There is no question that the way in which we have conducted securitizations in the past is broken.
I agree with Ethan Penner (in his July 10, 2008 Opinion Article in the WSJ, The Future of Securitization) when he says “Yesterday’s business model has been invalidated.” However, I do not agree with his conclusion that securitization can survive “with a simple tweak.”
Mr. Penner makes the case that, in addition to transferring credit risk, the two primary benefits of securitization are
- a vehicle that allows a lender to match the terms of its assets and liabilities and
- the “transparency that it brings to bear on the system.”
Penner’s article concludes that for securitization to return the lender must originate loans and have enough equity/balance sheet to keep the first loss piece, while securitizing the senior pieces with CMBS bonds to get the benefit of risk transfer and to match fund the loans.
In other words, by the lender keeping skin in the game, the interests of the lender and the investor stay aligned and, therefore, everything will work again. The article makes no mention of the role of transparency and standards (other than them being one of the key benefits of securitization).
While aligning economic interest is absolutely a good idea, I would suggest that point is so fundamental that it should be assumed as mandatory. If the equity and the investor do not have aligned economic interests, we should not even consider bringing back securitization.
But how much equity is needed to keep all players’ interests aligned? 10%, 20%, 50%? The amount of required equity will no doubt vary depending on the market, the assets and the relationship between the equity (lender) and the investor.
History has shown that in good times the lenders will be required to keep very little (if any) skin in the game. In bad time, lenders will be required to put up more equity.
While coming up with equity is a fairly simple “tweak,” it does not represent the permanent reforms that are required.
Standards and transparency
For me, Skin in the Game is not the long-term answer (although it will probably be required for lenders to re-enter the securitization market as it crawls back to life).
The keys are standards and transparency with all parties using common underwriting models. Having spent the last eight years creating the most widely used common underwriting tool in the CMBS market, I can say that all lenders do the math the same way. Bank of America, Royal Bank of Scotland, Hypo International, CWCapital, AIG and Genworth all underwrite using the same software. Rating Agencies including Standard and Poor’s and DBRS underwrite using the same tool. The reason the market has not historically shared underwriting has to do with the fact the no common underwriting platform existed, not because the math is different from shop to shop.
The systems used by the big players were developed (at great cost) internally and typically have an Excel-based calculator. Since the models are fairly complicated (although the math itself is fairly simple), each party sets up its systems a bit differently. They do not share identical structures, and they do not communicate. And, since these systems were expensive and painful to develop, many people have vested interests in keeping the systems in place — so they don’t look like wasted technology dollars.
Underwriting is NOT an “art form”
Of course, some lenders have not been interested in sharing the math because, when times were good, they simply did not need to. I remember one prospectus where the issuer actually called underwriting an “art form” and, therefore, could not explain the math behind the numbers.
If underwriting is defined as an Art Form, then making up numbers because of aggressive assumptions becomes OK and very hard to detect. If they could sell the assets without the disclosure, why bother? One true benefit of the credit crash is that this position, as we have said, has been declared invalid.
A common underwriting platform
How do we, as an industry, get to a common underwriting platform?
To date, the industry effort to create standards has been led by the CMSA through its work on the IRP (Investor Reporting Package) and the MBA under the C-MISMO banner (Commercial Mortgage Industry Standards and Maintenance Organization).
The CMSA IRP is a decent standard in that people generally use it, but the data available in the file is deficient. The MBA has tried hard (and continues to try hard) to “herd the cats” and get everyone to agree on the data standards. It should be noted that CMISMO is not trying to standardize underwriting, only data terms and structures. Even with this reduced scope, the process of creating standards has been painfully slow and, after eight years of trying, only a handful of standards have been created with minimal industry adoption.
However, even if CMISMO were successful in short order, since there is nothing in the standards regarding underwriting, the ultimate value of the standard is questionable. That being said, we are members of CMISMO and have offered our tools, free of charge, to help the CMSA gain traction in rolling out IRP 6 (in XML).
On the private sector side, my product (Backshop) has been the most successful in gaining market acceptance. It is the only third party application in which 100% of the underwriting is done within the website and the database (no Excel!), so the system is 100% structured.
But Citi Bank, Goldman Sachs, JPMorgan, Morgan Stanley, Wachovia and others still use proprietary models. I can attest that selling enterprise software into these big companies is a slow and painful process with all sorts of barriers that often have nothing to do with the product. That being said, these institutions have never experienced an “Invalidated” business model, so the time may be now.
True, long-lasting change
If we, as a market, all used the same “calculator” and were willing to share our underwritings with the rating agencies and the investors in an open, transparent manor, that would bring true and long-lasting change to the securitization market.
It is more than a “tweak” — because creating standards is harder than raising capital.
However, if the legacy systems of a few major players are shelved and the remaining players have a path to join a common standard, the math would open up, and the risks of the loans and securities would be transparent.
Investors would no doubt return if they were comfortable they were getting a positive risk-adjusted return and that, in my opinion, is the way to bring back the CMBS market.
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Jim Flaherty is CEO of CMBS.com and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.
www.cmbs.com
www.backshop.com
