Even though the U.S. Securities and Exchange Commission (SEC) clearly defined financial transparency as an important component of the foundation of our financial system, it is nearly non-existent in the world of mortgage-backed securities (MBS).
We believe that this is a critical and un-met market need associated with the $700 billion plus bailout or “Troubled Asset Relief Program” (TARP I, TARP II) and started by the Emergency Economic Stabilization Act of 2008 (EESA) on October 3, 2008 being discussed and now executed by the federal government. We would like to make a few key points:
1. The size and complexity of what must be done in purchasing and eventually selling some of the troubled mortgage assets is far greater than when the Resolution Trust Corp (RTC) was created in 1989. A balance between legislation and practicality and between business and technology will have to be struck for remedies to work.
2. New thinking with regard operational, process, and technology will be required to achieve that which is intended without creating waste or an overly burdensome environment as a result of inevitable legislative changes that will be forthcoming.
3. Because of the truly global nature of the market, the U.S. will have to work closely with governments and parliaments in other major market centers.
4. Commercially available technology is readily available to make the mortgage process far more paperless, and to enable its processes to be modeled, modified and iteratively innovated.
5. New business models and opportunities will arise in the next year based on expected legislative changes.
What is Financial Transparency?
“Financial transparency means timely, meaningful and reliable disclosures about a company’s financial performance. Companies need to provide transparent financials to raise capital. Investors need transparent financials to make informed investment decisions. Therefore, financial transparency is important not only because it is the bedrock of our financial markets, but also because it is absolutely essential to today’s investors.” – Commissioner Cynthia A. Glassman, U.S. Securities and Exchange Commission, Policy Roundtable Symposium on Enhancing Financial Transparency Federal Deposit Insurance Corporation (FDIC) Symposium Washington, D.C. June 4, 2002
“Just as the conquistadors searched for El Dorado, the world’s capital markets have long searched for a single set of high quality accounting standards that could be used anywhere on earth. That should come as no surprise, because the promise of a global standard is truly dazzling. An international language of disclosure and transparency would significantly improve investor confidence in global capital markets. ‘…a single set of high-quality standards would be a great boon to emerging markets, because investors could have greater confidence in the transparency of financial reporting.’
The question we can now plausibly ask, as International Financial Reporting Standards are increasingly accepted around the world, is whether IFRS are not just an imaginary … but will indeed emerge as the single set of high-quality accounting standards that so many have sought for so long.” Chairman Christopher Cox, SEC Address to the Annual Conference of the International Organization of Securities Commission Paris, France May 28, 2008
“When the SEC was founded nearly 75 years ago, a fundamental purpose was to restore investor confidence in our capital markets by providing investors and the markets with more reliable information. Today, we are continuing to build on that essential premise: that investors have a right to know the truth — and the risks — about the securities that trade in our public markets. Never in this agency’s history has this fundamental mission been more relevant, and more urgent.” Chairman Christopher Cox, SEC, in opening remarks to an SEC round table, October 8, 2008, Washington DC.
Historical Parallels to the S&L Crisis – Linked Deposits & Synthetic CDOs
The Resolution Trust Corporation was a United States Government-owned asset management company charged with liquidating assets (primarily real estate-related assets, including mortgage loans) that had been assets of S&Ls declared insolvent by the Office of Thrift Supervision, as a consequence of the savings and loan crisis of the 1980s. 747 S&Ls in the U.S failed, and the ultimate cost of the crisis is estimated a $160.1 billion, with about $124.6 billion paid by the U.S. government. While this pre-inflation adjusted number is small by comparison to the TARP II initiative, there is one similarity – lack of financial transparency in how the S&Ls did business.
One of the most important contributors to the S&L problem was deposit brokerage combined with abuses in “linked financing.” Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers’ money in those CDs. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. To make money from this expensive money, it had to lend at even higher rates, meaning that it had to make riskier investments.
