(The article featured below is a selection from Subprime, Mortgage and Securitization Law Update, which is available to subscribers of that publication.)

Intertwining of Bank and Securities Activities Strains Risk Management

In the wake of the Gramm-Leach-Bliley Act, Federal Reserve Board Vice Chairman Donald Kohn has noted that large commercial and investment banks have become indispensable to the efficiency and stability of the securities markets. For example, the $2 trillion hedge fund sector is critically dependent on a relatively small number of commercial and investment banks that serve as secured creditors and derivatives counterparties. And, as the financial market turmoil has revealed, banks provide liquidity support to various short-term financial markets, including the commercial paper market.

In remarks at a Fed credit symposium in Charlotte, N.C., Kohn also emphasized that the creation of innovative and complex securitized products has outstripped banks' risk-management capabilities. While securitization can transform illiquid assets into more-liquid securities, he noted, risk managers must be more aware of the ways that securitization can become a drain on a bank's liquidity position in times of stress.

Traditional Risks Take New Form

The Fed official also pointed out that large banking organizations, freed from the constraints of the Glass-Steagall Act, have significantly increased their capital markets businesses, including underwriting securitizations, securities custody, prime brokerage and both over-the-counter and exchange-traded derivatives. They also have made significant inroads into both traditional asset management and the management of hedge funds. Indeed, Kohn observed that the largest commercial banks are now major competitors in many of the business lines historically viewed as the province of investment banks.

For its part, the Fed is reexamining a host of things ranging from Basel II to liquidity to transparency. The Fed wants the Basel II capital requirements raised on specific exposures, such as super senior collateralized debt obligations of asset-backed securities and off-balance-sheet commitments. The central bank also wants to see better disclosures of off-balance-sheet commitments and of valuations of complex structured products.

According to Kohn, the entry of large banks into securitization raises a new threat to financial stability. In part, this threat stems from the complexity of banks' capital markets activity and from the services that banks provide to the asset-management industry, including hedge funds. Traditional risks, such as liquidity and concentration, have appeared in new forms.

Due Diligence

Kohn also emphasized the need for increased due diligence for both banks and investors who, according to Kohn, must devote more effort to due diligence when investing in complex securitized products and also avoid relying so heavily on credit rating agencies to do all their homework for them. As institutional investors fueled securitization by demanding fixed-income securities, said Kohn, they should have done better due diligence on the subprime risks they were taking on, but they largely failed to do so. The Fed official speculated that these investors relied on inadequate credit rating agency analyses or simply misunderstood the risk of very complex securities.

Another change affecting financial stability is the growth of services that banks provide, including running their own asset-management businesses and providing prime brokerage services to hedge funds. He urged banks to manage the reputational risks of their asset-management businesses.

Because institutional investors are naturally sensitive to the reputation of their asset managers, he reasoned, losses elsewhere in the bank can be compounded if they leave the bank's asset-management business exposed to a flight of business and a sharp reduction in fee income. Moreover, an increase in the business that banks do with hedge funds leads to an increase in the attention that banks must pay to counterparty risk management.

Reforming Securitization

A major cause of the market turmoil is that a good part of the risk associated with the securitization of subprime mortgages was not distributed into the market but instead was retained by banks. The most glaring example is their exposures to super senior tranches of collateralized debt obligations (CDOs) that had invested in subprime mortgage-backed securities. One reason for this was the decision of underwriters to retain some of the super senior exposure, in some cases reportedly because they met some resistance when they attempted to sell them at very slim spreads. The underwriters evidently misjudged the risk of those positions, Kohn posited, often because they relied too heavily on external triple-A ratings.

Further, while the originate-to-distribute model aims to move exposures off of banks' balance sheets, noted Kohn, there is the liquidity risk that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. And even when banks did distribute exposures, they did so to various off-balance-sheet financing vehicles in which they retained contractual and reputational liquidity exposures.

Kohn called on financial institutions, as part of reforming securitization, to enhance risk management comprehensively across business lines and fully integrate risk management into the decisionmaking of senior management. Self-interest provides a strong incentive to improve risk management, he said, but better risk management at the largest banks would also benefit the broader financial system.

Banks must also improve their management of counterparty risks. During the financial market disruptions surrounding the hedge fund Long-Term Capital Management, counterparty risk was a central concern. Subsequently, the Counterparty Risk Management Policy Group, headed by former Fed official Gerald Corrigan, developed a set of best practices for counterparty risk. While these efforts helped prevent serious losses from defaults of hedge fund counterparties in the recent turmoil, banks do not appear to have followed the best practices for their counterparty relationships with financial guarantors, where counterparty risk has crystallized into large losses.