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Great article!

Mohan

First of all, that 70% of loans originated today are not QRM does not mean that the private label industry has lost 70% of the ability to finance homes—it means that originators and securitizers actually have an incentive to monitor 70% of the loans that they had previously dumped off to investors.

Second, what is to protect consumer borrowers and investors in a world where securitizers and originators operate under an originate-to-distribute model of lending? It is evident that the prior model failed spectacularly and that diversification alone did not make securitized lending safe.

In the pre crisis RMBS market, the parties in the securitization chain, namely mortgage originators, sponsors and credit rating agencies, all acted in their best financial interests, to the detriment of investors. These parties all generated large fees for their role in the securitization chain, retaining little—if any—exposure to the loans they distributed. The proposed credit risk retention rules are a rebuke of the originate-to-distribute model of lending that seek to encourage better loan underwriting by giving securitizers and originators a financial incentive to monitor carefully the loans that they pass off to investors. Further, risk retention places default risk where it is best internalized—by the individuals who create and best understand the RMBS (and related re-securitizations).

Empirical research suggests that the expansion in mortgage credit to subprime borrowers was caused by an outward shift in the supply of mortgage credit by lenders (i.e., lax lending standards, abuses of intermediaries, demand from investors) rather than borrower’s demonstrating greater income potential (See Atif R. Mian and Amir Sufi 2007). Because there is a nearly insatiable demand for triple AAA rated debt on the market, securitization was used as a tool to create artificial supply (See Gorton and Metrick 2010). This was made possible because mortgage brokers cut as many loans as they could—even to individuals with no income job or assets—and distributed these loans to sponsors. Sponsors then turned the loans into ABSs and made increasingly complex re-securitization products, such as CDOs, CDO-squared, and CDO-cubed (not to mention purchased CDSs to eliminate any residual exposure on loans), which enabled them to pass any risk they retained in an ABS to investors.

Sophisticated investors in RMBS products (and related re-securitizations), such as pension fund and hedge managers, were unable to properly price risk nor understand how the structured finance worked. Without originators or securitizers monitoring loan quality, sophisticated investors were reliant on credit ratings agencies to reveal the loan quality in securitization pools. Contrary to their better judgment, however, credit ratings agencies gave risky ABSs and re-securitization products—that they knew were prone to high default rates—investment grade ratings in order to generate future business from sponsors.

To put it simply, all of the players best able to monitor loan quality failed to do so pre-Crisis because they had no financial interest in the long term performance of the mortgage loan. Financial incentives are the best way to ensure that loans are properly monitored. In fact, studies have shown that default rates in the RMBS market were lower when originators and sponsors were affiliated entities, whose financial incentives were aligned (Demiroglu and C. James 2009).

The Proposed Rules do not put decades long private label lending to an end (as you critics suggest)— they simply make the system more akin to what it was prior to modern securitization when community mortgage originators actually retained some of the risk on the loans they gave to consumer borrowers. Further, the QRM rule does not eliminate fee collection from the securitization picture; instead, it simply aligns the interests of those who collect fees with the interests of investors whose returns are tied to the performance of the mortgage loan. As critics to the QRM point out: a narrow QRM means that many safe loans will be non-QRM. This in turn means that there should be sufficient investor demand in these products to make non-QRM lending safe for investors and affordable to consumers.

A plausible account of Europe’s sovereign debt crisis is that some member states, including but not only Greece, have been living beyond their means in the sense of consuming more than they produce. Such nations were able to sustain their excess of consumption over production through borrowing at interest rates that, in retrospect, appear artificially low relative to the default risk. Artificially cheap credit was available because of the European Central Bank’s willingness to accept the sovereign debt of any member state as collateral, and perhaps because investors perceived that bondholders of a state in default would be partly or fully bailed out by other member states.

To the extent this account is accurate, any sustainable long-term solution must entail the elimination of mechanisms by which states are able to externalize the costs of overconsumption (that is, overspending relative to revenues) onto other member states. If each state were required to stand upon its own creditworthiness, then bond markets would force each state to undertake the internal reforms necessary to match consumption with production. Pan-European bonds, or bonds guaranteed by all member states, seem to be obstacles to this outcome, as they would mask differences in creditworthiness among member states and thus perpetuate the moral hazard whereby some members can, through artificially cheap borrowing, externalize the costs of their internal fiscal imbalances.

How would you reconcile your proposal of pan-European credit with the need for fiscal solvency and accountability within each member state?