This system was made more damaging when certain deposit brokers instituted linked financing. In linked financing, a deposit broker committed to a thrift that they could steer large deposits to that thrift, if it would lend certain people money (in some cases, the people, however, were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be have difficulty assessing loan quality and risk. In turn, Michael Milken of Drexel, Burnham and Lambert and others packaged brokered funds for several S&Ls on the condition that the institutions would invest in the junk bonds of clients. There was little or no visibility into the rationale behind brokered deposits, and no way to see whether linked financing was an underpinning of an S&L.
Today, banks and insurance companies risk exposure from “Synthetic CDOs” The problems with synthetic CDOs stem in part from the way they were made. In many cases, the banks that created the CDOs stuffed them with companies, such as Lehman and Iceland’s Glitnir, that paid the highest possible return for their top-notch credit ratings. That made the CDOs more attractive, but also riskier, because they contained companies that the market perceived as more likely to get into trouble.
Perhaps the weakest link in the market are specialized funds, known as “constant-proportion debt obligations,” that work much like synthetic CDOs but with one important difference: They use borrowed money, or leverage, to boost the returns they can provide for investors, a strategy that also magnifies losses.
According to the 10/21/08 edition of the Wall Street Journal, “CPDOs, for example, typically borrowed about $15 for every dollar their investors put in. They also contain safety triggers that force them to get out of their investments if their losses reach a certain level. Analysts estimate that most CPDOs reach those triggers when the cost of default insurance hits about the level where it is now…and some specialized CPDOs leveraged $80 for each $1 invested.
Flaws in the Current System that Led to Distressed Mortgage Assets
I – Lending Industry Practices
Creating financial transparency will be important to restoring confidence in the credit markets, to the extent the markets are dependent on the clean up, restructuring and restoration of a healthy market for securities that derive from mortgages. In short, after the assets are purchased, what will be done with them?
1. Inefficiencies. Mortgage lenders and other financial institutions have lamented for years that typically, mortgage loan data is re-keyed up to 20 (yes, that is TWENTY) times throughout the process which is not only inefficient but prone to creating errors. These errors and inefficiencies are propagated from origination to secondary markets and on into the securitized assets created from mortgages.
2. Quality of the originating agent. The selection, licensing, tracking and audit trail of mortgage brokers is weak at best, and while technology is readily and commercially available to solve this problem, some lenders believed it was not in their financial best interests to fix the problem or to carefully scrutinize the source of all broker / originators because they focused on volume over quality. Importantly, there is no easy way to tell if a residential loan that was securitized into a mortgage backed security was originated by a mortgage broker that meets minimum standards of ethics, although there are laws governing the fees they charge (see predatory lending later in this blog). Like brokered deposits of the S&Ls, over 50% of all mortgage loans are originated via mortgage brokers. It is up to the mortgage broker to provide the initial assessment of the credit worthiness of the borrower, the value of the property being financed and other critical components. Unscrupulous mortgage brokers can ignore their fiduciary responsibility and have financial incentive to do so because they make their money by charging fees to originate loans, and the quality of their work does not matter so long as a lender agrees to underwrite the loan and fund it. During the boom times of 2003 to 2006, there was seldom recourse against unscrupulous brokers for these practices. Brokers can “cheat” the system in several ways. First, the mortgage broker can order an appraisal from a ‘friend’ if needed to secure a desired valuation. Second, the mortgage broker can manipulate the “yield spread premium” by charging higher fees or adding hidden “junk” fees charged to borrowers. Third, the broker can manipulate other information that makes a risky loan look less risky. Some large sub prime mortgage lenders ignored the warning signs that some of their loans were being originated by unscrupulous mortgage brokers.
3. Paper. The supporting documents for the data keying are mostly paper. Paper makes it difficult to have an easily searchable electronic audit trail between what the parties intended when a loan was created. For example, the appraisal that was used to determine the value of a property, and the credit report that was used to determine the credit worthiness of the borrower are stored as paper. Some will be quick to point out that these documents are often “imaged” into electronic form, but usually the underlying electronic DATA which is the searchable component of the document is not captured. Drilling down on this point here are two key issues, one causes a trickle down effect to the other:
4. Paper is hard to store and retrieve. When a loan is originated, closed, and sold to an investor, the “asset” is usually still in paper form and is stored in a “loan vault.” Having toured these facilities before we know that most of them lack the technology to easily search for information on thousands or even millions of loans. It is performed manually. Technology, people and process exist to solve this problem economically, but it is not being used.
