Monday, May 4, 2009

Signaling And Mortgage Securities

My response to Arnold Kling's post "that securitzation depended on false signals of soundness."

Signaling is important in finance, but there were economic incentives to misread the signals of mortgage securitization. Additionally, there were regulatory structure issues that prevented corrections to the misread signals. Both problems are fixable.

Both investment banks and commercial banks must maintain capital against their assets. In both, the amount of capital (not identical for the two types of entities) for mortgage securities was determined by formulas that used the credit ratings of the SEC recognized credit rating agencies, NRSROs. A better credit rating required less capital.

Mortgage originators derive their income from fees, which need a continuing volume of new mortgages. Originators did not hold mortgages for their interest income and a principal agent problem occurred. As long as there were buyers of packaged mortgages (securitization), including lower quality mortgages, originators could replenish their limited amount of lendable funds and continue to generate fee income without regard to the deteriorating quality of the new mortgages.

The commercial banks and investment banks (buyers) preferred securitized mortgages with lower capital requirements, which were the higher NRSRO credit rated securitized mortgages. The buyers could put up less capital against these assets, purchase more of them with their existing capital base and derive a higher income.

If the buyers, the commercial banks and investment banks, monitored and analyzed the quality of the securitized mortgages correctly and read the signals, these buyers would have had to put up more capital against theses investments, purchase less of them and reduce their income.

The regulators accepted the credit rating agencies' ratings and their lower capital requirements. For a buyer to question the ratings, the buyer would have to accept lowering its income, putting higher capital against the assets and investing in fewer of them. To the commercial banks and investment banks, it was a clear cost benefit decision. The benefits were lower capital versus higher capital, higher income versus lower income, and more securitized mortgages versus fewer securitized mortgages. The costs were higher potential defaults and higher potential losses. Post WWII history made the benefits appear to outweigh the costs even on a risk-adjusted basis.

The NRSRO rating agencies depended on the volume of their ratings of mortgages to produce a continuing fee income stream. A lower rating meant the buyers would use more capital and there would be fewer mortgages for ratings. Each of the rating agencies jeopardized their reputations and brands through lowering the quality of their rating methodology for securitized mortgages. However, the SEC's NRSRO limitations and designation hurdles protected the ratings agencies, limited competition and ensured the existing NRSROs that they would not lose their current or future business clients or ratings income stream.

The regulatory structure for NRSRO designation prevented customers from turning to other rating agencies for mortgage securities ratings. The regulatory structure for capital, which depended on NRSRO ratings, economically inhibited the commercial banks and investment banks from doing their own analysis of the potential for losses in the packaged mortgage securities.

The problem that occurred was not lack of proper signals of the deteriorating quality of mortgage securities. There were many, including who was sourcing the mortgages, the existing decline in home prices and the increasing level of defaults. The buyers ignored the signals.

The prevalent signals were overridden and ignored due to the structural problems created by the regulatory structure for NRSRO designation and the NRSRO credit rating used for determining capital levels.

A successful securitization process does not need credit ratings and NRSROs. However, since commercial banks and investment banks are required to hold capital against their investments, a new methodology for determining capital levels without NRSROs and credit ratings is needed.

The problem was not false signals, but structural and regulatory issues that prevented buyers from reading and using the available correct signals.

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