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The Wall Street Model is Officially Dead

Posted by Larry Doyle on June 16, 2009 11:49 AM |

Dear friends, family, countrymen,

We are gathered here today to lay to rest a business model which revolutionized our financial industry. I have fond memories and knew the legendary “originate to distribute” well. In fact, I welcomed the opportunity to share the background and development of this model last November 12th, in writing “The Wall Street Model Is Broken….and Won’t Soon be Fixed.”

Regrettably, those charged with nurturing and protecting this model, in turn, cannibalized it. As such, today we officially gather to bury it. Tomorrow, President Obama will announce new guidelines and oversight for a new securitization model on Wall Street. The Financial Times provides a uniquely balanced perspective on this new model, Treasury Plans Strict Rules for Securitization:

The US Treasury is planning a sweeping overhaul of securitisation markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and flip them on to investors.

The authorities plan to force lenders to retain part of the credit risk of the loans that are bundled into securities and to end the gain-on-sale accounting rules that helped spur the boom of the markets at the heart of the financial crisis.

Sounds like a very good idea. Clearly the model needed to be ‘reborn’ given the massive abuses and fraud which were promulgated under the prior model. Recall that the prior model, also designated as the “shadow banking system,” embodied 40-45% of the total credit injected into our economy. Can we raise a strong, disciplined, and well behaved “model” to replace that void? I have serious questions.

As we assess the potential for the “new securitization model,” we need to understand how the “prior model” grew so large. Well, not unlike the abusive practices employed by professional athletes with steroids, our “old model” also cut a number of corners. In so doing, the “old model” mispriced the true risks of a wide array of loans originated over a period of years.

The “new model” will look to address the proper pricing of risks in loans. How will it accomplish this proper pricing?

1. The “new model” will require banks/originators to maintain an equity stake in the loan. What does that mean? It means that the bank/originator must maintain a degree of exposure to the performance of the loan. As such, the originator will have to set aside capital reserves against that exposure. Please remember this point as I will return to the cost of this capital reserve.

2. The “new model” will require rating agencies reviewing the credit quality of the loans to be much more diligent in the process. The rating agencies will have to allow investors an opportunity to review their credit review process. The rating agencies will also be required to develop a new means of generating revenue than the inherent conflict embedded in the system in which issuers paid for credit ratings.

What does all this mean? The rating agencies will be under a microscope and much more culpable. Revenues will not be generated purely based on volume. As liabilities for rating agencies increase, their due diligence will need to increase as well. This increased dilgence will be passed along to borrowers.  I will return to this point as well.

3. The “new model” will also require the banks/originators to change the accounting methodology for the sale of these loans. The banks/originators will no longer be allowed to book all of the income up front. That accounting practice, known as “gain on sale,” will change to an “accrual” based accounting method in which the banks/originators book income as the loan is paid off over time. This change will also impact banks/originators by forcing them to maintain greater capital reserves while not recognizing income as quickly.

In summary, I embrace the principles embodied in each of these points. That said, each change will increase the costs associated with the origination of loans. Who will absorb those costs? Originators? No way. Investors? No way. Rating agencies? No way. Borrowers? Way!!

Interest rates will move higher on the underlying loans under this model. They may very well move so high that the banks will not even want to sell the loans, but rather retain them for their own portfolio.

LD

  • fiscalliberal

    I think these changes are good and finance will come back to common sense. In a way, I have the view that a home is for living and not for speculation. So if I buy a moderate sized home, the costs should not be prohibitive and be better than paying rent.

    That said, I am still looking for the official government mechanism to officially close down any size of business in a orderly fashion. In a way, industry can avoid the close down if they keep their business solvent. More over if they need to close down, they can do it privately through bankruptcy. Going to the government is the implied hope of a bailout.

    By having a business go to the government for funding, is a signal that the market is already saying the business is not viable. So, the government needs a established procedure to close it down, no matter what the size.

    Also – just haveing the procedure there will give the businesses pause versus expecting a bailout.

    We also need to have people who commit fraud go to jail and that has not happened in the aggregate.

  • Fiscal…ultimately we need an economy that can operate on its own without the need or desire for Uncle Sam.

    Obviously this transition is a process. I do get very concerned that the transition itself is promoting behaviors counter to our ultimate goal.

    We are on the same page.

  • Kal B

    I think, it is better to have little more costly loans than losing the entire wealth. I think, these changes are for good but implementation is a challenge.

  • Petricone456

    Thanks for the insight! Scary to think that capitalism as we knew it has run off the tracks…

  • TeakWoodKite

    The “new model” will also require the banks/originators to change the accounting methodology for the sale of these loans.

    With the new methods will the “old” balance be carried forward or just forgotten in a sea of red ink?

    Will this not also have a global effect of slowing down the velosity of capital exchange?

    Sounds like the capital vicosity is straight 50 weight headed for “blood clot”. Banks are being told to increase the reserves and what better way to insentivise hording,

    When the Fed began to raise interest rates in early 1929, this began the tumble.
    However, a stock market crash could cause people to increase their liquidity preference which might lead them to hoard money.

    In the August 1990 issue of The Quarterly Journal of Economics, Christine D. Romer writes that “the negative effect of stock market variability is more than strong enough to account for the entire decline in real consumer spending on durables that occurred in late 1929 and 1930.

    If the Fed has left the building faster than Elvis, how is this not very similar?
    The Fed has no where to go but up. Especially when one takes into account the cost of global currency manipulation of the dollar by the Russians and Chinese and others seeking to step out of the way.






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