5. Paper pools are hard to understand, pooling of paper increases the lack of data and process transparency. When individual loans are “pooled” and later “securitized” into a new type of financial instrument, the lack of transparency or “opaqueness” is increased because now multiple paper-based loans are being turned into something else. It becomes very difficult for even the most financially and technically astute individual, rating agency, or due diligence firm to fully assess the quality, value, and risk associated with these securities.
6. Lack of accountability among the parties involved. Mortgage loan originators said they were following federal and state guidelines on the types of loans and level of risk. Rating agencies that valued the loans were not accountable; because they said they took the data the issuer gave them. Due diligence firms did their work, but said that in the end it is up to the seller and buyer of mortgage backed securities. Therefore there was no accountability or transparency with the due diligence firms. Individual residential loans are almost always created via a paper intensive process.
7. Lack of data and process transparency created barriers to entry. Large financial institutions used an opaque process to create barriers to entry for firms looking to get into the business of providing due diligence, rating the quality of the security or underlying loans, enabling more efficient transactions, or even originating loans.
8. Primitive methods for assessing the quality of the data hamper seeing the forest of loan pools and focus only on the tree. Despite an increasingly digital world, mortgage loan pool data is stored on a “tape” that must be read, dissected, analyzed, and its underlying paper sampled for accuracy. There is no way to easily aggregate this tape data today to compare the quality and accuracy of many pools, instead costly and labor intensive steps must be taken to assess just one pool, without knowing the opportunities that may be missed in other pools to find value.
9. No easily understood method of efficient exchange. Unlike the stock market, there is no open market with clearly understood reporting, valuation methods, trading visibility, and incentives any of the parties involved to change. Furthermore, companies have been founded to create electronic components as an underlying foundation of an exchange (eSignatures, eNotes, etc.) but despite what proponents of these technologies say, they are being used on a tiny, tiny subset of all mortgages today.
10. Lack of transparency prevents visibility into regulatory reporting and oversight. Technology now exists to analyze whether a mortgage loan conforms to local, state, and federal law regarding predatory lending and other requirements. However if the loan is paper based, it is difficult to apply these technologies.
11. Overly complex and unnecessarily predatory processes to mitigate risk or foreclose. Homeowners who pay mortgages are fearful of engaging in dialogue with their mortgage lender when they cannot pay. However, the mortgage lender’s method of communication with the borrower at risk of defaulting is through a collections department with people who are not skilled in credit counseling and who are often provided incentives on their ability to collect. Lenders know that their best interests and those of the homeowner are to keep the homeowner in their home. The costs to foreclose are usually higher than the costs to restructure loans. Why then do most mortgage lenders and the “loan servicing” departments resort to collections as a first resort when engaging distressed borrowers?
12. No incentives for the parties controlling large lending systems to change. Having personally spent time with some of the largest financial institutions in the world discussing ways to create efficiencies by removing paper, we can state with certainty that some firms won’t remove paper from their process or enable greater transparency because they are undisciplined, their senior management lack the technological vision, and they therefore conclude that it is “too expensive” or “disruptive” to do so. This has been because the focus has been on short-term financial results, and because for a time the loan origination volume was so large that these firms could not stop the process long enough to change it. When loan volume decreased, it was again “too expensive” to change because these firms were facing declining profits, or worse, downside impact of poor quality sub-prime loan portfolios originated through the very technology system they refused to change with any sense of urgency.
II – Policy of Government and Government Regulated Entities in Capital Markets
After loan were originated, underwritten, closed, and sold there were other factors that contributed to the crisis. In one way, mortgage brokers and lenders were feeding a supply chain of loans to Wall Street firms, securities and bond traders, and service providers who made their money via securitization and other complex financial structures or who provided services to those institutions (see rating agencies and due diligence firms in the prior section).
