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Tuesday, March 29, 2011

Leaving the Barn Door Open

It's bad to close the barn door after the horse is gone.  But it's just as bad to fill the barn back up with horses, then reassure everyone that it is now secure, because the barn door is only open wide enough for the horses to escape in single file.  That's what the FDIC appears to be ready to do with regard to mortgage-backed securities.

According to the New York Times, the FDIC is about to adopt rules that would go a long way to correcting some systemically catastrophic faults in the securitization business.  For that, they deserve praise (and I should point out, the FDIC under the admirable Sheila Bair has truly been a stand-up force throughout this mess).  But going a long way is like closing the barn door most of the way -- it doesn't help much if the horses can still slip through.

Ssb guide to mbs

Frequent readers here might remember that I've argued several times that the single most effective way to reform the MBS industry is to require loan originators to retain a certain percentage of the loans they make, and to choose those retained randomly.  I've suggested 20% be retained in-house, randomly chosen. The MBS industry can thrive, providing liquidity for the residential market, but originators are bound to the risk of the loans they originate, which creates every incentive for them to lend wisely.

The proposed FDIC rules, thankfully, adopt that very principle -- but then gut it in the details.

Rather than a simple percentage rule with randomized selection for the retained loans, under the proposed rules,

  • high quality loans are exempt from the risk retention pool, off-the-top;
  • only 5% of the risk from mortgage-backed securities derived from lower quality of loans that make up the risk retention pool must be retained;
  • the risk can be split among the loan originator, loan aggregators, and loan securitizers -- that effectively reduces the risk to any of them well below the 5% line;
  • the lenders have considerable flexibility in choosing their method of exposure to the 5% risk -- either by retaining a 5% exposure in all securitizations, or retaining a representative sample of loans in-house equivalent to a 5% exposure -- but the proposed rules do not specify a mechanism by which the 5% are selected or determined to be 'representative.'   

The proposed rules do not do enough, in my opinion, to make sure that the risk retained by originators is of sufficient quantity and quality to incentivize them to make only sensible loans.  Under the system that crashed the U.S. economy in 2008, lenders could reap the benefit of originating all loans, since the cost of originating bad ones was externalized to the usually uninformed holders of MBSs.  There are lots of potential ways of reforming the system, but none is as clean and efficient as requiring that a substantial portion (I still say 20%, as is required in Canada, which did not suffer an MBS crash) of risk is retained in-house, and that percentage is chosen randomly.  That system requires relatively little oversight, and no wiggle room for escape.

Bank of Canada

The proposed rules don't leave the barn door open as much as they might have, but closing it 2/3rds of the way doesn't help much if the horses can still get out.

There will be a comment period after the proposed rules are announced.  I hope to submit some, and I'd like to hear yours.

Mark A. Edwards

[comments are held for approval, so there will be some delay in posting]

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Law Reform, Mortgage Crisis | Permalink

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