Subscribe: RSS Feed | Twitter | Facebook | Email
Home | Contact Us

Retaining Risk on Wall Street: Necessary but Painful

Posted by Larry Doyle on November 5, 2009 1:03 PM |

How did Wall Street lead the United States economy into the ditch?

The pure ‘originate to distribute’ model employed on Wall Street spelled the death knell for Wall Street and our economy.

I addressed how firms won under that originate to distribute model in a commentary from November 12, 2008, “The Wall Street Model Is Broken….and Won’t Soon Be Fixed!!”:

At the turn of the century, the Wall Street model was a pure “originate to distribute” model with little to no residual risk on behalf of the originators or underwriters. When there is no residual risk, those who “WIN” are the players that can purely process the most volume. Well, how does one get volume? Lower the credit standards, put fewer restrictions on borrowers, little to no covenants (NINA Loans: no income, no asset check). WOW!!! What were we thinking?? Well, Wall St. felt, “let’s worry about it tomorrow or maybe not at all because we are making too much money today.”

Tomorrow has arrived and Wall Street must now deal with the concept of retaining risk in their loan originations. The topic of ‘risk retention’ has been bandied about over the course of the year, but it was ratcheted up dramatically in a recent meeting of the House Financial Services Committee and U.S. Treasury on October 27th.

What came out of that meeting has potentially dramatic implications for the entire spectrum of loan origination, securitization, and distribution businesses on Wall Street and their subsequent impact on Main Street. Let’s navigate.

Once again, our friends at 12th Street Capital provide a clear and concise review of these developments in commentary entitled Risk Retention in Securitization:

On October 27, the House Financial Services Committee and the Treasury Department released a discussion draft of proposed legislation that would implement the securitization reform proposals of the President’s Financial Reform Plan. While most of the discussion draft looks like what the President had originally outlined, the proposed legislation takes a much harder line on risk retention. The Financial Services Committee has doubled down on the amount of risk retention that would be required—10% of the credit risk vs. the President’s opening 5%. The 10% can be reduced (but not below 5%) if the credit underwriting of the lender and the diligence done by the securitizer comply with standards to be determined by the SEC and the banking regulators. The opposite is also true— the 10% can be increased if the SEC or banking regulators determine that the credit underwriting or diligence is not sufficient. What’s more, the party required to hold the risk retention piece will not be allowed to hedge that risk away.

But the most expansive change from what was initially proposed in the President’s Financial Reform Plan is in the scope of the risk retention requirement itself. The draft legislation would apply the 10% risk retention requirement not only to securitized loans—but also to all loans sold in the secondary market. And the language can be read to mean that the 10% risk retention requirement would apply independently to each secondary market transaction. Taking it to an extreme, if a loan were to be sold from the Originator to Purchaser A, who then sold to Purchaser B, who then sold to Purchaser C, …when we get to Purchaser I, has 100% of the credit risk been accounted for and we’re all good? That’s surely not the intent, but it’s not clear from the draft legislation. Many of the terms used are not defined.

Clearly, the origination business for institutions both on and off Wall Street needs strict discipline. The 10% level of risk retention will certainly mandate that discipline. That said, I have a hard time believing the 10% level would follow each and every transaction in the secondary market. If it did, rates tied to the underlying loans would ratchet higher. Expect the Wall Street lobby to use this fact and fight the proposed legislation hard!

What are the immediate implications of this risk retention policy? Banks originating loans will need to set aside more capital in reserve against the loans originated. In the process, that capital will be credit which will not flow to the economy. As a result, the credit crunch in our economy will likely be more severe. Rates for loans will remain high and potentially move higher, especially in the mortgage space. Underwriting guidelines will be very strict.

Should this risk retention policy not be implemented? No.  The pain of the medication will not be pleasant, but it is necessary. The fact is our economy and banking institutions should have always had strict and disciplined underwriting guidelines. Some semblance of this risk retention should have always been in place.

We are now paying the price for that lack of discipline and the accompanying excessive greed.

Once again, I thank our friends at 12th Street Capital for providing insights on this topic. For those interested, I am happy to provide the full 2-page review:


Recent Posts