1. Complex derivative structures and inadequate reserve requirements. The Gramm-Leach-Bliley, or Financial Modernization Act repealed provisions in the Depression-era Glass-Steagall Act prohibited a bank holding company from owning other financial firms and opened the way for banks to create complex financial derivatives such as those backed by sub prime mortgages. The bill was signed into law in November 1999 by President Bill Clinton. By blurring the authority that such regulators as the Securities & Exchange Commission and Commodity Futures Trading Commission had over various instruments, the law helped pave the way for the crisis. Derivatives are the epitome of a non-transparent financial instrument. Complex, hard to understand, highly leveraged, risky. When the downside risk of derivative values was realized because the mortgage underpinning their value started to fail, the leverage worked in a powerful way against financial institutions. In 2003, Warren Buffett called derivatives “financial weapons of mass destruction.”
2. Weaker regulations on debt ratios. Exacerbating the problem, many trading firms worked to be exempted from bank holding companies’ restrictive debt ratios in April 2004 during William Donaldsons’ Chairmanship of the SEC. This indirectly led to a surge of debt-to-equity ratios on these banks’ balance sheets from roughly 12 to 1 to between 25 and 33 to 1, exacerbating their liquidity problems as the credit crisis deepened.
3. Riskier loans by the GSEs and regulations eased by Congress. The Housing and Federal Housing Commissioner at the U.S. Department of Housing and Urban Development (HUD) said in 2004 that Fannie Mae and Freddie Mac (Government Sponsored Entities “GSEs”) were lagging behind the private market in making affordable loans available to low-income families and told them to do more—even though research by his own agency had warned of high foreclosure rates among sub prime loans as early as 2001. The quasi-governmental agencies increased their purchases of sub prime loans, helping fuel the housing bubble. Congress, which used HUD to set quotas that Fannie and Freddie were required to meet, withdrew HUD’s regulatory authority over the agencies in July 2008.
4. Aggressive lending practices and risky loan purchase practices such as no-doc loans and hybrid loans with low teaser rates that quickly spiked to much higher levels to low-income home buyers. New Century was one of many brokers that kept feeding the securitization machine, which itself was driving profits at big Wall Street banks who purchased and securitized the loans into new financial instruments.
Buyers (other than the Federal Government) Still on the Sidelines
The lack of accountability, and realized downside risk for investors caused a loss of faith in the financial markets. This resulted in a severe loss of liquidity or “credit crisis.” Private equity firms, hedge funds, and other entities have been staying on the sidelines looking for the right market timing to buy distressed assets. These buyers have the market intelligence and financial resources but lack to end-to-end services to take full advantage of the market. There is a need to increase efficiencies, transparency, audit trails, and responsiveness to the market and therefore an opportunity to provide services to buyers and sellers of these assets. There is no fully integrated service provider to the new “opportunity funds” seeking to buy discounted mortgages and related securities that can give them an integrated view of the market and the performance of their assets.
Market opportunity and inflection point
For nearly 100 years prior to 2007, highly integrated firms (Fidelity, First American, Stewart, others) evolved to provide a service chain to origination processes for financial institutions including from credit and collateral valuation including full “appraisals,” automated valuation models (“AVMs”), broker price opinions, (“BPOs,”) to title insurance, flood plain data, closing, escrow, servicing, securitization and sale of these assets. In this counter cyclical market, default processing, loss mitigation, and related services are offered by these firms to loan servicing divisions of banks and others, but there is no full-service end to end company that provides for the needs of private equity firms and hedge funds who have launched “opportunity funds” to capitalize on the market reversal.
These traditional companies are not innovators and do not understand or are incapable of being nimble enough to re-tool their staff, systems, and business model to service this immediate and critical need.
2008 marks an inflection point where new innovative technology, vision and people come together with those with the assets to provide improvements that benefit borrowers and financial institutions. This will also create new market opportunities.
