04 Aug Debauched RMBS

Overnight Marc Joffe sent a paper published 8/3/12, written by Pedro Romero at the Universidad San Francisco de Quito, entitled Why Did the US Market for Mortgage Backed Securities Unravel? 

Dr. Romero explains the Financial Crisis as an instance of Gresham’s Law: “Bad money drives out good if [the] exchange rate is set by law [Wikipedia quote].” He argues that ratings on RMBS had the force of law under the oligopolistic U.S. credit rating system. “These assets [RMBS] were not the result of a flawed design; they were rather debauched by government fiat.”

We don’t disagree. However, the mechanism of debauchment was a failure in the design of structured ratings. The problem of lagging ratings was abysmal in RMBS; it was positively debauched in RMBS CDOs. If you understand how CDOs were rated, you understand why. Unlike corporate and government bonds, for structured credits the composition of risk and value naturally changes as the pool pays down. If the ratings don’t keep up with these changes, they will understate value and risk. This creates an opportunity to adversely select poorer credits and resecuritize them at inflated values. When you do this with a static rating model that was created for corporates, not structured, and uses only the rating as a risk input, i.e., the CDO model, you bury the performance signal. This was done over and over again. We have reviewed deals where whole tranches of RMBS CDOs were sold to investors that had a fair value of $0 at closing.

I highlighted this flaw in the CDO model on page 149 of the full FCIC report. However, the problem of lagging ratings has never been taken seriously in the corridors of power. The stifling effect of the credit rating industry’s oligopolistic structure could perhaps account for this oversight. But deregulation by itself will not automatically make the blind see again. There’s no hope of that, at least in America, until academic finance relaxes its iron grip and opens up to debating financial ideas that are not 40 years old.

In any event, I would turn Dr. Romero’s paradigm around. Every general aspect of needed structural reform that he mentioned in passing would be best addressed by solving the lagging information problem in structured finance. It would be harder for central banks to mask credit problems as “liquidity shortages” for their own self-serving advantages.  The debt capital market could work within a more effective control structure and supplant Basel altogether. And, there would be more working capital to revitalize the real economy at the small-to-medium end of the credit spectrum, where it is most needed.