Innovative Relevance®

Sustainable housing market equilibrium can only be achieved with transparent, robust, and technology enabled non-government solutions

By Mark P. Dangelo

www.Innovative-Relevance.com

In the span of three years, the once popular and risk-dispersion phrase “financial innovation”, or “financial engineering” has become associated with deceit, illicit gains, fat-cat bankers, and an overall distain for social responsibility.  For the public, it appeared that all financial innovations were in the pursuit of personal and corporate greed.  Furthermore, the polarization of our industry constituencies – lenders, investors, homeowners, associations, insurers, and regulators – has created a chaos and void of inaction not merely in devising a “clean-up” strategy, but more importantly how can our intertwined economies grow again.

Consequently, politicians and pundits are quick to bury any idea of alternative forms of private securitization outside of public debt issuance.  In their zeal, the aforementioned groups cite lack of controls, an ability to properly value underlying assets, determining mark-to-market (FAS 157, now Topic 820), and all the other negative implications of historical tranching. By the end of October 2008, it appeared history would repeat itself as the worst global decline since the 1930’s shook financial investors, markets, and their overseers. 

Undeniably for investors, it was the misplaced risk principles, primitive correlations, market interdependencies, leverage multipliers, and ratio compositions (i.e., BASEL / BIS guidance) that contributed to an uncompromising aversion to anything outside of explicit government guarantees.  Now, just 14 months after a flight into the arms of public protection, investor confidence has now succumbed to the realization that any sustainable financial solution must be multi-faceted and adaptable to the private markets – governments and politicians are proving fickle. 

Simply stated, the need for capitalism still survives and is demanding new forms of debt and equity instruments across developed and emerging markets.  To avoid the mistakes of the past, have our lenders and market makers internalized the challenges and baseline representations facing a resurgence of private securitization?  What do regulatory and Congressional demands hold-in-store for financial institution portfolios bursting with record levels of government-backed paper?

Baseline and Retrospection

If truth be told, what a difference a decade makes.  In 2009, over $12 trillion of global government debt was issued as contrasted to under $250 billion nine years earlier[i].  These data points represent a 60 fold increase in just one form of debt (sovereign) currently under pressure by rating agencies, central banker actions, and an electorate preparing for mid-terms.  Can the record printing of sovereign IOU’s be sustained or will the “house” collapse in on itself?  It is worth noting that in Europe, for the first time in history, the cost of insuring sovereign debt is now higher than corporate bonds[ii].

Domestically, the diverse U.S. debt now has doubled since 2000 exceeding $35 trillion in its myriad of forms – municipal, Treasury, mortgage, corporate, Federal agency, money markets, and asset backed[iii].  Not surprising, the largest of the increases since 2000 belongs to the Federal agency bond category. 

Yet, is the real “King of Jesters[iv]” one who fails to accept that the on-going public and housing debt policy for the “social good” is simply conforming to a recipe for future sovereign downgrades and governmental bankruptcy?  As a net importer of global capital with mushrooming domestic debt, what happens when the U.S.’s musical chairs surrounding quantitative easing ends and the public debt issuance cannot be sold (to foreign investors)? 

All interesting macro questions, but more specifically, what will transpire in April 2010 when the Fed completes its final purchase of $1.250 trillion USD in MBS’s?  Are there new instruments that take the place of the “originate and forget” securitization model[v] made infamous by the writing down of over $3 trillion in debt in addition to the tens of billions in whole loans still decaying on financial institution balance sheets?  Without private security funding, issuance transparency, price discovery, and improved returns via bps spreads, can there really be a sustainable recovery without investor crafted bonds?

With delinquency and foreclosure rates still holding at near historical levels fueled by a loss of over 7.5 million jobs since 2006[vi], the plight of the homeowner, investors, lenders, and governments will continue.  Nevertheless, as concern leads into increasing despair, there are robust securitization ideas which demand and deliver sought after investor innovation supported by an impressive array of layered technology and analytical solution sets.  

The domestic and global markets are in dire need of new forms of financial innovation, which leverages the positive lessons learned, while mitigating the risks and exposures of our historical MBS / ABS failures.  In fact, it has been precisely these architectonic market voids and deficiencies that have resulted in significant momentum for Project RESTART, introduced by the AFS[vii].  So are there any private securitization frontrunners or forms that stand out?

Syndicated Investor-Guaranteed and Managed Asset (“Sigma”) Depository Receipts

Sigma DRs are a new form of asset-backed financial instrument – and one that is gaining significant interest among market makers, warehouse and mortgage lenders, institutional investors, and regulators.  So what is so special about Sigmas?   Classified as a single-tier ABS form of a Depositary Receipt, Sigmas blend the flexibility of traditional ABS with the transparency and exchange-trading liquidity of ADRs.