The funds (buyers) have the financial resources and market intelligence to see the opportunity, but lack the ability internally or externally to marshal all the capabilities to take full advantage of the market.
Key components to provide a solution
1. Leadership. A balanced perspective including legislative, industry operations, technology, and process experience from private sector companies will be necessary. A structure that is “rules based” only will be overly burdensome; a technology, operations and process perspective from talented, ethical people who have run businesses will create balance. Key areas we believe will be important are:
a. Operational experience from Wall Street CMBS and MBS at companies like CSFB and Deutsche Bank. Deutsche Bank is now the last financial services firm on the original Wall Street in New York and this is fitting. Its financial and geographic diversity have helped it remain healthy while many U.S. banks have faltered.
b. Experience with enterprise technology used in private sector financial markets, including regulatory compliance and analytics, eCommerce, business process modeling, and other technologies outlined herein.
b. RTC experience. The Resolution Trust Corporation pioneered the use of so-called “equity partnerships” to help liquidate real estate and financial assets. While a number of different structures were used, all of the equity partnerships involved a private sector partner acquiring a partial interest in a pool of assets, controlling the management and sale of the assets in the pool, and making distributions to the RTC. On 9/16/08 House Financial Services Committee Chairman Barney Frank, D-Mass pointed to an RTC like scenario where the federal government may purchase distressed debt and mortgages. However, the RTC was overly bureaucratic, requiring for example five approvers before the author of a one page internal memo could be distributed.
c. Operational experience with asset managers – People who understand REIT, hedge fund, and private equity structures who can coordinate all of the pieces to launch the operation. Recently, our team helped a well-known REIT launch a new fund that invests in distressed sub prime MBSs and CDOs. The team worked with the client to produce the fund documents, coordinate the filings, put the operational and administrative processes into place. The team evaluated and selected a fund administrator, and independent auditor. They ensured smooth service provider selection, day-to-day operations, investor reporting, technology and communications from the fund administrator.
2. Process Innovation. Use of tools that let stakeholders visualize the process, as it is today and how it needs to be changed. Participation in the design of a new process for originating, closing, selling, pooling and securitizing loans will improve it. Participation can be facilitated using readily available techniques and technologies such as business process modeling (BPM).
3. Technology & Operational Process Components
a. Valuation of assets – proprietary methods to value risk, prepayment, default, using analytics
b. Transparency in the pricing & valuation method for loan pools to help buyers and sellers understand how the analytics were used
c. Supporting software systems to show the transparency and due diligence
d. Ability to view the results of the work and assumptions used to validate pricing.
e. Ability to provide regulatory compliance reporting for HOEPA (Home Ownership and Equity Protection Act of 1994), TILA (Truth in Lending Act of 1968, and more specifically Regulation Z of the act), and other existing or new legislation
f. Risk & Loss Mitigation – Technology and people that assesses default, regulatory compliance, and prepayment risk of collateral and loans.
g. Tools for greater return – Experts in software that help increase financial return on real estate assets that can be integrated into existing software to help build a “dashboard” to give updates of the financial state of real estate assets from a facilities management and workplace management perspective.
h. Market making and transaction enablement to provide the underpinnings of a way to create a market to trade mortgage-backed securities and related assets in a transparent way similar to stocks and bonds. Very simply stated, a few components needed would include:
• Integration of federal government systems with private sector funds and systems.
• Online clearing house services and other Internet services
• Online information services such as of approved service provider lists
i. Automated regulatory compliance checks, analytics, and regulatory reporting
Legislative Changes to the System.
High Speed Legislation
Many have already discussed that a Sarbanes Oxley-like “SOX2” will result from legislation in reaction to the recent credit crisis. It would be wise for the federal government to this time mandate improvements for reporting as well as provide incentives for the use of technology as well as standards that enable transparencies by using a paperless approach. SOX lacked clarity on specifics for over a year, which left much to interpretation. New legislation should be enacted quickly, with high technology-like updates and policy releases that add clarity as rapidly as possible. Even small government Republicans will likely agree that since the private sector was responsible in large part for the loss of faith in the financial system, therefore the public sector has had to intervene.
