The Future of Securitization
04/08/08 - 07:08 PM EDT
Knowledge @Wharton
"CDOs are Doomed"
In the future, ratings agencies will need to operate on the assumption that a security rated AAA should be able to withstand a shock as great as the current crisis. "That will mean that under the best of circumstances, it will be harder to get a triple-A rating, which will reduce the profitability of securities," Guttentag says. Some forms of securities will die. CDOs are doomed, he adds, because the market has seen they are extremely difficult to value. "In the short term, the prospects are dismal. The market will recover, but I don't think we'll ever see CDOs again and the standards will be tougher, so the comeback will be gradual." Gyourko notes that the crisis is playing out in a presidential election year, complicating the response. "I think this is the worst time to have this happen. It's never a good time, but in an election year, you're more likely to get a bad policy response," he says. According to Guttentag, while Republican presidential candidate John McCain is taking a laissez-faire stance, the Democratic presidential candidates have focused on using the Federal Housing Administration (FHA) to refinance loans that are in default. The idea is similar to what happened during the Great Depression of the 1930s with another agency called the Home Owners' Loan Corp. which was created specifically for that purpose. The problem, says Guttentag, is that FHA is not designed as a bailout agency. "The FHA's core mission is predicated on it being a solvent operation, actuarially sound, charging an insurance premium large enough only to cover losses. How they would reconcile that is not clear." Guttentag says attempts may be made to create a separate bailout agency within the FHA with different accountability. "But the devil is in the details," he warns, "and the details have to do with exactly who is going to be helped, what the requirements are, what the nature of the assistance is going to be, and myriad other factors that have to be worked out." The Bush administration has taken some steps to ease the crisis, including encouraging lenders to modify contracts to avoid foreclosure. A strong case can be made for these measures, Guttentag adds. "The cost of foreclosure is often greater than the cost of modifying the contract and keeping the borrower in the house." One downside is that once some loans are modified for those truly on the brink of foreclosure, other borrowers who could somehow manage to avoid foreclosure may demand the same modifications, shortchanging investors. In testimony before the U.S. House of Representatives' Committee on Oversight and Government Reform, Wachter laid out a proposal developed with the Center for American Progress to resolve the current crisis. Under the so-called SAFE loan plan, the U.S. treasury and the Federal Reserve would run auctions, in which FHA originators, as well as Fannie Mae and Freddie Mac and their servicers, would purchase mortgages from current investors at a discount determined at the auction. Investors would take a reduction in asset value and yield in exchange for liquidity and certainty and the auction process would price pools and bring transparency back to the market. The FHA, Fannie Mae, and Freddie Mac could then arrange for restructuring of loans. Meanwhile, Allen notes the Federal Reserve has taken some dramatic steps with interest rate policy to resolve the current economic crisis, but that could lead to tension with Europe and Japan over currency valuations. As the dollar continues to fall, U.S. companies are increasingly more competitive overseas. "The Fed cut the rate at the beginning, and that was fine, but now things are getting way out of line," he says.
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