Tuesday, June 16, 2009

Skin In the Game

My friend Ted sent me comments from George Soros today, where the old man opined on the proposal I discussed weeks ago from Barney Frank to ban 100% securitization. First a quick refresher course: banks take loans and repackage them into securities such as MBS (mortgage backed securities) and then sell these new securities to investors. This makes the investor who buys the MBS the ultimate "lender" - they are providing the capital for you to buy your home. This also enables the bank to go and make more loans, as they have sold the risk on the previous batch of loans, and now have capital freed up. The negative effect of this is that it doesn't incentivize the banks to use stringent lending standards - because they have someone who is willing to take the risk for them.

My point is simple: that's how markets work! As I've said before, all securities transfer risk from a party who doesn't want it, to a party who does. The "security" in question could be a bond, an option, a stock, an MBS, a CDO, or something even more complicated. Let's get to Soros's comments:

"To avert a repetition, the agents must have “skin in the game” but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement."

Soros is addressing the proposal which would require banks to hold 5% of the securitized products on their balance sheets, unhedged - as a way of ensuring that the banks have incentive to offer only securitized product with sound risk-reward profiles. It shouldn't be hard to see why this is hypocritical - why single out MBS? Why not force BankAmerica to hold 5% of the outstanding stock in OpenTable - an IPO it recently underwrote? Why not force JP Morgan and Morgan Stanley to hold 5% of the bonds they underwrote for Microsoft? I'll tell you why - because that's not how markets work - and we shouldn't single out MBS as any different. People are wiling to buy OpenTable stock, people are willing to buy Microsoft bonds, and people are willing to buy mortgage backed securities. Buyers who fail to understand the product should not buy it - we shouldn't penalize the middle man for bringing together buyers and sellers.

My friend, Ted, highlighted these same points in an email he sent while debating the topic with a colleague of his. I thought his comments were clear and concise, and I'll share them here (emphasis mine):

"In most cases, I don't think the lenders thought they were making bad loans. In some cases, that may be true. That's also irrelevant, though. If there is a person that wants the loan and a person that wants to buy the loan, it's not up to the MIDDLE MAN to say no. That's absurd. That's like saying when filed to go public in the 90's, Goldman Sachs would turn them down because of their view on the business. THAT'S NOT THEIR JOB. If the company wants to sell some stock to the public and the public wants to buy some stock, then we have a MARKET. Welcome to capitalism!!!!! If you want something else, move to Cuba or go back in time to Germany during WW2. This new law that congress is passing that requires banks to hold 5% of the loans they issue is missing the point. Are they going to make the banks hold 5% of the equity of all IPOs? No!"

If people are blindly trusting (which they should not be!) the ratings agencies to guide them on the valuation of these fixed income instruments, then it would make more sense (although still not a lot of sense!) to require the ratings agencies to hold the securities in question. Maybe the ratings agencies should be paid in kind - when they rate a security AAA - their $20,000 fee or whatever the number is should be paid in said security - but don't blame the underwriter - the guy enabling the capital markets to flow.



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