procurement Standards

Liability is the "stick" but you also need a "carrot".

The 1984 Secondary Mortgage Market Enhancement Act (SEMMEA) removed restrictions on investment by regulated financial institutions in many private mortgage backed securities.

Until that time regulated Pension Funds and Insurance companies were obligated to hold a proportion of government backed investment grade securities, SEMMEA meant that they could buy the same class of asset with a higher coupon rate. That opened up the floodgates and the private sector was galvanized to meet the new demand; that was the "carrot" that created the securitisation industry in USA.

What went wrong was mainly that SEMMEA didn't specify properly the criteria; OK the Geither plan goes some way to doing this, but it's muddled, and in some senses it appears to be going back on this "Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible." (Page 44).

So what does that mean, does that mean that a AAA security or a SAMIII05AR7 originated by Lehman Brothers can't substitute a AAA Treasury? If that's what it means the securitisation industry is dead, and if it means that some other criteria are going to be used, then the industry will be dead in the water until that is all sorted out, what by 2011?

Taking away the carrot is not going to solve the problem, just specify a little more precisely what you have to do to get the carrot.

OK, OK...the PLAN talks about "transparency" and all that nice stuff, but the key is to have a functioning market where all of that is either in place or more or less in place. Well there is one, it's called XBRL, the time to re-invent the wheel is not now.

And talking about what you have to do to get the carrot, there is another thing. The valuations of the underlying collateral have got to be cleaned up; investors have to start believing not just in the ratings, they have to believe in valuations. None of this is complicated, the business model is that you loan money against collateral and if you loan more money than you are likely to collect in the event that the borrower defaults, you are moron (or a crook).

In the introduction to the chapter on securitisation in The Plan (page 40) it notes "innovations occurred too rapidly for many financial institutions risk management systems".  Sure thing, the essential "innovation" was writing loans more than what a dyslectic moron could see was the likely collateral that could be obtained if the loan went bad.

How you make sure is you use International Valuation Standards Valuation Application 2: Valuation for Secured Lending Purposes.

That's the valuation standard that explicitly acknowledges that markets often misprice, which is the subject of George Soros' book on "Reflexivity", the value you need to know is the minimum price you can sell the collateral for in the future, not how much you could have sold it for yesterday (mark-to-market) or how much some geek thinks you can sell it for in a hundred years time (mark-to-myth).

Sure, perhaps FASB might eventually get their heads around this concept (IVS was first issued in 2000 so that's nine years of head-scratching already, and they still didn't "get it").

But why wait

3. Industry Standards

The government has no place telling any industry how to manage their affair, that's communism or crony capitalism, take your pick.

Sure there should be proper markets for these things where investors are provided protection against shysters under the law, and sure the shysters used every trick in the book and what you "What you Saw" was definitely not "What you Got" (Tina Turner).

And the "consumers" that need protecting are the people who buy these things. Those are the same people that buy AAA Treasuries; pension funds and insurance companies who have long-term liabilities that they need to provide for, and sovereign wealth funds, from China to the Middle East. Those are the "customers" that need protecting and they foolishly though AAA meant something, and the US Financial System treated them shoddily.

The reason for making sure that the "quality control" is in place is nothing to do with ethics (ethics helps but it's not mandatory), it's simply bad business to sell a shoddy product, because when you want to sell something new, nobody is going to buy. Like now.

That's not a new idea, the Institut National des Appellations d'Origine (the wine growers' association) in France is a quality control organization, it's been around for a hundred years, there are others.

It is for all practical purposes impossible to value the legacy toxic assets vintage 2001 to 2007, every structure is slightly different, and disclosure is a nightmare. It's like a wine cellar full of "product" and the only way to know if a bottle is bad, is to open every one.

That's something only the industry can fix. Government can't do that job, but it can mandate that no one gets the carrot if they don't belong to the Association. Having an industry association would have also gone a long way to streamlining the current bout of angst.

Senator Shelby got it right in his comments on The Plan, this thing needs lots of consultation and lots of questions about unexpected consequences. That will take time, but something has to happen fast.

Don't be fooled by the stock market, the dramatic fall to 660 was an inevitable reaction to the excesses of the past and the prospect of Armageddon. Now it's correctly valued for this time and place, and 1,000 is not off the table, some industries can still make money, some are cheap (some are not), but right now investing in the essential economic infrastructure of USA is as good a bet as anything, there won't be hyper-deflation and there won't be hyper-inflation, just a slow inexorable decline in the weaker segments of the economy; until securitisation re-starts.

And if the "fat-cats" on Wall Street are not making obscene amounts of money churning out and selling new ABS by the end of 2009, expect US unemployment to hit 15% by this time next year. And watch the stock markets just drift sideways from 1,000. 

POSITIONS: Nothing relevant to this article (yet).

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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