While we are seeing the intervention so far as an injection of capital, legislation cannot be far behind. A few points that should be considered are:
1. Embrace technology. Such legislation should comprehend and open marketplace approach to foster innovation, capitalism, and integration of readily available technologies that can be used immediately, rather than wasting time building them.
2. Clarity between government agencies. Improved clarity and non-overlapping authority between regulatory agencies such as FFHA [Federal Housing Finance Agency, created as the successor regulatory agency from the merger of the Federal Housing Finance Board (FHFB) and the Office of Federal Housing Enterprise Oversight (OFHEO)] and the authority of State Attorneys General (AG) to regulate lending.
3. National standards. Possible consideration of a less complex, nation-wide standard of regulatory compliance to replace the complex web of federal, state, and local laws in place today.
Banks, and in the near to mid-term, the federal government must sell assets. Subsequently, the government will not hold the assets forever and will need to perform their own due diligence. The methods that provide clear audit trail between the logic the buyer and seller used to value the portfolio of distressed assets, the collateral valuation, borrower credit worthiness, risk, and due diligence will need to be provided to a class of customers that traditional companies do not provide.
Initial proof of a system and methodology that can work
A 10,000 loan pool worth $2.3 billion was sold to a private equity firm, using a methodology and software platform that is in development, and it added the transparency that was originally lacking from the pool.
The market for consulting, process, transaction and technology solutions includes:
· Healthy banks
· Private equity firms
· Hedge funds
· Opportunity funds
· Foreign governments & entities
· Depending on pending structures and regulations, taxpayers
A detailed framework that addresses many business, operational, technological, and legal / legislative steps must be hammered out. But here two key components that are needed immediately:
1. Use readily available technology and people who can move quickly to serve the market need and capitalize on this opportunity.
2. Initiate an educational and outreach project to both educate Congressional team members, private equity firms, and others who would like to secure a role as leaders or advisors to help put such a solution together.
3. Provide ways to create greater visibility into the quality of the service provided by the many parties involved in originating, valuing, buying and selling mortgage related securities.
4. Provide greater visibility into the variety and quality of loans available to be purchased and sold.
5. Since it appears that taxpayers will essentially become investors via the federal governments’ direct investment in banks, taxpayers should receive financially transparent reporting from the institutions that hold mortgages and especially mortgage backed securities, commercial mortgage backed securities (CMBS) and collateralized debt obligations (CDOs) based on mortgages. Also, a progress report to taxpayers detailing progress on reporting standards would help improve development of transparency and restore trust.
6. Since the federal government is also accountable, tax laws that allow individuals to deduct up to $3,000 per year capital losses against ordinary income should be revised. That amount should be increased in for the 2008 tax year, considered for extension into 2009, then perhaps reduced in 2010 and adjusted for inflation going forward. This would help investment, which lowers the cost of capital for new ventures. It would also spur consumer spending, giving a jump-start to the economy without the government needing additional artificial stimulus packages.
7. If the TRAP leads to the formation of an entity to acquire, hold and sell assets, it should be organized with a private sector org chart including a strong Chief Technology Officer who can provide vision to enable change and who has an equal seat at the table with operations, finance, risk management, and other functions.
More will need to be done. We will provide updates via our correspondence with several parties, and on our blog here.
Mike Arrigo, Managing Partner of No World Borders was formerly Senior Vice President at Fidelity and First American specializing in eCommerce, regulatory compliance, and efficiencies in financial systems for two publicly traded financial services firms. While there he gained visibility into the top 20 lenders responsible for over 70% of all mortgage loan volume as well as the GSEs. Before that, he was CEO of two venture capital funded start ups and has consulted to financial services, health care, medical device, pharmaceutical, employment and human resources firms, and other industries regarding efficiencies, regulatory compliance, and ways to remove paper-intensive process. He has shared ideas with staff members of Congress and Treasury regarding TARP. His complete bio is available at the No World Borders web site.