Due Diligence and Risk Management Key to Reform of Securitization

Reprinted from the CCH Federal Banking Law Reporter.

Enhanced investor due diligence and strengthened risk management are the keys to the future of "originate and distribute" securitization, in the view of a senior Financial Services Authority (FSA) official. In remarks to the Euro 50 in London, Banking Director Thomas Huertas also said that banks and financial institutions that held senior super tranches and did not distribute them quickly enough took on massive amounts of unmanaged liquidity risk.

The director joined the growing consensus that originate and distribute securitization is here to stay but must be completely overhauled, stating that there is simply no turning back to the world of originate and hold. Analogizing securitization to nuclear energy, he said that its future depends on whether it is effectively managed and regulated.

Credibility

The first thing that must be done, he continued, is to rebuild credibility with investors, which requires enhanced disclosure about the risks of securitization structures as well as information about the performance of the assets underlying the securitization. Although reformed credit rating agencies may endeavor to resurrect their crucial role as validators and evaluators of such information, the director believes that investors will move to a do-it-yourself model of robust due diligence. As part of that effort, they will demand ongoing information from the investment banks that underwrite new securitization issues. And, for their part, investment banks will need to think about how they warrant what they sell.

In addition, it is crucial for banks and other financial institutions to reform their own risk management practices, Huertas said. The most significant problems over the past year have been associated with banks that originated but did not distribute. For example, some banks thought that it paid to keep vast quantities of super senior tranches of securitized deals on their own books, he noted, quantities that amounted to several decades of daily trading volume in such securities.

In Huertas' view, these super senior tranches become the financial equivalent of "hula hoops piled up in the warehouse of a defunct retailer." At the same time, banks were warehousing extensive amounts of mortgages, pending securitization, so that they could save on underwriting fees, thereby taking on massive amounts of liquidity risk. They simply did not distribute quickly enough, said the official, thus effectively taking on inventory risk. Ultimately, the financial institutions either ran out of funding or found that investors did not share their assumptions about the value of the merchandise that they had stockpiled.

In reforming their risk management practices, banks and other financial institutions must above all get two things right, according to Huertas: they must build in the risk that really adverse events can occur; and they must take measures to protect themselves against these realistic disaster scenarios. He advised financial institutions to recognize that their own actions, including their policies with respect to remuneration, can have a material influence on whether they will or will not be subject to really adverse events.

Action Needed Now

In the near term, Huertas called for action on three fronts. He asserted that regulators must:

1. assure that banks keep adequate and better quality capital;
2. assure that banks have adequate liquidity; and
3. commit to intervene promptly when banks veer toward failing to meet these threshold conditions.

According to Huertas, if necessary, governments should pass reform legislation to strengthen the ability of authorities to make such interventions.