Later in 2010, Sigmas will be offered via a securitization protocol[viii] providing independently valued, sold, and traded issues that will be available to institutional investors and FINRA member firms through DelphX (www.DelphX.com), a SEC-regulated Alternative Trading System headquartered in Malvern, Pennsylvania. 

Providing transparency and liquidity[ix], Sigmas and DelphX offer a compelling liquidity solution to financial institutions holding whole loan portfolios (especially assets held for sale – HFS[x]).   The underlying assets remain actively managed by the original holder[xi] by means of Sigmas who in turn sells the asset-backed instruments, using a passive pro rata ownership interests in the collateral, through DelphX. 

Employing a continuous variation of the “Delphi Method[xii]”, DelphX enables market participants and regulators to:

·         access online continually-updated, asset-level information for all related Sigma transaction data,

·         independently assess the current and likely future value of each asset, portfolio, and related Sigma issue,

·         collectively determine the current market price of each Sigma issue through transparent, anonymous bidding and trading, and

·         settle all transactions with the issuing Depositary, the issue’s common credit counterparty to all subscribers.

To facilitate the loading, verification, and continuous updating of the granular loan-level data required for valuation and trading, DelphX announced last week that it had engaged MIAC (Mortgage Industry Advisory Corporation, www.MIACAnalytics.com) of New York, New York, as a partner in its initiative to “Restore Investor Confidence and Credit Markets.”  Utilizing an expanded and integrated DelphX adapted version of MIAC’s DataRaptor®, MIAC will also independently provide analytics, valuations, software, and services to DelphX subscribers.

From a regulatory and political standpoint, it is fairly easy to understand the growing appeal of Sigmas and DelphX, as the market seeks to regain investor confidence and head off draconian government oversight and artificially-managed stimulus packages[xiii].  Yet there are other financial instrument forms also rapidly appearing in the markets that provide another asset tool for the next decade of private securitization.

Covered Bonds, Part II[xiv][xv]

It was back in August 2008 when I advocated the use of newly announced Treasury and FDIC guidelines for covered bonds[xvi] – before the “dark times, before the Empire.[xvii]”  The euphoria for this government “approved” bond type vanished on September 15, 2008 with the bankruptcy filing of Lehman Brothers. 

However, rumors of their death have been exceedingly overstated.  Since their official introduction two years ago, Congress has heard and discussed the need for statutory frameworks, transparency needs, and investor risks associated with potential losses and asset coverage pools[xviii]. 

As with all forms of new instruments, covered bonds represent another option within the securitization mix for the decade.  Unlike some securitization forms, covered bonds are encumbered against the balance sheet of the issuing financial institution.  Stated differently, the debt liability is fully retained reducing an institutions’ leverage.  

Whereas price and risks for aforementioned Sigma’s is investor determined, covered bonds typically are rated by independent agencies.  Covered bonds have been in existence for hundreds of years across the European Union (EU), and at latest tally exceed $3 trillion Euros in individual and master trusts (and administered by various trustees operating within their countries of origin).  In general, covered bonds are an asset class well heeled – but not in the U.S.

Within covered bonds, as some campaign, investors can experience higher management fees and transparency challenges relating to the fenced assets and cover pools (all in a design to ensure their common AAA ratings).  However, this broad asset class has proven resilient during the last three years, and within the U.S. has received special seniority treatment during the 2009 banking M&A’s protecting the roughly $60 billion of domestic issues.  Of historical note, yields have typically ranged from 25 to 180 bps above U.S. Treasuries.

There are many nuances and regulatory requirements within the proposed and existing guidelines for covered bonds that cannot be covered here[xix].  In spite of that, it is evident that covered bonds must actively be part of the securitization mix starting in 2010.  As politicians and committee’s debate covered bond deployment, recourse, and exchanges for a third year running, new benefits and demands regarding claw backs and mortgage insurance[xx] will most likely secure their acceptance in 2010. 

However, what is clear is that without technology, data, and proactive integration of the comprehensive mortgage supply chain, the necessary market critical mass cannot be delivered nor maintained.  We have the components, but do we understand how to properly assemble them for sustainability?  This is a challenge for all forms of new securitizations.

* * * * * * * * *

And so it begins, the next iteration of private securitization is firmly underway.  For the preceding examples, they have relevancy for GSE’s, portfolioed whole loans, repurposed assets, and even “troubled” assets deposited with the various government agencies. 

Additional transformation of securitization practices have been inaugurated as there are many needs to satisfy securitization both in the private and public sector markets.  Each security form will have varied yields, risks, mitigation approaches, and investor benefits.  It is probable that many will find relevancy.

Implementation of securitization efforts will be delivered at the hands of vendors, outsourcers, and cross-industry association collaborations.  Political pressures and commitment will only come or subside when the outcome is certain.  So as unconditional support for governments wane[xxi], where will the outcomes and funding needed for the pipelines come from?  Are you prepared for the demands coming from the new supply chain equation – secondary demands drive servicing requirements which define origination?  The reverse financial supply chain will define the next decade.